There is much still to be known about the $2 billion in losses JPMorgan Chase is reporting due to a flawed hedging strategy. But this lack of knowledge hasn’t prevented proponents of Dodd-Frank’s Volcker Rule, which bans banks from certain types of trading, from jumping into the fray and claiming this as a justification for their vaunted rule to keep banks from “gambling” with trading strategies as opposed to the “safe” activities of lending.
But just as due diligence is required by banks and investors, so it is by policy makers. $2 billion is a big number that attracts a lot of headlines, but it is dwarfed by the trillions in losses from the “traditional” bank activity of mortgage lending. Yes, these mortgages were traded, but bad underwriting of unqualified borrowers — encouraged by government subsidies through Fannie Mae and Freddie Mac — and mandates through the Community Reinvestment Act — was the root of the problem.
What’s still unclear is about JP Morgan is (1) what is the extent of the actual loss as opposed to the “mark-to-market” or paper loss, and (2) would JP Morgan’s trading fall under “proprietary trading” covered by the Volcker Rule or “hedging,” which regulators recognize that banks must do to attempt to minimize risk, even though these attempts aren’t always successful.
What we do know is that it’s not just JPMorgan Chase CEO Jamie Dimon that had criticized the Volcker Rule. A host of mid-size banks as well as respected scholars have warned that it could infringe on legitimate financial activity necessary for economic recovery, such as market making of initial public offerings of stock.
First on the losses, there is good news and bad news. it seems like our old “friend” mark-to-market accounting has reared its head again. As reported by The Wall Street Journal, “the bank said it has suffered from ‘significant mark-to-market losses’ in its synthetic credit portfolio.”
Mark-to-market losses and gains are short-term changes in the trading value of financial instruments. In reading the Reuters coverage, it seems that the primary reason for JP Morgan’s loss is that hedge funds bet against its position in certain securities. Mark-to-market losses like this are frequently paper losses that translate into much smaller actual losses, or sometimes even no losses at all. That’s the good news.
The bad news is that mark-to-market accounting can do significant damage when it is enmeshed in mandates such as regulatory capital rules. One of the rare points of bipartisan agreement in analysis of the financial crisis was the role mark-to-market mandates played in exacerbating it. Banks were deemed to be insolvent because of a simple loss in trading value of mortgages that showed no signs of delinquency.
The Financial Accounting Standards Board, the quasi-private body that set mark-to-market standards, was forced to back down after the united Congressional opposition of everyone from conservative Reps. Michele Bachmann (R-Minn.) and Jeb Hensarling (R-Texas) to liberal Rep. Peter DeFazio (D-Ore.) and then-chairman of the House Financial Service Committee Barney Frank (D-Mass.). When FASB relaxed it standards, the stock market shot up, and the action coincided with the beginning of the (albeit very slow) recovery. Former Federal Deposit Insurance Corporation Chairman William Isaac has contended that if mark-to-market mandates were tackled first, much of the TARP bailouts would not have even been necessary.
But the larger problem of the government-created systemic risk from mark-to-market’s role in capital rules was never tackled, and instead Congress turned to Dodd-Frank and the misplaced nostalgia for the Glass-Steagall trading restrictions repealed during the Clinton administration, which is embedded in the Volcker Rule.
When looking at JPMorgan Chase, it’s important to understand that the Volcker Rule may not even apply here. The Volcker Rule bans banks from trading for profit for their own accounts, not from hedging risks through trading strategies. As the Reuters piece noted in paraphrasing an expert, “If the trades were meant to hedge against specific risks as opposed to clearly being done as a proprietary bet on the markets, it may not play as clearly into the Volcker rule debate as supporters of the crackdown want it to.”
But what is clear is that the Volcker Rule will “play into” obstruction of legitimate financial activity of all types of banks and entrepreneurs. “Proprietary trading” for a bank’s own portfolio frequently can’t be separated from the trading it does for it customers, and from trading that is necessary for activities that there is widespread agreement benefit the economy as a whole. For instance, in its “market making” function of launching and initial public offering, a bank must buy enough shares of the new company to ensure a liquid trading market for the newly public firm.
But the Volcker Rule as currently proposed could severely restrict banks from performing these essential market making functions. Now, even the rule’s namesake, former Federal Reserve Chairman Paul Volcker, told the Senate Banking committee on Wednesday that this would be going too far.
Policy makers would be well-advised to drop the superficial distinctions between lending, trading, and “gambling,” and focus on the realities of flawed policies like mark-to-market mandates that are creating more risk for all financial activity.