Dimon Redux: Why Bank Risk-Taking = Risk Making

In case you haven’t had enough of Congresscritters lobbing softballs at Jamie Dimon, the JP Morgan CEO is appearing before the House Financial Services Committee on Tuesday. There have been a number of suitably scathing accounts of how members of the Senate Banking Committee fawned over Dimon, with Matt Taibbi pointing out that Dimon was actually not terribly persuasive, stumbling and mumbling over the parts of his defense that were a stretch. But most important, they had an opportunity to demand explanations, such as of what the trade actually is, who was involved in approving it, when did it start to go awry and when did management realize there was a problem, and muffed it. For the overwhelming majority of the legislators, that was no accident.

As we wrote, Dimon took what is actually an indefensible position: that any bank risk taking should be permitted, so long as it will arguably do well when there is a crisis (watch for this to be broadened to merely be a bet to improve bank profits when its regular businesses are under stress). We pointed out that this logic would justify engaging in systemically destructive activities like the Magnetar trade, and that with government backstopping behind it to boot. And that is a bigger risk than it might seem at first blush.

Let’s go back to Dimon’s defense. It boils down to “we got on top of this pretty quickly, we’re a big bank and this isn’t much of a loss, shit happens and we’ve learned from this ‘mistake’.” In addition, Dimon claimed the underlying portfolio (as in the $370 billion of securities in the CIO, as opposed to the derivatives positions they also took) weren’t all that risky, because, among other things, it had an average rating of AA.

That sounds pretty tame, right? Well actually, JP Morgan was taking more risk in its CIO that any of its peers were. Per a May Bloomberg article:

JPMorgan Chase & Co. (JPM)’s biggest U.S. competitors say their corporate investment offices avoid the use of derivatives that led to the bank’s $2 billion loss and buy fewer bonds exposed to credit risk.

Bank of America Corp., Citigroup Inc. (C) and Wells Fargo & Co. say the offices don’t trade credit-default swaps on indexes linked to the health of companies. JPMorgan is said to have amassed positions in such indexes that were so large they drove price moves in the $10 trillion market…

JPMorgan’s competitors confine corporate-level trading mostly to interest-rate and currency swaps — the most common derivatives — and put a greater percentage of funds into U.S. government- backed securities such as Treasury bonds.

“Traditionally, banks use government bonds, because they’re safer,” said Ray Soifer, a former Brown Brothers Harriman & Co. bank analyst who’s now chairman of Green Valley, Arizona-based Soifer Consulting LLC, which advises banks and investors on strategy and risk management. “JPMorgan is going down the credit spectrum from U.S. Treasuries, because they’re reaching for yield.”…

About half of the $381.7 billion in JPMorgan’s chief investment office portfolio is in company bonds, asset-backed securities and mortgage debt not backed by the U.S. government, according to a March 31 filing. That compares with 7.7 percent at the end of 2007..

Similar assets at San Francisco-based Wells Fargo (WFC) represent 34 percent of a $230.3 billion portfolio. It’s 11 percent of New York-based Citigroup’s $270.6 billion book, and 10 percent of the $297.1 billion pool of securities at Charlotte, North Carolina-based Bank of America.

JPMorgan has about 30 percent of its holdings in U.S. Treasuries and bonds issued or guaranteed by U.S. government- backed agencies, according to its filings. That compares with 87 percent at Bank of America, 50 percent at Citigroup and 47 percent at Wells Fargo.

JP Morgan is taking more risk in its CIO than its competitors deem necessary or prudent. And also keep in mind: JP Morgan has also shown the fastest deposit growth of the major banks. As Amar Bhide has pointed out, the sort of “excess deposits” that the CIO deploys are not the funds of ordinary individuals, but hot international money. Remember, some banks (Bank of New York, for instance) are actually discouraging deposit inflows. It’s pretty likely that JP Morgan is getting more than its share of these funds because it wants them.

In addition, even though the CIO is clearly engaged in hedge-fund type activities, which are exactly the sort of thing the Volcker rule was designed to squash, let’s take Dimon at his word, and assume he really only wanted to insure against tail events, like another crisis. Surely that’s a good idea, no?

Actually, it’s a bad idea. The reason is that sort of trade is subject to what traders call “wrong way risk”: that the catastrophe you were insuring against is pretty likely to blow up your insurer, leaving you unprotected. That’s why, for instance, the Goldman defense that it didn’t need the AIG bailout, that it had bought CDS on AIG, is patently ridiculous. If AIG had gone down, the domino effect of its failed trades would have almost certainly knocked out many, potentially all, of AIG’s counterparties. And the worst of this sort of insurance is that too many market participants think it works. That means they assume their failure prone hedges have lowered they risk, and they fail to do the foolproof but more costly preventive measures, namely, selling down positions.

