Banking: Same as It Ever Was

Three years ago, JPMorgan Chase (NYS: JPM) CEO Jamie Dimon addressed worries that his bank had too much exposure to derivatives. "The company manages those exposures name by name -- like a hawk," he said.

Last week we learned that those exposures blew up into a $2 billion loss -- a figure that will likely rise. So much for those hawk eyes.

Some background: Earlier this year, it became apparent that a JPMorgan trader was making a huge bet on derivative products tied to the creditworthiness of large companies such as Campbell Soup (NYS: CPB) and MBIA. The trader was dubbed "the London Whale" because his bets were so large they moved the index they traded in. It appears these were credit default swaps -- an insurance product of sorts that promises to pay someone else if a bond defaults. If they sound familiar, they're the same product that sank AIG (NYS: AIG) in 2008.

As the London Whale began moving markets, investors started pointing out the size of the trade to journalists, who ran with the story a few months ago. Dimon became defensive and irritated, in April calling the media attention "a complete tempest in a teapot." Yes, it was a big trade, but so is JPMorgan. "Every bank has a major portfolio. Obviously it's a big portfolio; we're a large company. ... It's our job to invest our portfolio wisely and intelligently," he said.

That was then. Last week, Dimon admitted that "we told you something that was completely wrong a mere four weeks ago." Hedge funds piled in on the other side of the trade, Europe stumbled, and now those derivative bets are hemorrhaging money.

Dimon, to his credit, has offered himself for self-sacrifice with an almost fanatical level of mea culpas. He admitted the company was "sloppy," "stupid," and "dead wrong." "In hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed, and poorly monitored," he said.

And to be fair, the losses (so far) aren't terribly large. Two billion dollars is a lot of money to most businesses. For JPMorgan, it's about five weeks of earnings. The company has $184 billion of shareholder equity. The division responsible for the losses manages $350 billion of assets, so the loss adds up to all of 0.57%. Even with leverage, this isn't show-stopping news.

Why, then, are we having a field day with the story?

Two reasons.

The loss "plays right into the hands of a bunch of pundits out there," Dimon said last week. Sure does. After the 2008 bailouts, anyone interested in banking has wondered why banks that are both implicitly and explicitly backed by taxpayers continued to be allowed to, for all intents of the word, gamble. And this was gambling, not hedging, as banks often like to claim. Bloomberg columnist Jonathan Weil explains it well:

The footnote on credit derivatives in JPMorgan's latest quarterly report says the company sold $3.16 trillion of credit protection as of March 31 and bought $2.95 trillion of credit protection on the same underlying instruments. ... In other words, on a companywide basis, JPMorgan was a net seller of credit protection last quarter -- to the tune of about $206 billion, up from $116 billion as of Dec. 31.

Here's what's important. There's nothing wrong with gambling. It's almost always regrettable, but to each his own. But JPMorgan is different. What happens when trading losses mushroom large enough to push the bank into the throes of death, like Lehman Brothers and AIG a few years ago? Since JPMorgan is a commercial bank, most of its depositors are insured from loss by the FDIC. Now, the FDIC is funded by fees levied on all commercial banks, so when a bank goes under, it's usually the banking industry, not taxpayers, that foot the insurance bill. But JPMorgan is so incredibly large -- it has more than $1 trillion of deposits -- that the FDIC's current $11.8 billion (link opens PDF file) deposit insurance fund couldn't come within a hair's breadth of covering the losses. Who would? You, the taxpayer, who would be on the hook for the FDIC's $500 billion line of credit at the U.S. Treasury.

It wasn't always this way. From the 1930s through the late 1990s, commercial banks were legally separated from the investment banking arms that engage in speculative trading. But that's no longer the case. Well-intentioned FDIC insurance designed for bland and vital commercial banking is now intermingled with reliably explosive gambling. A sensible patch for this regulatory flaw dubbed the "Volcker rule" has been watered down into irrelevancy, so the traders' heads-I-win-tails-taxpayers-lose system still exists. That's one reason why JPMorgan's recent losses are such a big deal.

Here's another. JPMorgan and Dimon are known as the industry's best of the best -- the best risk managers, the smartest minds, and the least likely to screw up. They're almost universally seen as different from those other hooligans. President Barack Obama endorsed Dimon by name. So did Warren Buffett. So does the market -- JPMorgan consistently trades at a higher valuation than most of its peers, highlighting its ability to sail through the financial crisis without much of a hiccup.

And yet! Despite being the best of the best, JPMorgan can clearly make disastrous, ill-informed bets that lose billions of dollars. Makes you wonder what kind of mayhem Citigroup (NYS: C) or Bank of America (NYS: BAC) are capable of.

Joe Nocera of TheNew York Times said it better:                                                                  

In his conference call, Dimon claimed that the disastrous hedging strategy had not violated the Volcker Rule. Rather, he said, it violated the "Dimon principle." By which he meant, I think, that it was an example of the kind of dumb risk-taking that JPMorgan usually avoids.

But that's just the point, isn't it? Even at a bank as ostensibly well-run as JPMorgan, the incentives still exist for giant, risky bets to be made that can go very wrong. JPMorgan can withstand a $2 billion hit, but not every bank can -- and who's to say that the next derivatives debacle won't be $5 billion or $10 billion?

While analyzing the 2008 financial crisis, Dimon once wrote to shareholders that the problem was simple: "bad risk management," he wrote. "This not only caused financial institutions to fail, but it also revealed fundamental flaws in the system itself."

Those flaws are alive and well -- and right under Dimon's nose.

At the time this article was published Fool contributor Morgan Housel owns B of A preferred. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Citigroup, JPMorgan Chase, and Bank of America. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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