Dimon Redux: Why Bank Risk-Taking = Risk Making

In case you haven’t had enough of Congresscritters lobbing softballs at Jamie Dimon, the JP Morgan CEO is appearing before the House Financial Services Committee on Tuesday. There have been a number of suitably scathing accounts of how members of the Senate Banking Committee fawned over Dimon, with Matt Taibbi pointing out that Dimon was actually not terribly persuasive, stumbling and mumbling over the parts of his defense that were a stretch. But most important, they had an opportunity to demand explanations, such as of what the trade actually is, who was involved in approving it, when did it start to go awry and when did management realize there was a problem, and muffed it. For the overwhelming majority of the legislators, that was no accident.

As we wrote, Dimon took what is actually an indefensible position: that any bank risk taking should be permitted, so long as it will arguably do well when there is a crisis (watch for this to be broadened to merely be a bet to improve bank profits when its regular businesses are under stress). We pointed out that this logic would justify engaging in systemically destructive activities like the Magnetar trade, and that with government backstopping behind it to boot. And that is a bigger risk than it might seem at first blush.

Let’s go back to Dimon’s defense. It boils down to “we got on top of this pretty quickly, we’re a big bank and this isn’t much of a loss, shit happens and we’ve learned from this ‘mistake’.” In addition, Dimon claimed the underlying portfolio (as in the $370 billion of securities in the CIO, as opposed to the derivatives positions they also took) weren’t all that risky, because, among other things, it had an average rating of AA.

That sounds pretty tame, right? Well actually, JP Morgan was taking more risk in its CIO that any of its peers were. Per a May Bloomberg article:

JPMorgan Chase & Co. (JPM)’s biggest U.S. competitors say their corporate investment offices avoid the use of derivatives that led to the bank’s $2 billion loss and buy fewer bonds exposed to credit risk.

Bank of America Corp., Citigroup Inc. (C) and Wells Fargo & Co. say the offices don’t trade credit-default swaps on indexes linked to the health of companies. JPMorgan is said to have amassed positions in such indexes that were so large they drove price moves in the $10 trillion market…

JPMorgan’s competitors confine corporate-level trading mostly to interest-rate and currency swaps — the most common derivatives — and put a greater percentage of funds into U.S. government- backed securities such as Treasury bonds.

“Traditionally, banks use government bonds, because they’re safer,” said Ray Soifer, a former Brown Brothers Harriman & Co. bank analyst who’s now chairman of Green Valley, Arizona-based Soifer Consulting LLC, which advises banks and investors on strategy and risk management. “JPMorgan is going down the credit spectrum from U.S. Treasuries, because they’re reaching for yield.”…

About half of the $381.7 billion in JPMorgan’s chief investment office portfolio is in company bonds, asset-backed securities and mortgage debt not backed by the U.S. government, according to a March 31 filing. That compares with 7.7 percent at the end of 2007..

Similar assets at San Francisco-based Wells Fargo (WFC) represent 34 percent of a $230.3 billion portfolio. It’s 11 percent of New York-based Citigroup’s $270.6 billion book, and 10 percent of the $297.1 billion pool of securities at Charlotte, North Carolina-based Bank of America.

JPMorgan has about 30 percent of its holdings in U.S. Treasuries and bonds issued or guaranteed by U.S. government- backed agencies, according to its filings. That compares with 87 percent at Bank of America, 50 percent at Citigroup and 47 percent at Wells Fargo.

JP Morgan is taking more risk in its CIO than its competitors deem necessary or prudent. And also keep in mind: JP Morgan has also shown the fastest deposit growth of the major banks. As Amar Bhide has pointed out, the sort of “excess deposits” that the CIO deploys are not the funds of ordinary individuals, but hot international money. Remember, some banks (Bank of New York, for instance) are actually discouraging deposit inflows. It’s pretty likely that JP Morgan is getting more than its share of these funds because it wants them.

In addition, even though the CIO is clearly engaged in hedge-fund type activities, which are exactly the sort of thing the Volcker rule was designed to squash, let’s take Dimon at his word, and assume he really only wanted to insure against tail events, like another crisis. Surely that’s a good idea, no?

Actually, it’s a bad idea. The reason is that sort of trade is subject to what traders call “wrong way risk”: that the catastrophe you were insuring against is pretty likely to blow up your insurer, leaving you unprotected. That’s why, for instance, the Goldman defense that it didn’t need the AIG bailout, that it had bought CDS on AIG, is patently ridiculous. If AIG had gone down, the domino effect of its failed trades would have almost certainly knocked out many, potentially all, of Goldman’s counterparties. And the worst of this sort of insurance is that too many market participants think it works. That means they assume their failure prone hedges have lowered they risk, and they fail to do the foolproof but more costly preventive measures, namely, selling down positions.

And more generally, Dimon’s position is that all is fine in risk taking as long as the bank can absorb losses. And he continues to maintain JP Morgan didn’t need any bailouts in 2008, when in fact JP Morgan got more than just TARP monies (most important, it continues, like all the big banks, to benefit from the tax on savers known as ZIRP). And let’s not kid ourselves. JP Morgan is a major derivatives clearer. If AIG or another big broker dealer had gone down, JP Morgan most assuredly would have been damaged, likely consumed, in the ensuing firestorm.

But as Andrew Haldane pointed out, the payoff to banks and their executives is now like an option. The downside is contained. And the way to increase the value of an option is to increase volatility. Thus banks taking on more and more risk, willy-nilly, is completely rational given their incentives. In fact, from their perspective, there is no limit on how far they should pursue this strategy. Banks have done this not simply by levering up their businesses, but also via increased complexity (which increases fragility) and the explosion of derivatives (which also increase leverage, both in the banks and system-wide, in ways that are difficult to measure with any precision).

So the brouhaha about the failed CIO trade is well warranted. It provides a window into undue risk-taking at JP Morgan, and a generalized industry policy of pushing the envelope, which is the right thing to do if you have managed to set up “heads I win, tails you lose” wagers with deep-pocketed chumps. Unfortunately, that sorry fact is almost certain not to be aired at this week’s House hearings.