Tuesday, May 15, 2012

JP Morgan Chase Loses $2.3B - Why We Care

About 80 years ago we learned a valuable lesson about banking: Greed is Bad.  Back then, there were no federal or state regulations separating commercial banks (banks like Wells Fargo, Chase, CitiBank, Bank of America, Commerce Bank, etc.) from investment banks (banks like Goldman Sachs, Morgan Stanley, Lehman Brothers, etc.).  This set the stage for a situation more predictable than a Tyler Perry movie; commercial banks started to act like investment banks, who, for all intents and purposes, are the crack heads of the financial world.   What I mean by that is, commercial banks joined forces with investment banks (and in some cases they morphed into investment banks like Agent Smith) and started using the money in their vaults for risky investments on Wall Street.  This posed one slight problem: commercial banks hold the personal checking accounts and savings accounts of everyday people.  Because there was no division between the two banking systems, when the Wall Street investment banks lost all of their money at the blackjack tables, they took the commercial banks right along with them. Millions of people who had nothing to do with the high-risk stock market had their entire life savings wiped out.  And that, ladies and gentlemen, is how, in 1929, unregulated Greed created the Great Depression. What's worse is that the everyday people who lost their life savings in commercial banks back then didn't even understand why it happened.

Enter Glass-Steagall, stage left.

In 1933, as a direct response to the foolishness described above, Glass-Steagal was passed by Congress setting up the FDIC (the federal government insures your bank account for up to $250,000) and, more importantly, creating a legal barrier between commercial banks and investment banks. Investment banks were free to do whatever they wanted to do, but if you were a commercial bank then, from that day forward, you were forbidden from going to the casino with the average Joe's personal savings or checking account.  Because of this change, our economy slowly recovered and life moved on.  And for a while, things were looking fine...until one fateful day in 1999, Republican Senator Phil Gramm and Republican House members Jim Leach and Thomas Bliley passed the Gramm-Leach-Bliley Act which was signed into law by then Democratic President Clinton.  The Act specifically repealed Glass-Steagall's separation of commercial banks and investment banks. 9 short years later...well, you don't need me to tell you what happened next because we're still living it.  The point is this: allowing commercial banks to behave like investment banks is like giving Lindsay Lohan the keys to your brand new car.  Just as we should not be surprised if (when?) Lohan gets wasted and wraps the car around a tree, we should likewise not be surprised when JP Morgan Chase -- America's largest commercial bank -- loses $2.3 Billions dollars on risky investments.



It would appear that the masters of the universe are at it again (did they ever really quit?). 

WHAT HAPPENED?

When they're not nickel-and-diming us to death with $5 penalty fees that they've completely conjured out of thin air, commercial banks typically make their money by either (A) making loans and collecting interest on the loan payments or (B) investing in securities.  The story with JP Morgan Chase involves the latter.  When Glass-Steagal was in effect, commercial banks used to play it safe by investing in low-risk government bonds, such as U.S. Treasury Bonds.   After Glass-Steagal was repealed, commercial banks have decided to live life on the edge and have gone after the big money.  Instead of investing in government bonds, JP Morgan Chase decided to invest a large amount of its money -- $62 Billion to be exact -- in corporate bonds.  Although it's a relatively higher risk than investing in government bonds, investing in the bonds of corporations is not exactly like betting all of your money on horse #9...if you do it in moderation.  The key word being "moderation."  JP Morgan Chase, however, bet about 17% of their $380 Billion portfolio on these corporate bonds.  By comparison, corporate bonds only make up 4% and 1% of CitiBank's and Bank of America's investment portfolios, respectively.

In order to "hedge" or protect themselves against any potential loss, Chase took out what are known in the financial industry as Credit Default Swaps.  Don't let this term scare you, it's just a fancy way of saying "insurance."  Whenever banks make a risky bet, they take out insurance on the bet just in case they lose.  What was unusual about this particular transaction is that Chase then took out insurance on their insurance.  They hedged against their own hedges.  Somewhere in the middle of all that cross-mojonation and new math they lost at least $2.3 Billion (possibly as much as $4 or $5 Billion) when the corporate bonds they originally bet on (but then bet against...but then re-bet on?) actually defaulted.  In addition to losing $2.3 Billion, the blunder also caused Chase's stock to plummet over the weekend costing shareholders Billions of dollars.


WHY DO WE CARE?

Normally we wouldn't care.  After all, a $2 Billion dollar loss to JP Morgan Chase -- a Bank which netted a profit last year of nearly $19 Billion and which also has over $2 Trillion in assets -- is something that it can absorb easily.  The take away from this loss, however, is bigger than the dollar value.  We should all care about this case because JP Morgan Chase is a commercial bank just like the one where you and I currently deposit our paychecks or whatever money we're lucky enough to have at the moment.  They only lost $2 Billion this time. Next time...who knows?

Chase's CEO Jamie Dimon has been making his case in the court of public opinion lately that America's banking system doesn't need the new Dodd-Frank banking regulation that was passed by Congress and signed into law by Obama in 2010.  In particular, Dimon has been extra critical of the so-called "Volcker" rule (named after Fed Chairman Paul Volcker) which would bring back Glass-Steagal's separation of commercial banks and investment banks.  Under the Volcker rule (which is set to go into effect this summer), many experts assert that the precise problem that happened to Chase here would not have been allowed.  While there is still some debate on the merits of that claim, the undeniable fact remains that JP Morgan Chase's loss lets us all know that commercial banks are still making big gambles with our bank accounts - which, by the way, is a gamble with our tax dollars at up to $250,000 per person.  In other words, even after the worst recession since the Great Depression, it's still business as usual on Wall Street.



QUESTIONS:
1. Did the Occupy Wall Street folks have it right?
2. Does too much regulation stifle the business activities of big banks and big business?
3. Would a 2nd Term of Obama help or hurt this situation?
4. Would a Romney presidency help or hurt this situation?
5. Should somebody be going to jail for these kinds of things?
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