What Happens When JPMorgan Fails?

JPMorgan Chase (NYS: JPM) CEO Jamie Dimon was hauled before Congress yesterday for a finger wagging over the bank's recent $2 billion trading blunder. For all the haranguing and grandstanding, Sen. Jerry Moran asked one of the only relevant questions of the hearing; he wondered if JPMorgan failed, then could it go down without costing taxpayers money? The answer was also the most telling.

"Yes," Dimon replied.

And at 11:42 EDT, reality died.

The timing couldn't have been better. The day before, a JPMorgan internal assessment of what it would take to push the bank into bankruptcy was released. The conclusion: a loss of $50 billion.

JPMorgan had $2.3 trillion of assets at the end of last quarter. A $50 billion loss, then, is the equivalent of just 2.17% of assets. That's one of the scariest simple math equations that exists in today's economy.

No need to worry, the report assures. After failing, the bank could be hosed down, cleaned out, and "returned to private sector as a new bank with a clean balance sheet." Taxpayer money used to keep the bank operating in the interim would be repaid, the report promises. Everyone lives happily ever after.

Maybe that's what would happen, but I doubt it. It's inconceivable to think that a bank JPMorgan's size could fail without the FDIC and other taxpayer-backed bank authorities being utterly overwhelmed. The numbers here are astronomical: JPMorgan has more than $1 trillion in deposits, and its balance sheet equals 15% of the country's gross domestic product. Nothing works as planned with a bank that size.

But let's assume for a moment that JPMorgan could fail without costing taxpayers a dime. Is that the end of this story?

Not even close. Nearly everyone in the country would pay a price.

We don't have to do much assuming here; we have 2008 as a template. If JPMorgan failed, we have a good idea what would happen.

Credit markets would freeze
As the financial system ponders who's holding the bag, everything stops and credit grinds to a halt. Anything not called U.S. Treasuries is deemed too toxic to touch. Even the bluest of blue chip companies suddenly can't access credit markets, and thousands of businesses around the country that rely on credit to fund inventory and payroll go bug-eyed. Nobel Prize-winning economist Robert Solow described this in 2008:

So businesses that would normally be investing in a new computer or a new fleet of trucks or whatever that would need to borrow, can't borrow. And if they could borrow, they would be paying a very high rate of interest. So they stop.

And then the real economy begins to slow down, and people lose their jobs because their firms can't sell to consumers, can't sell to other businesses. A modern economy is a more complicated piece of machinery than a simple barter economy. Production is very complicated. You start with God knows what, and you end up with some extraordinarily complicated piece of equipment or the machinery that appears in my dentist's office when I sit down. That can't be directed without a good deal of action which is taken now and can only pay off many stages later. And that's where the credit mechanism comes in. Industry that depends on it has to slow down, simply because it can't get the funds that enable each stage in production to pay off the previous stage.

Other banks would fail
In May 1931, an 80-year-old, well-connected, highly respected bank called Credit-Anstalt in Vienna failed. The global banking world was stunned. How could such a large and powerful bank fail? And if it can fail, who's next? It was sheer panic. Princeton historian Harold James explains the ensuing chaos: "The Viennese panic brought down banks in Amsterdam and Warsaw. In June and July the scare spread to Germany, and from there immediately to Latvia, Turkey, and Egypt (and within a few months to England and the U.S.)." BusinessWeek's Peter Coy puts it more bluntly: "Thus the failure of Credit-Anstalt accelerated the financial panic that turned a recession into a global depression."

There is never just one cockroach in the kitchen, and there's never just one major bank failure. Panic spreads like wildfire.

Markets would crash
This is standard in any financial crisis. Hedge funds and other institutional investors that do business with or are in any way connected to wobbly banks freak out, sell whatever they can and crawl into a bunker. Selling begets more selling, and on and on. By the time the dust settles the world is a few trillion dollars poorer, confidence is shot, businesses are undercapitalized, and unemployment spikes as consumer spending dries up. The Federal Reserve eventually stems the panic with massive intervention, but God knows what the eventual outcome of that is.

And all of that from JPMorgan losing 2.17% of assets.

This is real, folks
None of this is speculative fiction. It's what history tells us happens every time a large bank fails. The same scenario would play out if Citigroup (NYS: C) , Bank of America (NYS: BAC) , Goldman Sachs (NYS: GS) , or any other too-big-to-fail bank were to go under. And eventually, they probably will.

Some might make the doubtful argument that JPMorgan's failure wouldn't cost taxpayers a penny. But no one, not even Dimon, can argue with a straight face that horrific damage wouldn't be inflicted on the rest of the economy if a big bank collapsed. Everyone pays the price for too big to fail.

At the time thisarticle was published Fool contributorMorgan Houselowns preferred shares of Bank of America. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Bank of America, Citigroup, and JP Morgan Chase. Motley Fool newsletter services have recommended buying shares of Goldman Sachs Group. 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 insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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