Would JP Morgan’s in-house trading be exempt from the Volcker rule? Probably not. It was too dangerous, and it is hard to see how it qualifies for even the proposed rule's very loose concept of hedging.
JP Morgan Chase’s $2 billion mark-to-market trading loss is a gift to those of us who want to preserve and strengthen the Volcker rule.
One estimate is that the loss may eventually reach $7 billion. Traders on the other side are taking potshots as the bank tries to unwind its positions gradually. JP Morgan has cancelled a $15 billion share buyback. (The Independent, May 22, 2012.)
The New York Times says that Ina Drew, head of JP Morgan’s chief investment office, lost control of her unit’s powerful, London-based traders. ( The New York Times, May 20, 2012, p. A1.)
What’s wrong with this picture? JP Morgan is a federally insured, regulated commercial bank. A story about traders who scare their own bosses and whose activities account for a big chunk of income is acceptable at a hedge fund or even an investment bank. A trading operation where the traders are so powerful has no place in a federally insured, regulated commercial bank.
Timmy Geithner suggested that Jamie Dimon should resign from the board of the New York Fed. He said that Dimon had a decision to make, and that regulators should be perceived to be above political influence. There are three investigations going in the United States and one in the United Kingdom.
Where were the regulators? They were examining the London unit only sporadically, having been told there was nothing to see here. Embedded examiners who asked pointed questions were overruled. (The New York Times, May 27, 2012.) And shouldn't someone have asked why ostensibly conservative treasury operations were located in freewheeling London?
There is no bank balance sheet item called “surplus deposits” or “excess deposits.” The treasury operation, called the chief investment office, was reoriented toward aggressive investing in 2006. It was a profit center. It was profitable for the past three years.
JP Morgan had a huge portfolio (about $400 billion) in its investment office. Perhaps half of the assets were corporate debt, some of it acquired from the basketcase WaMu. The portfolio was held in the bank's available for sale book, where value changes don’t hit the P&L but do go on the balance sheet. (ASC 320-10-25-1.)
The portfolio also holds roughly $100 billion in dodgy asset-backed securities and CLOs, purchased recently, seemingly for speculative purposes, according to Financial Times. Only about 30 percent of its assets were safe government securities.
JP Morgan offset the portfolio buy buying credit default swaps. The bank argued that the position was an economic hedge. The position was not eligible for integrated hedge accounting, which requires an effective hedge, because it was not a hedge. So the marks on the derivatives would appear on the income statement.
It apparently was a directional bet, and even if it wasn’t, it became one. JP Morgan went from long to short to long again.
JP Morgan wrote underpriced swaps on a basket of corporate debt, CDXNA.IG.9, a traded index of credit default swaps. It also apparently bought long bets on junk debt. It apparently holds $100 billion notional value of these derivatives—or more than 12 percent of the index, according to The Wall Street Journal.
The strategy might have been a flattener curve trade. That is, it was a bet that the creditworthiness of the portfolio would improve and yields would go down.
Hedge funds were on the other side, unhappy that JP Morgan had distorted the market by becoming the largest protection seller. They whined to journalists. The London Whale was their nickname for JP Morgan’s since-departed point man.
When the mark-to-market loss on the derivatives was disclosed, JP Morgan restated VaR to be roughly double the previous claim, using a different, older model. Before restatement, the VaR number for the chief investment office was roughly the same as for the bank’s entire investment bank line of business. Bank examiners use the bank’s models to assess risk (isn’t that comforting?).
“What scares me isn’t the $2 billion loss JP Morgan made. What scares me is the record $19 billion in profits,” said Amir Bhide of Tufts University. He wanted to know what JP Morgan had to be doing to earn that much when consumer banking is unprofitable. The answer, as he implied, is that they were running a giant hedge fund inside the bank.
Blame goes all the way to the top—Dimon isn’t Jeremy Irons’ character in Margin Call, the clueless boss who can say he didn’t know. The London operation was encouraged to gamble.
Would this trade have been covered by the Volcker rule? Prop trading would be narrowly defined. Hedging would be allowed, as an exception to everything else in the rule, and would not have to be precise.
Proprietary trading is statutorily defined as “engaging as a principal for” the bank's “trading account” (12 U.S.C. section 1851(h)(4)).
The proposed regulations echo this in their definition of trading account, which focuses on short-term resale, benefit from price movements, and market risk capital rule positions (___.3(b)(2)(i)). Prop trading is rebuttably presumed for any position held 60 days or less (___.3(b)(2)(ii)).
The proposed regulations’ definition of trading account excludes trading for liquidity management, for which the bank has to have a plan (___.3(b)(2)(iii)(C)). The concept of trading account also excludes a derivatives clearing organization (¬¬___.3(b)(2)(iii)(D)).
This narrow definition of trading account, with a focus on intent to sell the assets in the next 60 days, would allow JP Morgan to argue that the chief investment office portfolio, classified as held for sale, was not a trading account.
The proposed rules forbid material exposure to high-risk assets or a high-risk trading strategy, defined as significantly increasing the likelihood of a big loss or failure (___.8(a)(2) and (c)), or threats to the safety and soundness of the U.S. financial system (___.8(a)(3) and ___.17).
It is, of course, the irony of ironies that regulators should entrust giant banks whose existence is a daily threat to the safety and soundness of the U.S. financial system to judge the extent of the threat for themselves. Before retracting its share buyback, JP Morgan maintain that the trading loss was no biggy.
And that it was some sort of hedge. It did not qualify for hedge accounting. Financial accounting rules require that hedges demonstrate a high degree of efficacy in offsetting changes in the fair value of an asset.
Every three months, or whenever reporting is required, hedge effectiveness has to be tested using a reasonable method. If the hedge is ineffective, it had better be part of a documented dynamic hedging strategy that is continuously repositioned (ASC 815-20-25).
Yet hedging does not have to be precise under the proposed Volcker regulations. JP Morgan and other big banks had a lot of meetings with the agencies drafting these rules. A bank would have to have robust, detailed hedging procedures and internal controls (___.5(b)(1)). Hedging is not to be left to a trader’s discretion, according to the preamble.
A permissible hedge must hedge specific risk, be reasonably correlated subject to continuous review, and maintain correlation (___.5(b)(2)(iii)). Reasonable correlation is a lenient hedging standard. Hedges should be monitored for maintenance of correlation and increased risk exposure (___.5(b)(2)(v)).
Hedges must not give rise to significant exposures that were not already present (___.5(b)(2)(iv)). Although there is no proportionality requirement, this rule is the main restriction on hedging. Hedges are supposed to be identified when entered. But the preamble would excuse unanticipated risks that arise during the existence of the hedge.
The Financial Stability Oversight Council warned that hedging could hide speculation. If a crude offset would qualify, then the position could be used to put on risk, as the JP Morgan case demonstrates. The preamble to the proposed regulations states that the hedging exception is intended prevent trading from being mischaracterized as hedging. Oh, and don’t pay the hedgers based on profits (___.5(b)(2)(vi)).
Aggregate, portfolio hedging is clearly permitted (13 U.S.C. section 1851(d)(1)(C) and ___.5(b)(2)(ii)). The preamble notes that aggregate hedging is expected to be demonstrably risk-reducing. Basis risk hedging is also permitted, and there is no definition of what that is.
Progressive commentators predicted any exposure could be described as a basis hedge for something in the bank’s trading book. If JP Morgan's positions would have qualified as either a basis risk hedge or an aggregate hedge, then the proposed Volcker rule implementation needs a serious rethinking. At a minimum, some of the restrictive statements in the preamble should find their way into the regulations.
