As I’ve been saying for years now, the hidden leverage of over-the-counter credit swap contracts is the real problem here. And playing hide-and-seek with underfunded regulators is a huge part of the problem.
I was even thinking about putting together a cheap e-book explaining this (I still might do it).
Put into a quick analogy for the 99.99% of the world that finds financial alphabet soup to be like trying to see the bottom of the bowl of split pea soup, I shared this with a friend who asked what I thought about the London Whale:
I think describing our five largest banks as deposit-taking and lending businesses is like calling Las Vegas the buffet capital of the world.
The latest “surprise” coming from one of the most visible profit centers of one of the largest banks in the world just shows us that this risk simply can’t be managed when it is ultimately a risk to the taxpayer. Either we stop guaranteeing banks (bad idea) or we make the banks pay into a resolution fund for the inevitable next blowup (good idea).
Unfortunately for all of us, the fact is that paying former Congressmen and their staff members seven figure compensation to act as lobbyists is now the highest return investment any company can make. For example, after all the caterwauling about America’s high stated corporate tax rate (35%), the reality is that the average American corporation pays just 15% in Federal income taxes. What makes some pay nearly the full rate and others pay nothing? Lobbying money.
I read a study last week showing that among the S&P 500 largest public American companies, the more a company pays in lobbying dollars, the lower its effective tax rate.
So Jamie Dimon pays tens of millions of his shareholders’ dollars to lobbyists, and they get to keep playing in the dark with their CDS book. How does a bank get around the issue of the nearly-toothless “Volker rule?”
Simple. Call it legitimate hedging (which it can be).
I’m reminded of how the commercial mortgage and project loan trader in my former department actually made most of his true “trading” profits.
The problem he had (as a trader) was that his loans and bonds changed hands very infrequently, with typical holding periods of six months or longer. As with most traders, he was something of an action junkie, so what to do while the paint dries? Even when a trade is agreed, the bankers and lawyers have to work through the piles of paper that constituted the mechanics of buying or selling a loan backed by commercial property.
I knew (and could even get my trader to admit) that he was actually a closet ten-year Treasury trader. At the margin, because of the “basis” spread between commercial mortgages and Treasuries, he literally had to monitor and adjust his hedges many times more frequently than he was buying or selling the underlying commercial loans. He might, for example, lighten up his short position in 10-year T-Notes the Thursday before the first Friday of a month where downside employment surprises might happen. It was usually only 10% or so of the position, but completely legitimate if the Treasury market might take a sudden spike upward (a predictable reaction to lousy employment numbers).
As a nimble trader, he could put his short position back on in the few minutes after the announcement when the market spiked too high, and then over the next few days get back into a properly hedged position, which typically meant he had to be short about 70% of the face amount of his commercial loan position.
Over the course of a year, my commercial mortgage trader probably traded ten to twenty times as many Treasuries as he traded commercial mortgages or CMBS.
Same is true for banks with big books of corporate loans, like JPM. They hedge with Treasuries, interest rate swaps, and with CDS basket trades like the high-grade corporate index the London Whale screwed up with at JP.
Without having any inside information, I can easily guess that their corporate bond basis traders and risk managers thought nothing of trading ten or twenty times the volume of those hedge contracts as they had in actual exposure.
So let’s stop and think about it: The Volker Rule was supposed to stop banks from speculative trading using the bank capital, backstopped as it is by taxpayers. But they set up a $70 trillion loophole (and that’s just for JPM, the total derivatives book is well over $250 trillion at America’s top banks). That loophole was to allow hedging, and to allow non-disclosure of Credit Default Swaps that weren’t “plain vanilla.”
By the way, those five top banks in the US reported that 70% of their profit last quarter came from their derivative operations. So now you see why I say the deposits, loans and branches are just a front for the casinos in the bank’s back rooms. And why I say that the best investment Jamie Dimon made was the money spent on lobbying to keep the casino open, and make Dodd-Frank into a toothless tiger.
Or maybe Las Vegas should be known worldwide for its inexpensive all-you-can-eat buffets.