Winner of 2010 Rube Goldberg Machine Contest* (photo: Argonne National Laboratory/flickr)


JPMorgan CEO Jamie Dimon and an army of lobbying mercenaries have been attacking Dodd-Frank and it’s implementation with campaign contributions and a bunch of false arguments. Until we found out about a huge loss on the Whale Trade, the moneythugs were winning. Maybe now regulators will be able to see through the lies, and actually enforce the law.

I. What Happened.

Lisa Pollack offers a detailed explanation of the best guess as to what actually happened in a series of posts at FT/Alphaville. Her explanation is lucid and illustrated with charts that make it fairly easy to understand. Here are what I think are the main points.

Suppose there was a fund that contained 1 share of each of 125 of the largest US corporations. The value of the fund would be equal to the sum of the prices of each of the stocks. Suppose the price of the fund is higher than the price of the individual stocks. Traders can make a profit by selling the fund short and buying the 125 shares (not counting commissions). When the market corrects, so that the fund value is equal to the 125 stock prices, they close the trade with a small profit. That is an arbitrage transaction. There are hedge funds and other traders who try to exploit those differences to make small profits.

Pollack says that something similar happened in the Whale Trade. The trades involved credit default swaps and a CDS Index that works something like our stock fund example. The CDS index used in the Whale Trade pays off if there is a default on bonds issued by any of 125 giant US corporations. There are separate markets for trades in CDSs for those corporations, but they are relatively thin. In addition, the costs of buying and selling the credit default swaps is higher than it would be in the stock market, and the cost of paying for protection on the underlying corporations is expensive, more so than the price of paying for shorting securities.

Pollack puts up charts showing that there was a difference between the index and the price of protection on the underlying securities. The index was cheap compared to the price of the underlying stocks. The difference grew over time, and several hedge funds tried to profit from the arbitrage. They were frustrated because the gap didn’t close. They figured out that it wasn’t closing because JPMorgan was selling the CDS Index protection and keeping it from rising to its fair price.

The New York Times confirms that JPMorgan began selling the CDS Index protection aggressively last summer. That’s a dead give-away: JPMorgan wasn’t hedging, and it wasn’t making a market. It was driving a small market to protect the Whale Trade. Eventually the hedge funds figured it out. The NYT explains:

There were two ways that JPMorgan could win this bet. If the companies in the index did well, the bank’s cost of insuring the index would continue to fall. JPMorgan could also artificially drive the price lower by continuing to issue more and more insurance — a distinct possibility thanks to JPMorgan’s size and stature.

The hedge funds had fought to keep this market unregulated, so even though this looks like a market manipulation, there was no one to complain to. So they leaked to the press. The NYT says that the trade began losing money in March, and the leaks were in late March or early April. That forced regulators to look into the risk of the trade, and JPMorgan’s disclosures about the trade.

Jamie Dimon said first it was a tempest in a teapot. Now, JPMorgan has to mark the Whale Trade to market, and the losses are hitting the balance sheet, so he can’t say that anymore. Instead, he claims that it’s nothing, the kind of mistake that could happen to anyone, and that the bad thing is that it plays into the hands of a bunch of pundits. [cont'd.]

II Why are Regulators Weakening the Volcker Rule?

Banks have spent a fortune working to weaken the Volcker Rule, which tries to prevent banks from using money from FDIC-insured banks in speculative trades for their own account. They were successful in the first proposed regulations, which created loopholes big enough to allow Dimon to claim that this trade did not violate the Volcker Rule.

One big argument was that banks need to be able to hedge their own portfolios, and should be able to do proprietary trades for that purpose. Of course, there is no necessary connection between these two. If you want to hedge, there are plenty of third parties that can arrange things for you. There isn’t any reason you should be allowed to do your hedging and make a profit at the same time.

The Dodd-Frank language for the Volcker Rule permits hedging, but the Senators responsible for the language say that it was to allow hedging a specific position, not an entire portfolio. As Senator Merkley put it, portfolio hedging is a license to do anything.

Regulators didn’t figure that part out, and the proposed rules arguably permit the Whale Trade as hedging a huge portfolio and profiting at the same time.

JPMorgan says that the purpose of the Whale Trade was to hedge its large portfolio of debt securities issued by giant US corporations. That doesn’t make sense on its own merits. Why would you undertake an expensive derivatives-based strategy to hedge a portfolio of strong credits? It would be much cheaper to monitor the corporations and sell any bonds that might be problems. That’s a strategy that has worked for centuries.

The answer is simple. You can’t make money monitoring a portfolio, but you can make money hedging with proprietary trades. Banking toady Charlie Gasparino explains:

[The Volcker Rule] deprives banks of massive fees at a time when they need them most by preventing them from using their own capital to make trades in the market. Dimon’s case against the rule was compelling: such activity had little to do with the 2008 financial collapse, which resulted from different kinds of risk taking activities.

Pollack’s description of the Whale Trade shows that its sole purpose was to make money. It had nothing to do with protecting the portfolio. There was no other reason for JPMorgan to be flogging its CDS marketing arm to sell that CDS Index protection, pushing it off on anyone and everyone to protect the Whale Trade. That is the real problem: JPMorgan was driving a small market to benefit itself.

The Whale Trade was created in the Chief Investment Office at JPMorgan. The Washington Post reports:

Dimon, 56, had pushed the unit to boost profit by buying higher-yielding assets, including structured credit, equities and derivatives, two former employees have said. The shift to riskier bets underscores how blurry the line can be between so-called proprietary trading and what banks say is hedging.

JPMorgan has hundreds of thousands of credit default swaps on its books. In the fourth quarter of 2011, it bought about $2.85 trillion in notional amount of CDSs and sold a similar amount. With those numbers, little mistakes turn into real money. This time the loss is contained. Next time, maybe not. Guess who pays when that happens.
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Students from Maine South High School gather around their Rube Goldberg machine, an engineering feat which used hydraulics, Alka-Seltzer, ball bearings and a toy train to deliver a squirt of hand sanitizer into a waiting hand. The machine won first place in the competition.

CDSs should be entered in this competition.