May 21, 2012 – Op-Ed by Phil Angelides featured in the Huffington Post and co-authored by Bart Dzivi.
Jamie Dimon was hailed as the wizard of Wall Street. Until the revelation of JPMorgan Chase’s disastrous derivatives bet, he was the man who supposedly could do no wrong. He had sailed through the storms of the worst financial crisis in eight decades, suffering neither the securities losses that sank Lehman, nor the credibility losses that wounded Goldman Sachs. The House of Morgan — which had been dismantled by the Glass-Steagall Act in the 1930s — was being remade, in Dimon’s image, into a trillion dollar plus colossus, striding across the globe. But, alas, even wizards are not all powerful, not in Oz and not when trading in financial derivatives.
Banking in the United States is a heavily subsidized industry. The two primary and on-going sources of subsidy are the insurance of deposits, backed by the full faith and credit of the United States, and access to extraordinarily cheap money from the Federal Reserve. And that doesn’t even count the trillions of dollars showered on banks to keep them afloat during the financial crisis. The policy rationale for providing these subsidies is not to enrich bankers, but to provide support to a banking system that fuels the economy through lending to productive businesses and consumers. Speculating on derivatives may provide liquidity for the financial markets, but it is not an endeavor that is worthy of federal financial assistance.
The Volcker rule, as it was initially envisioned and before it was pummeled by Wall Street’s voracious lobbying assault, was designed to distinguish between financial activities that merit subsidy and those that do not. Making a loan to an entrepreneur who wants to start a hardware store on Main Street is worthy of subsidy because small businesses cannot directly access the financial markets and the extension of credit to deserving enterprises is a path to expanded economic opportunity and greater prosperity for the country.
Betting on financial derivatives, where one party is long the contract, and another party is short the contract, is not an activity that can credibly lay claim to public subsidies. It does not expand capital access for businesses that put people to work and provide goods and services to the economy. It is simply a zero-sum game of chance dominated by a handful of giant banks. According to the Office of the Comptroller of the Currency, at the end of 2011, just five banks — JPMorgan Chase, Citigroup, Bank of America, Goldman Sachs, and Morgan Stanley — held 95% of the $304 trillion in derivative contracts held by U.S. bank holding companies. JPMorgan alone has a derivatives book with a notional value that is about five times larger than the gross domestic product of the United States. It is a big business for these banks and that’s why they have used their immense political and financial power to block the enactment of a strong Volcker Rule and new regulations to rein in reckless derivatives trading — leaving our financial system and the global economy still dangerously exposed to risk four years after the financial meltdown of 2008.
Unless the derivative portfolios of the big banks are dramatically reduced, regulated, and put on exchanges, it is not a matter of if one of them will fail, it is a matter of when — with potentially catastrophic consequences for the financial system as a whole given the scale of these banks and the size of their derivatives positions. These highly leveraged institutions are likely to suffer severe losses at some point because of the risks of the instruments in which they are trading and because of the financial incentives that still exist today to make outsized, risky bets. In the absence of real reform of bank executive compensation practices, the risk reward ratio for unbridled speculation remains asymmetric: heads, the banks win; tails, the taxpayers lose. The head of JPMorgan’s chief investment office that caused the $3 billion-and-counting losses made $14 million in 2011, while Dimon himself has been awarded a $23 million pay package. Whom the gods would bring down, they would first reward with eight-figure bonuses and stock grants. Now that the bank’s trades have now gone so terribly wrong, will Dimon and the others responsible see their winnings clawed back? Don’t hold your breath.
All of the five behemoth banks rely on sophisticated financial models to gauge their trading risk. However, time and time again, these models have proven to be woefully inadequate in modeling human behavior, recognizing that the marketplace often defies neat statistical patterns, and predicting the black swan events that inevitably shake the financial markets. When Paul Volcker spoke to the Financial Crisis Inquiry Commission of “the hubris of financial engineers,” he undoubtedly had in the mind these models, which bankers construct to rationalize the risky behavior that led to the financial crisis and that evidently persists today.
Mr. Dimon undoubtedly thinks these losses are a one-off event. He apparently blames the losses on a poorly designed financial model and poorly executed trades. That view not only displays a deeply ingrained hubris about Wall Street’s power to master the universe, but it also just plain wrong. It is endemic to the business of trading in exotic financial derivatives that there will be outsized and unexpected losses. It’s a business in which banks simply don’t belong.
Instead of paying millions for a new financial model to justify a new round of speculation, and tens of millions more to bottle up the Volcker rule and derivatives regulation, Mr. Dimon should call former Citigroup Co-CEO John Reed and ask him to lunch. A once reigning wizard of Wall Street who helped engineer the repeal of Glass-Steagall at the end of the last century, Mr. Reed now understands the necessity of the Volcker rule and the utility of modesty — two subjects about which Mr. Dimon still has a few things to learn.
Phil Angelides served as Chairman of the Financial Crisis Inquiry Commission, which conducted the nation’s official inquiry into the financial and economic crisis. He previously served for eight years as California’s elected State Treasurer. Follow him on Twitter: @PhilAngelides.
Bart Dzivi was Special Counsel to the Commission and previously served as Counsel to the U.S. Senate Banking, Housing, and Urban Affairs Committee.