Macey’s Apologia for JPMorgan’s “Hedginess”
By William K. Black
Jonathan Macey is one of the world’s most vitriolic opponents of effective financial regulatory cops on the beat. Those regulatory cops on the beat are essential to prevent a Gresham’s dynamic. When cheaters prosper markets become perverse and bad ethics drives good ethics from the markets. Macey’s argument relies on his assertion that we do not need financial regulators because he asserts that the industry is self-correcting because its officers are reliably dedicated to the interests of its customers due to their desire to maximize their executive compensation. His desired anti-regulatory policies have by and large triumphed over the last 30 years, producing the increasing criminogenic environments that drive our recurrent, intensifying financial crises. His assertions have been repeatedly been falsified by reality in those crises, but the worse his predictions fare the more dogmatic and snide he becomes in attacking those whose predictions have proven correct.
Macey writes periodically as a reliable apologist for the one percent in the Wall Street Journal. His latest piece decries the criticism of JPMorgan’s proprietary derivatives trading and the evisceration of the Volcker rule through JPMorgan’s successful lobbying with two groups that Macey concedes to be “captured” by the finance industry – the Federal Reserve and the Treasury Department.
Macey inhabits an alternate delusion in which his dogma creates a faith-based “law and economics” that displaces reality. This makes his columns exercises in “truthiness” – the assertion of non-facts as if they were facts because he really wishes they were facts. I explain why his column decrying the (fictional) imminent criminal prosecution of Jamie Dimon, JPMorgan’s CEO, represents the intersection of truthiness and “hedginess.”
Macey accuses (unnamed) regulatory villains of “hysteria” based on fiction rather than facts, but it is Macey who is guilty of both abuses. His May 14, 2012 column is entitled: “Losing Money Isn’t a Crime.”
“Regulators, politicians and news reporters are hysterical at the news of J.P. Morgan’s recent $2 billion trading loss. The Securities and Exchange Commission is investigating to see whether laws were broken.
We appear to be on the verge of making it a crime for a business to lose money.”
Well, no, actually none of them have been “hysterical.” The SEC is, as Dimon said they should, (finally) looking at what happened that caused the $2 billion loss at JP Morgan. There is no indication that the SEC is “on the verge of making it a crime for a business to lose money.” The opposite is true. Federal financial fraud prosecutions during the Bush administration fell by over one-half compared to 20 years ago – and prosecutions have declined under the Obama administration. Indeed, the Wall Street Journal ran a story the same day as his column noting that the Department of Justice is so embarrassed by its failure to prosecute elite financial frauds that it no longer even keeps statistics on such prosecutions.
Hedge accounting is infamous as a fertile territory for accounting fraud. We found that a very large Midwest savings and loan was claiming that speculative investments that suffered large losses were “hedges.” The accounting abuse hid the S&L’s insolvency. In 2003, the SEC found that Fannie and Freddie had engaged in accounting abuse of purported hedges for the purpose of manipulating reported income so that the senior managers could maximize their bonuses. The Department of Justice failed to prosecute and the new senior managers continued to engage in accounting fraud until their frauds destroyed Fannie and Freddie. There are excellent reasons to investigate losses involving asserted hedges – and the problem is the Justice Department’s failure to prosecute such accounting frauds. A prosecution in 2004 might well have prevented the failures of Fannie and Freddie and prevented hundreds of billions of dollars of losses.
Macey repeatedly goes to extremes that Dimon has retreated from after recognizing that his positions were false and indefensible.
“The truth is that nobody should care about J.P. Morgan’s loss—nobody except J.P. Morgan stockholders and a few top executives and traders who will lose their bonuses or their jobs in the wake of this teapot tempest. The three executives with the closest ties to the losses are already out the door.”
