05/12/2012 02:52 pm ET Updated Jul 12, 2012

Thoughts on the Big JP Loss

I've been waiting to learn more about the big JP Morgan Chase loss -- $2 billion and probably growing when a derivative bet went bad -- before writing about it. So after perusing this AMs papers, here are some thoughts:

What happened?

The bank invested in corporate bonds, then bought insurance as a hedge against losses on the bonds. The form of these insurance policies are those good old credit default swaps (remember them from the meltdown days?) where JP makes bets with other banks that pay off if the underlying bonds go bad.

Now, here's where the trouble starts. They then added another level of hedging, essentially selling insurance policies on the first hedge. So now, if the firms backing the bonds do badly and the bonds default, JP is covered by hedge #1. But under hedge #2, as long as the companies covered by the insurance do well, JP collects insurance premiums from investors betting the other way.

The bet on the second hedge grew so large that other banks recognized that if the economy were to look a bit more shaky, the underlying CDS index could flip and JP could lose big. Remember, these are derivatives -- securities whose value is tied to a price. So for JP to lose money on hedge #2, they don't have to actually pay out like a real insurance company. They just have to make a wrong bet of the direction of the index.

JP had such large bets of hedge #2, that counterparty banks recognized they would be cornered if the CDS index spiked. And that's just what happened.

Will JP need another bailout? Are we headed back into another financial recklessness-induced recession?

Though the extent of the losses are not yet know, that's not likely. JP appears to be handily able to cover the losses. Of course, we should not forget the reason they're back in the black had a lot to do with $95 billion in bailout funds from the TARP, which they've since paid back.

What does this say about financial oversight reform? Would a fully implement Dodd-Frank bill have prevented this loss?

That's the most interesting part of this. The answer to the second question is not entirely clear, though I think, if the rules were properly implemented and enforced, Dodd-Frank would have prevented this outcome. Hedge #1 would probably be legit but hedge #2 -- the one that blew up -- looks more like the type of proprietary trading the Volcker rule is intended to block. (The usually careful and reliable Allen Sloan gets this wrong today -- the facts of the case and the magnitude of the losses aren't even known yet and he's somehow determined that the case proves we don't need the protection of a Volcker rule.)

It's also possible that under Dodd-Frank transparency rules regarding derivative positions, market participants and more importantly, regulators at the Federal Reserve, would have seen that one bank -- actually one trader at one bank -- was getting cornered such that a reversal in the index had the potential to cause sudden and systemically dangerous losses.

But the fundamental truth here is the one known since Adam (Smith, that is) and amplified by the great financial economist Hy Minsky: humans underprice risk. Their proclivity to do so increases as the business cycle progresses and confidence takes over (remember, JP's bet was unwound by the fact that the economy wasn't as strong as they thought). The advent of a global derivatives market with notional trades in the trillions greatly amplifies the risks.

The fact that humans like Jamie Dimon -- he who presided over JP's self-proclaimed "fortress balance sheet" -- he who inveighed against financial reform as imposing unnecessary oversight on such skilled risk managers as he and his staff -- fall prey to this fundamental truth only underscores the lesson of this episode in financial hubris.

And that is this: financial markets are inherently unstable. They will neither self-correct nor self-regulate. Their instability poses a threat to markets and economies and people across the globe. Therefore, they need to be regulated. That's not to say that anyone knows the best way to do this yet in order to balance the necessity of oversight with the dynamics of the markets. We don't know where to set the speed limits. It must be an iterative process.

But we do know they need to be set, and JP's loss should be taken as a warning that our tendency is to set them too low. And it should be taken as an even bigger warning against positions like that of Gov. Romney that Dodd-Frank should be repealed.

This post originally appeared at Jared Bernstein's On The Economy blog.