JP Morgan Loses a $2B Gamble

Earlier this week JP Morgan Chase CEO Jamie Dimon accepted responsibility for disappearing $2 billion in just six short weeks. The best part of the story is JP Morgan Chase will still be profitable this quarter, just not the $5.4 billion produced in the 1^st quarter of 2012. The worst part of the story is investors reacted by devaluing the company’s stock by 10%, vanishing $20 billion in market value in just one short day. The losses were not limited to JP Morgan. Stock prices for the other massive US banks fell in concert. We simply do not know enough about how banks create and destroy profits. When a (regarded as) stable bank like JP Morgan cannot hide avoid losing big on its gambles, we shudder to think of what is happening right now at the poorly-managed, fraudulent institutions. We do know when the markets tumble the government rush in to absorb the losses behind the TOO BIG TO FAIL® crisis-rhetoric. Inevitably, the joke is on us.

At the risk of criminal oversimplification, JP Morgan lost $2 billion because they made loans they felt were likely to default and hedged the bet on those loans by purchasing a form of insurance on non-payment, likely in the form of a credit-default swap. Taking a second look, they decided they had too much default insurance and the re-upped on the likelihood of payment on the loans. Basically they went to a blackjack table where they could split 7’s, buy insurance, and then double-down. They lost the bet.

This kind of behavior in isolation, by an institution earning annual profits in excess of $20B, is at worst a bit reckless. The problem is we have evidence called ‘2008’ banks do not behave this way in isolation. They do this in a complicated web of interrelated transaction distributing the risk widely across international financial markets impacting virtually everyone on this planet. The immediate reaction to the news has been renewed vigor for financial regulation (or enforcement of the current rules at least). This assumes our government is capable of 1) understanding the ways banks make and lose money and 2) compelling behavioral changes. The major problem with these assumptions is wealthy corporations and persons in the financial industry contribute a lot of money to political campaigns, purchasing significant influence over government decision-making and enforcement. As we have seen many times over, passing a law banning a particular behavior is one thing; effectively eliminating the behavior is something else entirely.

This raises a more serious question. Are the six major American banks too big to govern? Their influence on all sectors of our economy is far greater than we can manage. For capitalism to work markets have to be in constant motion towards greater efficiency. Banks of this size are not efficient and they behave irrationally because we have backed them with the collective might of our GDP.

The predictable outcome of JP Morgan’s loss is upset shareholders will demand corrective action to restore their dividends. If the past informs the future, the correction will be higher fees on the billions of transactions Chase bank customers make each year. You will hardly notice the few extra dollars you spend on these fees, the slight increase in the cost of goods you buy at retailers paying higher fees. If the other banks have made similar sized faux pas the impact will be more severe and this summer’s blockbuster sequel will be TARP 2: Still Too Big, Still Too Failing. We know what a disaster that show will be.