Co-written 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.
Follow Phil Angelides on Twitter: www.twitter.com/PhilAngelides
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I'm not sure how - if he's so freaking smart - he "missed" that when any appraiser could have told you that in some areas, home prices were going up anywhere from 15 to 40% PER YEAR. Historically, homes have appreciated at 3% on average.
And the "smart bankers" somehow managed to "miss" this fact?
Seriously, I saw this back in 2000 when I bought my home, and my next door neighbor appraiser kept telling me over the next 6 or 7 years how prices were "going crazy" in some areas (15 to 40% - per year). How do you NOT see that if you're in the banking business? He didn't know a bubble when he saw one?
I don't think those guys are all that smart. They just have huge egos, and a love of money.
The bottom line is that Jamie Dimon and the other big bank CEOs want a free reign. And they realize that they are large and powerful enough that if it goes terribly and hugely wrong the US taxpayer will be there again with an open checkbook. Sure, someone like Jamie Dimon might be canned but he will collect tens of millions in severance on his way out the door.
He is not the Wizard of Od, he is the Alien that wants control of the world.
"Banking," "Insurance," and "Finance" are three mutually inter-dependent lines of business. All three must exist. All three have opposing business objectives. None can survive without the other two. Yet, in order for any of them to survive, they MUST NOT be interlinked.
When the three are held separate, as Glass-Steagall did, they form an immovable tripod. You know what they say about a three-legged stool.
Bind them together, and you have a pole that is constantly pulling itself to the ground, first this way then that way.
What happens next? Easy: FRAUD. Constant fraud. Swindling, securities fraud, cheating, extortion, bribery, usury. The system literally consumes itself. One branch of the company is literally gambling against another branch of the same company. I submit that it cannot be otherwise, because, if the pole cannot stand upright, you must weave ever-more elaborate illusions to pretend that it does.
Regulators and lawmakers get caught up in it, too. Like the magically-cursed pair of dancing shoes of many a cautionary parable.
If it was purely a game of chance; then players would just go to Vegas and gamble there. Derivatives are a means of transferring risk between someone who is willing to accept the risk (at a cost) and someone who is not. By definition, all risk involves an element of chance. For example, if someone (ie the long party) was willing to invest in his belief that housing prices would rise and another party (the short) was willing to invest in his belief that housing prices would fall; then matching both parties up with a derivative ultimately resulted in the transfer of money from the stupid/unlucky long party to the smart/lucky short party. The advantage to society in general was that the derivatives long party’s misplaced faith in the housing market did not contribute to the vast numbers of unsaleable vacant houses that we have now. Problems arise with derivatives when they are purchased on credit and the losing party is unable to pay. However, this a potential problem with all investments made with borrowed money - just ask all the individual mortgage holders who are unable to repay their long investments (mortgages) that they made with borrowed money when they bought their homes during the bubble.
Which one of them is feeding those horses, or caring for them?
Furthermore: you can be 100% sure that the "vast number of unsaleable vacant houses that we have today." They were built on speculation, from artificially stimulated demand also based on speculation.
=All= derivatives are purchased "on credit."
Today, we have millions of foreclosed houses, and NO IDEA who actually owns those mortgages! But bankers don't even mind: wanna buy a "mortgage-backed derivative security?" On sale today!!
"Extraordinary Popular Delusions and The Madness of Crowds" has been continuously in-print for more than 120 years and it is just as apropos today as it was a century ago.
Then, as now, don't suppose that lawmakers and regulators don't get caught-up in the whole thing, because they do. ESPECIALLY them! Because they have the power to control it, and thus, because of that power, to grow especially and more-rapidly wealthy (sic) thereby.
Polonius
This is a frequently repeated distortion. The Federal Deposit Insurance Corporation is funded by levies paid by the banks themselves - not by the government or the taxpayers. Any money paid out to the depositors of failed banks comes from the banking industry’s own insurance payments. If the FDIC needs additional funds to meet its obligations; they can and do go back to the banks for more money.
You can review the role of the FDIC at their official website: http://www.fdic.gov/about/learn/symbol/index.html
quotes:
“The FDIC receives no Congressional appropriations – it is funded by premiums that banks and thrift institutions pay for deposit insurance coverage and from earnings on investments in U.S. Treasury securities. The FDIC insures more than $7 trillion of deposits in U.S. banks and thrifts – deposits in virtually every bank and thrift in the country.”
“The FDIC insures deposits only. It does not insure securities, mutual funds or similar types of investments [ie derivatives] that banks and thrift institutions may offer.”