Today’s Courier Herald Column:
Late last week, JP Morgan Chase announced to investors that the company would be taking an unexpected loss of about $2 Billion because of unexpected trading losses in derivatives. The company’s London investment office created an insurance product as a hedge against the credit default of 125 large North American based companies.
JP Morgan bet big that an improving economy would increase the value of their hedge. Instead, they flooded the market with too much of the product, with the hedge becoming significantly larger than the underlying index which they were attempting to mitigate risk. Unwinding the positions will cost the bank dearly, not only with a large amount of the bank’s capital but by shaking the institution’s squeaky clean image. JP Morgan Chase had been one of the few large institutions that emerged fairly unscathed from the financial meltdown of 2008.
The problems for JP Morgan have more to do with public perception than financial realities. It claimed roughly $175 Billion of equity on its balance sheet at the end of last year and is earning about $5 Billion per quarter. It can handle the financial loss.
The fact that a large bank can continue to have internal controls that allow investment units to create investment instruments with unknown risks and lose billions demonstrates that the problems that caused the 2008 financial crisis may not have been fully mitigated. The fact that it occurred at a bank with JP Morgan’s image and on the watch of its CEO Jamie Diamon reminds a nervous financial community that unexpected financial losses can happen anywhere, and under any management team.
The question remains are there policy changes that need to be made.
A Republican friend’s Facebook status is currently posted as “JP Morgan loses $2 Billion of investors money and President Obama says the industry needs more regulation. Obama loses $500 Million of taxpayers’ money in Solyndra and says that’s the risk of investing.” President Obama made remarks calling for additional unspecified regulations Tuesday on the same day he conducted a fundraiser at the New York home of the Wall Street firm The Blackstone Group LP’s President Tony James.
There is common ground in the two opposing partisan responses. Private money, not taxpayers’ money, should be used to take risks. Risk involves the possibility of loss which is an essential part of the free market capitalist system. Taxpayer money should not be used to take investment risk, and the financial system should be insulated from the perception (and since 2008 the reality) that taxpayers are the backstop to risky financial transactions.
From a policy perception, this equates to the return of Glass-Steagall laws. Glass-Steagall was passed in 1933 to separate the U.S. commercial banking system from investment banking. The FDIC insured banking sector used primarily by consumers and small business was firewalled from the unlimited risk taking highly unregulated world of Wall Street bankers. In 1999, the law was repealed.
It was the repeal of that law that allowed institutions such as JP Morgan to merge with commercial banking powerhouses like Chase Manhattan. Mixing the two systems has had more consequences than just increasing the amount of the financial sector exposed to unlimited risk. Investment banks now use their commercial bank subsidiaries as a conduit to move FDIC insured bank deposits into more risky highly leveraged investment vehicles on which the investment banks thrive – during good times anyway.
The opportunity cost of this funds transfer is that is less money available for the commercial banks to loan back to small businesses and consumer customers that would otherwise expand the economies where they work and live. Capital has been removed from local communities, shipped to Wall Street to be repackaged, and then sold off on world markets. All of which is fine, or at least legal, until taxpayers have to settle the risk.
Taxpayers back FDIC institutions. They are highly regulated for a reason. Risk is minimized to ensure a stable financial system.
Taxpayers should not back Wall Street investment banks. When they do, as was done in the aftermath of 2008, the consequences trickle back down to other banks. Georgia now has lost 25% of its small banks mainly due to the real estate bubble created by the largest few.
There needs to be a separation between taxpayer insured commercial banks and risk taking Wall Street firms. Neither is inherently bad, but both are inherently different. As such, they should be quite separate.
To make that happen, Glass-Steagall should be re-instated.