Macey starts by defining the “truth” as representing his views on a subject. That kind of circularity signals the weakness of his unsupported assertion. We should all “care” about a loss of this nature, and regulators should “care” urgently. We should care because the purpose of the Volcker rule is to prohibit precisely the kind of speculative position in financial derivatives that JPMorgan took. JPMorgan claims that it is free under the regulations proposed to implement the Volcker rule to purchase unlimited amounts of financial derivatives – as long as it calls them “hedges” even though they are not hedges. That interpretation would make the Volcker rule useless because it could not be enforced. Any bank could evade the rule by simply calling its derivatives hedges.
We should “care” about rendering the Volcker rule unenforceable because it was holding or issuing large amounts of toxic financial derivatives (“green slime”) that caused hundreds of billions of dollars of losses to financial institutions, trillions of dollars of losses to the household sector, and contributed to the failure of at least eight systemically dangerous institutions (SDIs): Bear Stearns, Lehman, Merrill Lynch, AIG, WaMu, Wachovia, Fannie, and Freddie. These SDI failures were important triggering events for the global financial crisis. We should all care that the SDIs have used their political power and their influence over the Federal Reserve and the Treasury Department to delay and weaken rules essential to prevent a replay of the investments in the toxic financial derivatives that drove the most recent crisis. The regulators should “care” on an urgent basis about JPMorgan’s massive losing investment in financial derivatives and should act to ensure that the rules ban such investments.
The fact that three employees are leaving JPMorgan (perhaps with large golden parachutes) tells us very little. None of us can know without an investigation whether they were the ones who should be held accountable for the managerial failures, the losses and (if the investigation finds such facts), any violations of accounting, reporting, or securities disclosure obligations.
Macey now launches a bizarre conspiracy theory.
“It is no coincidence that all of the hue and cry over this loss is being made just when regulators are on the verge of issuing their final interpretation of the so-called Volcker Rule, which makes it illegal for banks to take proprietary positions in securities. Perhaps the outcry over J.P. Morgan’s trading losses is an effort to create the crisis atmosphere needed to succeed in making the final version of the Volcker Rule extremely rigid. Politicians already are using the loss as a pretext to regulate. Congressman Barney Frank even went on TV to say that he hopes the final version of the Volcker Rule will prevent the kind of trading that led to the massive loss at J.P. Morgan.”
Actually, it is wholly a “coincidence” from the standpoint of the critics that “all of the hue and cry over this loss” is being made on the verge of issuance of the final Volcker rule. The decision to make the speculative investment in derivatives and the timing of that investment was solely that of JPMorgan – not the critics. Dimon made the decision weeks ago to dismiss the importance of JPMorgan’s surging losses in its huge speculative position in financial derivatives as “a tempest in a teapot.” Indeed, Dimon has apologized for his behavior. The losses were disclosed only on the “verge” of the issuance of the final Volcker rule solely because Dimon deliberately delayed the disclosure for weeks.
Representative Frank should be commended for expressing his support for the issuance of a final rule that meets the intent of Congress to prevent a recurrence of the catastrophic losses the SDIs suffered from financial derivatives. Macey criticizes Frank on this basis:
“Mr. Frank neglected to mention that J.P. Morgan was hedging. The sole purpose of hedging is to reduce risk. The particular trades that J.P. Morgan was making were designed and intended to protect the bank’s balance sheet against losses from its exposure to the apparently increasing risk of some of its European assets, including approximately $15 billion in European distressed debt.”
Macey present these claims as if they were undisputed facts. They are not, and (1) they are highly unlikely to be true and (2) if they are true then JPMorgan is engaged in unsafe and unsound practices and its regulators should order an immediate halt to such practices. We need to begin with uncertainty. One of the grave dangers demonstrated by the current crisis was the opaqueness and fragility of “markets” for over the counter (OTC) derivatives – the kind of derivatives that caused JPMorgan’s losses. None of us know without a high quality investigation what actually occurred. What we do know is that banks often call bad investments “hedges.” Officers who make bad investments have strong, perverse incentives to claim that they were hedges. We do not know whether JPMorgan’s losses came from financial derivatives they intended to function as hedges and we do not know what they were supposed to hedge. We also do not know whether the purported hedge changed over time. We also don’t know whether the game at JPMorgan was to speculate by taking large positions in risky financial derivatives while claiming that the speculative position was really a hedge against something – anything. Any trader in a bank the size of JPMorgan with massive holdings of financial derivatives can easily gin up an explanation of why any particular derivative could be a hedge against losses in some portion of JPMorgan’s vast portfolio of investments.
