EconoMonitor

JP Morgan Debacle Reveals Fatal Flaw In Federal Reserve Thinking

Experienced Wall Street executives and traders concede, in private, that Bank of America is not well run and that Citigroup has long been a recipe for disaster.  But they always insist that attempts to re-regulate Wall Street are misguided because risk-management has become more sophisticated – everyone, in this view, has become more like Jamie Dimon, head of JP Morgan Chase, with his legendary attention to detail and concern about quantifying the downside.

In the light of JP Morgan’s stunning losses on derivatives, announced yesterday but with the full scope of total potential losses still not yet clear (and not yet determined), Jamie Dimon and his company do not look like any kind of appealing role model.  But the real losers in this turn of events are the Board of Governors of the Federal Reserve System and the New York Fed, whose approach to bank capital is now demonstrated to be deeply flawed.

JP Morgan claimed to have great risk management systems – and these are widely regarded as the best on Wall Street.  But what does the “best on Wall Street” mean when bank executives and key employees have an incentive to make and misrepresent big bets – they are compensated based on return on equity, unadjusted for risk?  Bank executives get the upside and the downside falls on everyone else – this is what it means to be “too big to fail” in modern America.

The Federal Reserve knows this, of course – it is stuffed full of smart people.  Its leadership, including Chairman Ben Bernanke, Dan Tarullo (lead governor for overseeing bank capital rules), and Bill Dudley (president of the New York Fed) are all well aware that bankers want to reduce equity levels and run a more highly leveraged business (i.e., more debt relative to equity).  To prevent this from occurring in an egregious manner, the Fed now runs regular “stress tests” to assess how much banks could lose – and therefore how much of a buffer they need in the form of shareholder equity.

In the spring, JP Morgan passed the latest Fed stress tests with flying colors.  The Fed agreed to let JP Morgan increase its dividend and buy back shares (both of which reduce the value of shareholder equity on the books of the bank).  Jamie Dimon received an official seal of approval.  (Amazingly, Mr. Dimon indicated in his conference call on Thursday that the buybacks will continue; surely the Fed will step in to prevent this until the relevant losses have been capped.)

There was no hint in the stress tests that JP Morgan could be facing these kinds of potential losses.  We still do not know the exact source of this disaster, but it appears to involve credit derivatives – and some reports point directly to credit default swaps (i.e., a form of insurance policy sold against losses in various kinds of debt.)  Presumably there are problems with illiquid securities for which prices have fallen due to recent pressures in some markets and the general “risk-off” attitude – meaning that many investors prefer to reduce leverage and avoid high-yield/high-risk assets.

But global stress levels are not particularly high at present – certainly not compared to what they will be if the euro situation continues to spiral out of control.  We are not at the end of a big global credit boom – we are still trying to recover from the last calamity.  For JP Morgan to have incurred such losses at such a relatively mild part of the credit cycle is simply stunning.

The lessons from JP Morgan’s losses are simple.  Such banks have become too large and complex for management to control what is going on.  The breakdown in internal governance is profound.  The breakdown in external corporate governance is also complete — in any other industry, when faced with large losses incurred in such a haphazard way and under his direct personal supervision, the CEO would resign.  No doubt Jamie Dimon will remain in place.

And the regulators also have no idea about what is going on.  Attempts to oversee these banks in a sophisticated and nuanced way are not working.

The SAFE Banking Act, re-introduced by Senator Sherrod Brown on Wednesday, exactly hits the nail on the head.  The discussion he instigated at the Senate Banking Committee hearing on Wednesday can only be described as prescient.  Thought leaders such as Sheila Bair, Richard Fisher, and Tom Hoenig have been right all along about “too big to fail” banks (see my piece from the NYT.com on Thursday on SAFE and the growing consensus behind it).

The Financial Services Roundtable, in contrast, is spouting nonsense – they can only feel deeply embarrassed today.  Continued opposition to the Volcker Rule invites ridicule.  It is immaterial whether or not this particular set of trades by JP Morgan is classified as “proprietary”; all megabanks should be presumed incapable of managing their risks appropriately.

