Saturday, May 12, 2012

NY Times editorial board calls for reform that will prevent another meltdown

In the wake of JP Morgan's $2 billion trading loss, the NY Times editorial board wrote
It was a stunning admission from a man who led JPMorgan through the crisis relatively unscathed, but it doesn’t explain what actually went wrong. 
What Mr. Dimon did not say is that the loss also occurred because of a continued lack, nearly four years after the crisis, of rules and regulators up to the task of protecting taxpayers and the economy from the excesses of too big to fail banks; and, yes, of protecting the banks from their executives’ and traders’ destructive risk-taking. 
The fact that JPMorgan’s loss — which Mr. Dimon has warned could “easily get worse” — is not enough to topple the bank, is not the point. What matters is that JPMorgan, like the nation’s other big banks, is still engaged in activities that can provoke catastrophic losses. If policy makers do not strengthen reform, then luck is the only thing preventing another meltdown.
Bank regulators should start by adopting a forceful Volcker Rule. Proposed by Paul Volcker, the former Federal Reserve chairman and included in the Dodd-Frank reform law, the rule would curtail risky and speculative trading with the banks’ own capital....
The problem with adopting the Volcker Rule is that Mr. Dimon says this trade happens to comply with the rule as it was hedging a risk the bank has.

The Volcker Rule by itself is not a panacea.
Dodd-Frank also calls for new rules on derivatives — including transparent trading and requirements for banks to back their trades with collateral and capital. If such rules were in place, JPMorgan’s trades could not have escaped notice by regulators and market participants....
The Fed noticed the trades, but is has a policy of not interfering with individual trades.  By its own admission, its focus is on ensuring that the bank has enough capital to absorb any losses.

The problem with this approach of course is that banks are fully capable of taking a position that results in a greater loss than they have capital to absorb.  Our current financial crisis confirms this.

The market did notice the trades.  Bloomberg wrote about it extensively 6 weeks ago.

What the market did not know was whether the trades were a hedge (in which case there was something that JP Morgan had an exposure to that went up in value as the trade went down) or simply a large bet.
Mitt Romney has called for repealing Dodd-Frank. That may win him Wall Street cash, but it is profoundly dangerous. President Obama and Congressional Democrats can take credit for Dodd-Frank, but they have not done enough to ensure that the rules are strong enough.
Had JP Morgan been required to provide ultra transparency, a position favored by Mr. Romney, and disclose on an on-going basis its current asset, liability and off-balance sheet exposure details, the market could have seen the trade being put on.

Equally importantly, it could have determined whether this was a bet and not a hedge (JP Morgan has yet to finger its exposure that went up in value to offset the loss on the trade, a requirement if a trade actually hedges an exposure).

Based on this assessment, the market could have exerted discipline on JP Morgan that would have resulted in the trade being a fraction of its actual size.
The force of Mr. Dimon’s critique of Dodd-Frank has rested on his personal reputation for smarts and on JPMorgan’s sheen of invincibility. His own admitted fallibility and the bank’s shocking stumble are the best argument in favor of strong regulation. Now politicians and regulators need to stand up to the banks.
Stand up to the banks and require the banks to provide ultra transparency.

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