What we can know without further investigation is that JPMorgan’s claim that it purchased over $10 billion dollars of complex derivatives of derivatives (an index of credit default swaps (CDS)) to hedge “$15 billion in European distressed debt” is nonsensical. Such indices do not constitute hedges against “European distressed debt.” Under accounting rules, a hedge must have a demonstrated relationship to the investment that is to be hedged and that relationship must tend to offset losses. The bank also has to monitor the hedge to see that it actually performs in general accordance with its historical pattern. If the monitoring demonstrates that the hedge is not performing the bank is required to cease treating it as a hedge and recognize losses.
There are two additional questions that arise from Macey’s version of the facts. Why does JPMorgan have “$15 billion in European distressed debt” in its investment portfolio? Why hasn’t it sold these troubled assets and contained its losses? The second question arises from a factual claim that Macey made in this passage:
“Moreover, since the trades were part of a hedging strategy, the $2 billion decline in the value of the investments that constituted the hedge must be balanced against gains in the assets against which they served as a hedge. While we don’t know the exact amount of these gains, J.P. Morgan has reported that there were such gains, and that the ultimate loss likely will be about one-half of that reported.”
This story Macey tells makes no financial sense. The last six weeks have been terrible for “European distressed debt.” JPMorgan should have suffered large losses, not a billion dollars in “gains”, on its European distressed debt and those losses should be growing. Those losses should be in addition to the $2 billion in losses in the “hedginess” investment in the CDS index. But that points to a further reason that JPMorgan’s “hedge” story rings false. Remember, the root concept of a hedge is that the values of the two investments tend to move in the opposite direction (negative correlation) so that losses in one asset are offset by gains in the hedge asset. If “European distressed debt” fell in value, however, what would we expect to happen to the value of CDS – which have large exposure to European debt? We would expect the CDS to also fall in value – we would expect a positive correlation. That means that we would expect the faux hedge to increase the losses in the “European distressed debt” rather than to offset those losses. The expected positive correlation provides an additional reason why the “hedge” story told by Macey and JPMorgan makes no sense.
The first sentence of the passage I quoted above reveals Macey’s startling naiveté about “hedginess” and accounting and securities scams and about the reliability of JPMorgan’s hedging claims.
“Moreover, since the trades were part of a hedging strategy, the $2 billion decline in the value of the investments that constituted the hedge must be balanced against gains in the assets against which they served as a hedge.”
In a word: no. Because a bank calls a trade a hedge it does not follow that the “decline in the value of the … hedge must be balanced against gains in the assets which they served as a hedge.” Macey is so impassioned an apologist for Dimon that he has assumed his answer – he has not only assumed a hedge, he has assumed an effective hedge. A faux hedge can lead to losses in both the asset purportedly being hedged and the asset purportedly purchased as the hedge. This happened at Fannie Mae and Franklin Savings. It is almost certain to be happening at JPMorgan because the value of their “European distressed debt” should have been falling, and that fall should be continuing.
The CDS indices pose special risks because there is no real secondary market for such OTC derivatives. If the purported “hedge” does not perform and the bank has to unwind its faux hedges it may suffer severe losses.