Dennis Kelleher and Better Markets are right about the broad need for implementing Dodd-Frank and they are particularly right about the problems that surround non-transparent derivatives (follow them @bettermarkets for some of the smartest lines and best links as the JP Morgan debacle continues to develop).  The Better Markets press release on Thursday night put the entire situation in a nutshell:

“Jamie Dimon and JP Morgan Chase just proved what anyone not getting a paycheck from a Wall Street bank already knows: gigantic too-big-to-fail banks are too-big-to-manage.”

Anat Admati and her colleagues at Stanford (and her growing band of supporters in the US and around the world) are right about bank capital.  The people in charge of Federal Reserve policy in this regard are dead wrong – perhaps because they spend far too much time talking to Jamie Dimon and his fellow executives, while consistently refusing to engage with their better informed critics.

Ms. Admati skewered Jamie Dimon at length and in detail 18 months ago on exactly these issues.  You must read her original Huffington Post piece.  She has been relentless ever since – see this material.  She was right then and she is right now: we need much higher capital requirements and much simpler rules – focus on limiting leverage.  Big banks should be forced to become smaller – small enough and simple enough to fail.

It is time for the Federal Reserve to move its policy on these issues.

This post originally appeared at The Baseline Scenario and is posted with permission.

20 Responses to “JP Morgan Debacle Reveals Fatal Flaw In Federal Reserve Thinking”

CurtMay 11th, 2012 at 11:14 am

The problem that exists in all the markets I can think of is a measurement problem. We who are trying to understand these systems do not have accurate accounting systems. We really don't know what the rate of inflation is. We really don't know the state of the Chinese economy. We don't know the long range value of internet companies. We don't know what kind of information hedge funds use to trade on and how close it is to inside information. I could name 10 more important statistics we don't have an accurate measurement of. But if you have a more accurate measurement than others you can make huge sums of money thru leverage.

What if we paid 10 economist 1 million a piece to cover this story, would not it be worth it to the public? But the market place has no mechanism for this to happen.

Instead we have well intentioned people expressing shock at the outrageous behavior and publications like the NY times giving puffy pieces. This has the effect of making some people think that something is being done, but in reality the game goes on. The Roubini blog at first seem to give better information, but it appears in the end it was just a means for special clients who pay the fee to get rich along with Roubini. The asymmetric information system acts as a tax on the non rich and encourages the rich to engage in behavior which is either unproductive or counter productive.

How many hours of talented economists would it take to cover this story in depth, because we know the NY times has not the talent or the will. I would suggest the author here gave some insight and I would be bold enough to say he did not spend three days on this article.

Dan BucklesMay 11th, 2012 at 2:16 pm

Gee, if I remember correctly, in 1998 Brooksley Born went in front of Congress and was brow beaten into submission by Allen Greenspan and Congress that she didn't know what she was talking about when it came to the black holes in the too big to fail banks. She was right and they were wrong, but they are still trying to sell us that regulations don't work and the free market will regulate itself. But, most of the public knows and feels the pain, and now are waiting for the government, in particular, President Obama, to prosecute and break them up.

LCRMay 11th, 2012 at 9:34 pm

"But global stress levels are not particularly high at present – certainly not compared to what they will be if the euro situation continues to spiral out of control. We are not at the end of a big global credit boom – we are still trying to recover from the last calamity. "

Are you kidding? Global stress is extremely high, just well hidden like a JP Morgan trade book. The euro situation will get worse, not an "if". We are at the end of a global credit boom. It is completely exhausted and will bust. Just wait until US treasuries rise. The US is either turning Japanese or European, we have to wait and see.

AmarMay 11th, 2012 at 9:49 pm

I guess it involves issues around integrity, competence and leadership. For instance, many of these alphabet soup instruments are created at a relatively junior leadership level. At a junior leadership level, they know what the instrument is comprised of, yet they did not have the experience to understand the risks and future implications. While, the senior leaders- who have the experience to understand the risks-don't completely understand how the instruments are structured.

AmarMay 11th, 2012 at 9:50 pm

Is Jamie Dimon now joining the ranks of Alan Greenspan and Dick Fuld ?