And more generally, Dimon’s position is that all is fine in risk taking as long as the bank can absorb losses. And he continues to maintain JP Morgan didn’t need any bailouts in 2008, when in fact JP Morgan got more than just TARP monies (most important, it continues, like all the big banks, to benefit from the tax on savers known as ZIRP). And let’s not kid ourselves. JP Morgan is a major derivatives clearer. If AIG or another big broker dealer had gone down, JP Morgan most assuredly would have been damaged, likely consumed, in the ensuing firestorm.

But as Andrew Haldane pointed out, the payoff to banks and their executives is now like an option. The downside is contained. And the way to increase the value of an option is to increase volatility. Thus banks taking on more and more risk, willy-nilly, is completely rational given their incentives. In fact, from their perspective, there is no limit on how far they should pursue this strategy. Banks have done this not simply by levering up their businesses, but also via increased complexity (which increases fragility) and the explosion of derivatives (which also increase leverage, both in the banks and system-wide, in ways that are difficult to measure with any precision).

So the brouhaha about the failed CIO trade is well warranted. It provides a window into undue risk-taking at JP Morgan, and a generalized industry policy of pushing the envelope, which is the right thing to do if you have managed to set up “heads I win, tails you lose” wagers with deep-pocketed chumps. Unfortunately, that sorry fact is almost certain not to be aired at this week’s House hearings.

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  1. Richard

    Excellent post.

    While there are probably a number of ways to end the big banks betting with the taxpayer money, the most effective is to require them to disclose their current positions.

    Based on what has been said in a number of articles, the banks are worried that if they have to disclose their positions/bets, the markets would trade against them.

    In addition, the amount of risk they are taking is made clear to investors who in turn can discount the banks’ stock and unsecured debt prices to reflect this risk. An increase in the cost of funds and a decrease in the share price adds to the disincentive to take bets.

    1. Susan the other

      Heaven forbid they should practice capitalism. Its much better for those terrible infants to be given a great big cardboard box with “The Exchange” written in market above the cut out door where they can go and play with each other all day long. Of course, they will promise to wear their diapers. Jamie Dimon will have to have an XXL.

    2. enouf

      Based on what has been said in a number of articles, the banks are worried that if they have to disclose their positions/bets, the markets would trade against them.

      Why in the world would you even think *anything* these psychopaths say/show is HONEST, TRUTHFUL, and TRUSTWORTHY?! After all, they are nothing more than Global Welfare Queens, committing acts of Global Financial Terr’sm .. duh.!

      ooops.. there’s that nasty *trust* meme wielding its ugly head again.


  2. Doug Terpstra

    Having to question your boss in public will be tough for the House Financial Services Committee, but even more agonizing for the public to watch.

    “Please, sir, by your leave is there anything we can do to make your life easier? May I fluff your pillow?”

  3. Lambert Strether

    “[T]he way to increase the value of an option is to increase volatility.”

    Given that FIRE rules our world, that sounds like a general explanation for a regime of permanent stress and anxiety (an most of our news coverage).

    Not so much “shock doctrine” as a million shocks, constantly applied to the prostrate body politic.

    Remind me again why we need the financial sector at all, since they cause pain and suffering as an essential part of their business model?

  4. MichaelC

    One new thing that came to light in Dimon’s testimony was his explanation that new BIS capital rules were the catalyst for reducing the positions.

    These new rules (BIS 2.5) require significantly more capital to be held against trading books, like the CIO portfolio. BIS 2.5 went into effect in Europe 12/11. But the rules will not go into effect in the US. Perhaps when (if) the US adopts BISIII the higher capital charges will impact US banks. In the meantime, the US banks have a competitive advantage, ie lower capital charges, for trading portfolios, like the one housed in the CIO book.

    Once again Dimon’s truthiness isn’t quite what it seems at first blush. The ‘regulators made me do it and I was just following orders’ line masks the incentives in place at JPM and other US banks to increase the size of their trading books.

    The anticipated capital charges JPM was supposedly preparing for were undefined at 12/11, and the timing was and is still unclear. He left the impression that the regulators required him to reduce his positions (or hold more capital) and he was merely complying with the rules, but his incompetent staff FU his orders.

