Banking Bloodbath: What It Means for You


On Thursday, JPMorgan's (NYS: JPM) CEO made an astonishing admission: The second-largest bank in the United States plans to lose at least $2 billion on a "sloppy" and "flawed, complex, poorly reviewed" trade.

Just four years after the financial crisis, here we are again.

Shares fell more than 9%, which, along with Bank of America's (NYS: BAC) loss, helped drive the Dow (INDEX: ^DJI) down 0.3%. Since then, both banks and the index have continued to sink further.

What the heck is going on?
Bank traders and executives are incentivized to take large high-risk, high-reward bets, since they earn high bonuses when such bets work out, whereas shareholders and taxpayers take the losses when things go wrong. So it should be no surprise that, left to their own devices, this sort of thing will happen.

When the massive trade raised eyebrows last month for distorting markets, JPMorgan demurred that it was just trying to reduce its risks with a hedge.

But that explanation never made much sense. Basically, the trade involved selling credit derivative swaps, which on its face would mean doubling down on its exposure to corporate debt.

But calling the trade a "hedge" allowed JPMorgan to claim it wasn't engaging in the sort of high-risk trade that took down AIG (NYS: AIG) and helped fuel the financial crisis back in 2008. Although AIG has since exited the gambling business, JPMorgan, Bank of America, Goldman Sachs (NYS: GS) , Morgan Stanley, and Citigroup have had to be dragged away kicking and screaming.

The most incredible thing
Massive proprietary bets were supposed to be outlawed by the Volcker Rule provision of financial reform. But implementation of the rule has been delayed and watered down by Wall Street, with JPMorgan leading the charge (rather nastily, too).

By claiming the trade was a "hedge," JPMorgan was able to argue that the trade wouldn't have been banned by the version of the Volcker Rule it had watered down. But clearly what the bank has shown is the opposite: That when it comes to large, bankwide hedges, too-big-to-fail banks can be incompetent or lying. Either way, the SEC and the Fed are going to need to stand up to Wall Street by tightening up the Volcker Rule or breaking up too-big-to-fail banks.

Otherwise, the next time we face a financial crisis, it's going to be a lot worse than JPMorgan shareholders losing $2 billion.

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At the time thisarticle was published Ilan Moscovitzdoesn't own shares of any company mentioned. You can follow him on Twitter@TMFDada. The Motley Fool owns shares of Bank of America, JPMorgan Chase, and Citigroup.Motley Fool newsletter serviceshave recommended buying shares of The Goldman Sachs Group. The Motley Fool has adisclosure 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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