05/17/2012 02:53 pm ET Updated Jul 17, 2012

A Quick Word on JP Morgan's "Hedge Gone Wrong" -- Was It a Euro Election Bet?

Perhaps the most revealing aspect of the $2.3 billion loss disclosed by Jamie Dimon last week after the U.S. equity market closed is that it may have been incurred using the bank's "excess deposits" -- namely the balance of customer funds that exceeded the banks loan portfolio.

What that means is that instead of using these funds to loan out to America's large and small businesses that are screaming for capital, or homeowners anxious to refinance their mortgages at historically low rates, JP Morgan was using these funds in its own terms to hedge against risk of loss in its existing loan portfolio.

Ironically, it now appears that it might have actually been LESS RISKY for the bank to loan some or all of the excess of deposits -- totaling $300 billion, $100 billion of which was tied up in this particular trade according to press reports -- out to worthy borrowers rather than play counter-positioned games in the non-cleared (i.e., opaque) shadow credit default swap/index derivatives market.

Let's put aside Dimon's mis-statement that this trade did not involve "client" money -- he apparently doesn't consider "depositors" as "clients." Let's put aside the fact that Dimon last month referred to this very trade as a tempest in a teapot when the Wall Street Journal fingered it as an aberrant position that was perplexing the London market because it was moving the price of the very index it was betting on (something a true hedge by its nature would not intend to do).

Let's just notice that this was a situation where JP Morgan first was using depositors' money (insured to some considerable degree by the U.S. government) first to buy a CDS as a bet protecting against the possibility that an index of U.S. corporate bond credits would deteriorate in price (presumably because the overall U.S. economy falters, thereby increasing default risk on the bank's loan portfolio). The value of the CDS would rise to offset the loan losses.

Then, as the U.S. economy showed signs of strength in late 2011 and in early 2012, they decided to 'hedge the hedge' by selling the same derivative, which was essentially a countervailing bet the U.S. economy would strengthen, whereby the loan risk would fall and the banks profits from the sale of the CDS would offset its losses on the CDS position the bank had previously bought -- as its value would go down if the U.S. economy continued to do well. These CDS dealings aggregated $100 billion, and after the French and Greek elections, the markets essentially turned against the second hedge, causing the bank to begin to sell off its exposure at a loss.

Indeed, the timing of these trading moves leads to the obvious question (which no one has yet asked) whether the London-based French and Greek traders (you can look up their nationalities) who just happened to run the desk at Morgan London that pushed and executed this strategy were in reality making a bet on the outcomes of the French and Greek elections themselves (had Sarkozy won and had the Greeks elected a pro-bailout/austerity majority, the second hedge might have performed quite well and the bank would be sitting pretty).

Put simply, was JP Morgan using depositors' funds to make a massive bet on the outcome of Eurozone elections to cover the fact that they might have over-hedged their exposure on U.S. loan losses out of fear that the U.S. economy would fall back in the spring as it has the past two years, partly because of concerns about the survival of Eurozone economies and bailout plans? If so, we don't need just a Volcker rule, we need a "sanity clause"!