The Real Problem With Wall Street

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The banking industry has been through a lot in the last four years. The collapse of Lehman Brothers helped bring the entire industry to its knees, and without the government swooping in with a variety of programs, including TARP, the entire industry could have collapsed.

The reason for the collapse and the mechanics behind it have been well documented, but one prevailing concept continues to eat at the industry's very core, and it recently reared its ugly head at JPMorgan Chase (NYS: JPM) : The idea that hedging is an effective and safe way to eliminate risk.

Don't get me wrong; risk management is a vital part of running a bank. You don't want all of your exposure in one market or industry for fear that one specific market could collapse. The problem with today's industry is that they think synthetic instruments and all sorts of other derivatives somehow wipe away the risk associated with their business. They call it hedging, they even call it insurance, but besides the added complexity and risk to the banking system, the attitude traders and executives have toward hedging is troubling to say the least.


Hedging is not insurance
The concept of hedging is really very simple on the surface. I have a bet somewhere and I want to limit my downside risk, so I make a bet that should move in the opposite direction somewhere else. For example: I may like Apple's stock but am worried about another recession hurting sales, or new products entering the market, so I hedge it by buying puts.

The banking industry has taken this simple concept to an incredibly complex level with the products they have created. Options, futures, credit default swaps, correlation swaps, synthetic thingamabobs are all viewed as ways to hedge risk. That's fine if you understand the underlying risk with all of these products, but the mindset of the industry is that they're more than hedges, they're insurance.

Jamie Dimon proved that he relied too much on hedging to reduce risk because a proper hedge should have resulted in no net loss. He may have even turned a position that started as a hedge into a proprietary bet that resulted in the company's recent losses. In a last-minute conference call, he said, "In hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed, and poorly monitored." But it's more than just banking executives that think hedging shields them from risk. Some of the people setting rules within the government have a flippant attitude about hedging and its role of "insuring" against losses.

In his book On the Brink, Henry Paulson, the former Treasury Secretary who came up with TARP and presided over Goldman Sachs (NYS: GS) when many of these exotic products were invented, comments frequently about the cost to hedge against losses in the debt of Lehman Brothers, Morgan Stanley, Goldman Sachs, and other big banks leading up to the crisis. But he doesn't call it hedging, he calls it insurance, a sign that even the leaders of the industry don't see risk for what it is.

When recounting the days after Lehman's collapse, he said that rates had doubles and, "to insure $10 million of debt now costs about $450,000 for Morgan Stanley and about $300,000 for Goldman." He didn't say hedge, he didn't account for other risks involved in credit default swaps like counterparty risk -- he called it insurance. Let me be clear about one thing: Credit default swaps and complex derivatives are not insurance!

On one level, Paulson no doubt understands the difference, but to so casually call it insurance underscores the mistaken attitude toward risk on Wall Street.

Assets back insurance, synthetic derivatives are bets made with counterparties that are usually just as leveraged as you are. They're apples and oranges, or maybe more accurately, apples and lit cherry bombs.

Why it's so dangerous
It's hard to explain to people how difficult it is to understand the risk of derivatives, much less a large portfolio of derivatives. For a summer, I worked at a hedge fund that traded derivatives, and I found even a single contract to be mind-numbingly complicated, so when hundreds of complex trades go wrong, it's not surprising.

JPMorgan is showing us just how bad even a small mistake can get. When you're a giant bank and you're doing a huge "hedge" or proprietary bet, you can move the market to get into a trade, costing a lot to get into the hedge. If you're wrong, like JPMorgan was, it moves against you after the trade, and the losses pile up because you can't get out of the trade. A week ago, this recent mistake was supposed to be a $2 billion loss for JPMorgan, but some traders betting against JPMorgan are claiming it will explode to $6 billion to $7 billion -- it starts to look like a snowball running down a mountain. A $2 billion loss was a kick in the bucket, but if we start approaching $10 billion, the story changes, even for a company the size of JPMorgan.

It's still a house of cards
The biggest problem is that the banking system is still built on a house of cards, with funding that can evaporate overnight, so trades and hedges gone wrong can sink a financial institution quickly. 

It used to be that deposits were combined with bank assets and loaned to people for businesses or mortgages, very simple concepts that had collateral. Today, banks are taking risks in currencies, commodities, stocks, bonds, and anything else they can get their hands on, making their businesses extremely complex and risky. They think hedging will take away some of that risk, but it exposes them to default by counterparties and other unforeseen consequences. As Dimon is finding out, there's no such thing as insurance in trading.

What Wall Street has is an attitude problem
Too many years of these trades working out in their favor made Wall Street complacent before the financial crisis, and after being bailed out by the government, they didn't seem to learn any lessons. Instead of viewing hedging as another risk, the industry still views them as "insurance." Instead of building smaller, less complex businesses, Wall Street has decided that bigger is better, which means that complexity goes up, and the market can squeeze you in a crisis, like it will do with JPMorgan.

I'm sorry Wall Street, but the only insurance provided to your business is the insurance taxpayers have taken out by electing officials who aren't strong enough separate commercial banks from investment banks and shrink you down to size.

Your attitude problem has become our national problem -- it's sad to see that after everything we've been though, nothing has changed.

At the time this article was published Fool contributorTravis Hoiummanages an account that owns shares of Apple. You can follow Travis on Twitter at@FlushDrawFool, check out hispersonal stock holdingsor follow his CAPS picks atTMFFlushDraw.The Motley Fool owns shares of JPMorgan Chase. The Fool owns shares of Apple. Motley Fool newsletter services have recommended buying shares of The Goldman Sachs Group and Apple. Motley Fool newsletter services have recommended creating a bull call spread position in Apple. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.

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