I guess these kinds of issues involve integrity, competence and leadership at the seniormost levels in banking and finance sector.

For instance, many of these alphabet soup instruments are created at a relatively junior leadership level. At a junior leadership level, they know what the instrument is comprised of, yet they did not have the experience to understand the risks and future implications. While, the senior leaders- who have the experience to understand the risks-probably don't have the vaguest idea how these instruments are structured. That's compentency failure.

There is a failure at top management to accept this ignorance. That's integrity failure.

Top leadership should have the competency to put in the right risk management structures, even though they don't understand the nitty gritties of the instument. That does not happen. That's leadership failure.

barfMay 12th, 2012 at 8:40 am

wait 'till Treasuries rise? Wait till they FALL in yield instead! EVERYTHING is predicated on inflation and "expected returns." What happens if we get DEFLATION instead?

barfMay 12th, 2012 at 8:42 am

I have no problem with "Jamie Dimon appearing on CNBC with forty other Morgan employees who know wtf is going on here." In the defense of transparency of course…

barfMay 12th, 2012 at 8:52 am

I fail to see the problem in "Federal Reserve thinking" here. The problem is MORGAN's risk management…not the Fed's (or the TREASURY DEPARTMENT i might add.) Indeed "the vicious stress tests were their idea" which goes a long way for me in explaining why the market over-all "ho-hummed" this calamity. Obviously what is missing from this analysis as well is an organization call The Central Intelligence Agency. The amount of data being collected by that and all the other MASSIVE intelligence Agencies more than prepares Federal Authorities for "what's going down." And of course "other nations have intelligence agencies as well." that would include Britain btw http://www.youtube.com/watch?v=Ii1tc493bZM&feature=player_detailpage” rel=”nofollow”>.http://www.youtube.com/watch?v=Ii1tc493bZM&feature=player_detailpage

Sierra7May 12th, 2012 at 9:21 am

Contracts depend on knowledge (transparency) and trust.
Both are severely lacking. You have to be an outright fool or have "too much money to burn" to really trust any of the major banning houses anywhere today.
Without trust we have just a cheap runned economy.
It should have been outright apparent that doing almost nothing to change things in 09 and 2010 when we had the opportunity, dismantle majors, indict ceo's and others for outright fraud, anything that followed would (will) be crap.
Fini!
Great comment about Brooksley Born; I remember those hearings well. Greenspan was and is nothing but a political hack and disgrace.

spiderMay 12th, 2012 at 10:03 am

Can our national banks be regulated in the suggested way while their international competitors remain unregulated? I don't think so.

benleetMay 12th, 2012 at 12:00 pm

Financial corporate debt in 1970 was 10% of GDP, in 2007 it was 116% (from The Financial Crisis, Magdoff and Foster, page 220). I think it amounted to 37% of all US debt, double total government debt. "We are not at the end of a big global credit boom – " The last few decades the growth of financial corporate debt has been meteoric. You can go to Statisitcal Abstract of the US (Income and Wealth) and look at the figures. What purpose is served for our society by this misuse of surplus, to reserve the excess of labor and enterprise it in the bank accounts of a tiny wealthy minority? To allow greed — when 0.5% of the adults of the world own 32% of everything, and 9% own 82% there has been a season of greed (this is from Credit Suisse Bank's World Wealth Report, 2011). When greed is allowed to rule, there's only one real remedy.

LCRMay 12th, 2012 at 6:13 pm

We are in stagflation right now. I think that treasury rates will rise as treasury prices are in a ridiculous bubble. Yes, the 10 year can cross 1.7% but not for long as that would signal absolute disaster in Europe. The US is the largest debtor nation in history with no end in sight. We are the best house in a bad neighborhood of over indebted developed nations. When you take out our deficit spending (government and private) from the past 20 years we have no economy, it is a farce of an economy. America has no money put aside for infrastructure. States are getting crushed and are hiding their losses like JP Morgan. And future obligations will continue to crush us. The Fed will print, that will not lead to deflation

DevasaMay 15th, 2012 at 7:28 am

American Banks are in heaven.
Lose money, Government pays up.
Gain money, they keep it.

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