Bottom line, the “hedge Europe” story makes no financial sense. The financial derivatives JPMorgan purchased could not meet the requirements for real hedges before they were made, did not demonstrate reliable hedging performance after they were made, and could not be sold without potential severe losses when they failed to hedge. The CDS index investments were not in fact “hedges.” They were not even close to being hedges. Is it conceivable that the JPMorgan traders failed to understand that the CDS index investments were not hedges. If that is the case they are so incompetent that they do not hedge, but rather invest in “hedginess” – assets that they wish served as hedges. The regulators need to shut down JPMorgan’s investments in financial derivatives if they cannot distinguish real from faux hedges. It is far more likely that the JPMorgan traders were making a speculative investment in the CDS index derivatives and that the “hedge Europe” faux hedge was a cover story for the regulators.
Macey then moves to his conclusions based on these failed analytics. His first conclusion is bold: “Thus, far from serving as a pretext to justify still more regulation of providers of capital, J.P. Morgan’s losses should be treated as further proof that markets work.” The “markets” for financial derivatives destroyed the global economy and caused the Great Recession. Macey has airbrushed out of history the orgy of green slime that the markets blessed and called “AAA.” JPMorgan’s losses, at this juncture, do not pose any critical threat to the bank. Its speculation in financial derivatives under the fig leaf of “hedginess” will, however, destroy the firm if it continues and the government will bail it out.
Macey’s second conclusion says it’s all a learning experience.
“J.P. Morgan and its competitors will learn from this experience and do a better job of hedging the next time. They will learn because they have to: In the long run their survival depends on it. And in the short run their jobs and bonuses depend on it.”
Macey’s conclusion has been falsified repeatedly by history. “JPMorgan and its competitors (1) largely did not hedge their green slime, (2) their financial derivative holdings generally got worse, not better over time, (3) when they did partially hedge they took excessive counter-party risk and, absent a bailout of AIG, would have suffered severe losses. Their survival did not depend on competence. Citicorp and Bank of America’s senior managers were extremely poor – but they were systemically dangerous institutions so we bailed them out. Their bonuses created the perverse incentives that make green slime dominant. As George Akerlof and Paul Romer explained in 1993 in their article entitled “Looting: the Economic Underworld of Bankruptcy for Profit” – accounting fraud is a “sure thing” guaranteed to make the senior officers wealthy. The bank may fail, but the senior officers walk away wealthy.
Macey’s third conclusion is that the government does not learn: “J.P. Morgan lost $2 billion. They’ll learn from experience. Regulators rarely do.” Except, it was the regulators who warned repeatedly against the green slime and it was the banks that overwhelmingly refused to learn. It was the government that learned the lesson and passed the Volcker rule and it is the largest banks, led by Dimon, who are eager to continue to take the speculative position in derivatives that caused the global financial crisis. Dimon, and Macey, are furious at the people in government who have learned. Dimon and Macey are the people who failed to learn from the global crisis.
Macey’s final conclusion is that everyone in government is despicable.
“The second lesson from J.P. Morgan’s failed hedging effort is that politicians and regulators are opportunists who will use any pretext to increase their power and influence.”
I do not believe that Macey has ever been a regulator or understands that people who work for the government actually try to serve the public and prevent crises. I challenge Macey to read the literature on our response to the S&L debacle and then explain how we were incapable of learning or sought only to increase our power rather than to seek to contain the elite frauds. I’ll be happy to serve as his guide to talk with people who heard Ed Gray and Joe Selby predict that their reregulation efforts would lead to them being unemployed and unemployable – and continued to do their duty.
JPMorgan runs a gigantic proprietary trading operation in financial derivatives – not a “hedging” operation. The financial world understands this.
If he were to back away from Dimon’s posterior, it is possible that Macey would take advantage of his broader view to note that the systemically dangerous institutions like JPMorgan have immense economic and political “power and influence” and enjoy such large explicit and implicit federal subsidies that they represent the American version of crony capitalism. Macey continues to be one of the leading anti-regulatory architects of the criminogenic environments that drive our recurrent, intensifying financial crises and enshrined crony capitalism. As his predictions and policies are repeatedly falsified he has responded by becoming ever more dogmatic.