The $2 Billion Boo-Boo

At the end of every e-mail you get from Wall Street investment advisers and brokers is the phrase “Past performance is not necessarily indicative of future results.” Would that anyone read the small print. JPMorgan Chase came through the financial crisis relatively unscathed only to stomp on a land mine in the form of a bungled series of risky derivatives trades. The derivatives positions were designed to hedge the firm’s portfolio against slower economic growth, but they proved too complex to manage, resulting in a $2 billion–and growing–loss for the bank. According to a number of reports, the U.S. Department of Justice has opened an inquiry into the trades. (DOJ won’t officially confirm or deny, as per usual, until there’s a public filing.) The FBI has begun a preliminary investigation into the deals, which are financially just a bruise for the bank. JP is still expected to post a $4 billion profit in the next quarter alone.

But the write-down represents a major loss of face for CEO Jamie Dimon, the Teflon banker who has lobbied hard against re-regulation in the post-meltdown era. Justly famous for his command of banking detail, Dimon was forced to eat a huge helping of humble pie, admitting that the offending trade had been “flawed, complex, poorly reviewed, poorly executed and poorly monitored.”

A few weeks back, Dimon told investors that concerns over the London trading group in charge of the deals were “a complete tempest in a teapot.” DOJ will be interested to find out if he knew the losses were coming and lied about it on the call, or if those around him knowingly misinformed him before he spoke to investors. Either would be a criminal offense. And both are unlikely, given the public scrutiny of the industry lately and Dimon’s reputation, but it might be possible that traders in London were trying to hide the initial losses, hoping they could make their money back before the bosses noticed. Making a stupid trade is legal. Lying about it isn’t, but as one former prosecutor told me, it happens all the time.

Let’s assume the risky trades, which involved complicated derivatives that Warren Buffett once called “financial weapons of mass destruction,” are legit. The problem is that the resulting losses have totally undermined Dimon’s arguments for watering down or eliminating the Volcker rule, which would prohibit banks from proprietary trading–that is, risking their own capital. Thanks in large part to Dimon’s personal lobbying, the proposed rule currently allows for “portfolio hedging.” That means banks could set up synthetic derivatives like the ones that backfired in JPMorgan’s effort to try to hedge its loan portfolio, as long as they don’t actively try to make a profit from them. (Historically, the problem for banks is that they borrow short and lend long, so they are exposed to interest-rate risk.)

It’s hard to believe that JP’s chief investment office, which made the trades, wasn’t designed to be a profit center when the head of it, now set to leave the bank, earned $15 million last year. But even if you buy that, the case underscores that any portfolio hedging carries what’s known as basis risk. In the case of a huge bank like JPMorgan, which is several times as big as the world’s largest hedge funds, its very size is bound to create a market-moving event when it takes a position large enough to protect itself. “If you are the market,” one risk expert told me, “you can’t hedge it.”

The other issue is that no one–not even smart guys like Dimon–fully understands the complexities of synthetic derivatives. Aside from underscoring the fact that the “too big to fail” problem is still very much with us, the JPMorgan losses show that risk management is far from an exact science. Indeed, I’ve never understood why financial-risk modeling has ever been considered much more than rune reading. After all, it involves throwing thousands of variables about all the bad things that could happen into a black box, shaking them up with the millions of positions taken daily by banks and extrapolating it all into a simple, easy-to-understand number about how much is likely to be lost if things go belly-up. What could possibly go wrong, especially when you’re relying on past assumptions (the sovereign debt of the U.S. and Europe will never be downgraded!) and don’t account for the fact that market-moving events often create their own momentum? Who knew trouble in Greece would make it tough to get a loan in Italy?

Ultimately, the only way for banks to manage risk is to take on less of it. We’re headed into a world where banks will soon be doing just that, either by choice or by regulation. You don’t have to read the fine print to know that this will likely result in fewer unexpected $2 billion losses–and fewer $23 million pay packages.