    The defense that higher capital charges were coming also undermines JPMs case for the VAr model fiasco. Under the new rules the VAr should have produced a significantly higher number for the existing positions at implementation date. The fact that it produced a lower figure is pretty damning evidence of incompetent review or something else.

    To be fair, JPM only needed to disclose the Var calculation under the US rules, so it is possible that the more onerous risk exposures were calculated and distributed internally.

    If the risk exposures were being managed and monitored as if the new capital charges were in effect as Dimon suggested in his testimony, he should provide the internal reporting that supports that claim, or STFU about using the capital rules as an excuse.

    Point is, the BIS caital charges may have been a factor, but not in the way Dimon presented it. The relative capital cost advantages to US banks trading books also exposes another factor in the US banks vehement opposition to Volcker restrictions. Volcker would strip the banks of the ability to exploit that capital cost advantage.

    (See deus ex macchiato http://blog.rivast.com/?p=5994 for a nice summary explanation of the issue and S and Ps longer form explanation of the impact of the new capital charges http://www.standardandpoors.com/ratings/articles/en/us/?articleType=HTML&assetID=1245334380388)

  5. enouf

    Does anyone commenting on NC (this blog) really believe that only if we can dissect the Demons’ (and their minions’ ways (the .99% of the 1%) and *explain* (dissect) what has been done wrong .. and *how* the dastardliness was achieved, etc, will help bring about real change?! (Justice?!) .. All the while staying within the confines of the mindframe Box that has been drawn for you? Are you mad?! Good grief!

    Get Back to the Basics Bozos!
    Stop with the bullsh** gobble-di-g00k, lest you be enraptured into its subservitude. FRAUD has a very overall encompassing definition — shall we redefine it? shall we alter our (written words about the) Rule of Law?

    If one cannot define; or rather, to differeniate between TRUTH and LIE, then one has no business being publically heard, let alone being *Representative* of their constiuent electorate! — throw the bums out! .. please!!


    1. ChrisPacific

      Does anyone commenting on NC (this blog) really believe that only if we can dissect the Demons’ (and their minions’ ways (the .99% of the 1%) and *explain* (dissect) what has been done wrong .. and *how* the dastardliness was achieved, etc, will help bring about real change?! (Justice?!)


      But not to business or government – they already know. We need to explain it to the voting public.

      If one cannot define; or rather, to differeniate between TRUTH and LIE, then one has no business being publically heard, let alone being *Representative* of their constiuent electorate! — throw the bums out! .. please!!

      Agreed, but it won’t happen unless you can convince a majority to vote with you, and that requires explaining to them why they should. If you can’t do that, you are just a guy on a soapbox ranting in the town square.

      1. stripes

        For many Americans who get it, it is difficult to comprehend why the entire country is not in full revolt by now. I am not talking taking about revolt by violence, but by default and boycott. People are doing without food and medicine, health insurance and Dr visits to pay a mortgage ..a bill of credit, that is insolvent because of $1.2 quadrillion dollars in derivatives fraud committed by the financiers who don’t give a damn about them. The politicians, the attorneys and law enforcement have thrown US under the bus. Now we are just being ran over repeatedly by the FED and their Political cohorts and minions. We do need to expose the traitors and they should be voted out. The fraud should be prosecuted because it is still going on and it is a danger to our freedom and independence, therefore it is a danger to our National Security. Financial terrorism by the FED has hijacked US. We need to issue U.S. BANK NOTES and Abolish the FED….!

    2. stripes

      Remember Jesus was LABELED a “dangerous man” for calling out the money changers. Full exposure is neccessary in a time of such massive fraud, lies, deceptions, coverups and corruption…I liked what Dylan Ratigan said on his show a while back …finding out the truth will make you Pi**ed. We need to hear the truth to get Pi**ed off enough to want to stand up for our rights. That is what they really fear. A nation full of millions of Americans who have educated themselves and have armed themselves with well documented proof of massive political corruption and massive bank fraud. That is powerful.

      1. enouf

        Hi stripes;

        My point wasn’t the not show the massive fraud, coverups, deception, etc — it was why bother trying to explain it in such great detail? Plus, many (of the “voting (sheeple, MSM-tied) public”) would have a hard time even understanding these financial ‘instruments’, heh, let alone have the time to read/review all the info/articles/comments, like here at NC. Most are just way too busy trying to get by, stuck in their daily grind.


  6. kris

    “And the way to increase the value of an option is to increase volatility”


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