JP Morgan Chase’s $2 Billion Loss Under Investigation

As the Department of Justice and the FBI open their investigation into how JP Morgan Chase lost $2 billion, the government is investigating to determine if any criminal wrongdoing occurred.  The inquiry is in the preliminary stages.  Additionally, the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), which regulates derivatives trading, are also looking into JPMorgan’s trading activities.  JPMorgan CEO Jamie Dimon said that the bank made “egregious” mistakes and that the losses tied to synthetic credit securities were “self-inflicted.”

The probe is perceived as necessary, given the ongoing debate about bank regulation and reform, and one expert said it raised the level of concern around what happened.  “The FBI looks for evidence of crimes and goes after people who it alleges are criminals.  They want to send people to jail.  The SEC pursues all sorts of wrongdoing, imposes fines and is half as scary as the FBI,” said Erik Gordon, a professor in the law and business schools at the University of Michigan.

According to Treasury Secretary Timothy Geithner, the trading loss “helps make the case” for tougher rules on financial institutions, as regulators implement the Dodd-Frank law aimed at reining in Wall Street.  Geithner said the Federal Reserve, the SEC and the Obama administration are “going to take a very careful look” at the JPMorgan incident as they implement new regulations like the “Volcker Rule,” which bans banks from making bets with customers’ money.  “The Fed and the SEC and the other regulators — and we’ll be part of this process — are going to take a very careful look at this incident and make sure that we review the implications of what that means for the design of these remaining rules,” Geithner said.  Under review will be “not just the Volker Rule, which is important in this context, but the broader set of safeguards and reforms,” Geithner said, noting that regulators will also scrutinize capital requirements, limits on leverage and derivatives markets reforms.  “I’m very confident that we’re going to be able to make sure those come out as tough and effective as they need to be,” Geithner said.  “And I think this episode helps make the case, frankly.”

Geithner said that Dodd-Frank wasn’t intended “to prevent the unpreventable in terms of mistakes in judgment, but to make sure when those mistakes happen — and they’re inevitable — that they’re modest enough in size, and the system as a whole can handle them.”  The loss “points out how important it is that these reforms are strong enough and effective enough,” he said.

With the passage of Dodd-Frank, banks are required to hold more capital, reduce their leverage and assure better cushions across the financial system to accommodate losses.  Geithner’s comments are similar to those made by other White House officials, who have avoided blasting the bank for its bad judgment, and instead used the event to bolster the case for the financial overhaul.

“We are aware of the matter and are looking into it,” a Justice Department official said “This is a preliminary look at what if anything might have taken place.”  The inquiry by the FBI’s financial crimes squad is in a “preliminary infancy stage,” the official said, and federal law enforcement agents are pursuing the matter “because of the company and the dollar amounts involved here.”

JPMorgan’s and the financial system’s ability to survive a loss that large showed that reforms put in place after the 2008 financial crisis have succeeded.  Nevertheless, the loss by the nation’s largest bank highlights the need for tough implementation of the Volcker Rule on proprietary trading and other rules that regulators are still finalizing.  “The whole point was, even if you’re smart, you can make mistakes, and since these banks are insured backed up by taxpayers, we don’t want you taking risks where eventually we might end up having to bail you out again, because we’ve done that, been there, didn’t like it,” according to President Obama.

Mark A. Calabria, Director of Financial Regulation Studies for the Cato Institute, takes a contrarian view.  Writing in the Huffington Post, Calabria says that “Unsurprisingly, President Obama and others have used the recent $2 billion loss by JPMorgan Chase as a call for more regulation. Obviously, our existing regulations have worked so well that more can only be better!  What the president and his allies miss is that recent events at JPMorgan illustrate how the system should — and does — work.  The losses at JPMorgan were borne not by the American taxpayer, but by JPMorgan.  The losses also appear to have been offset by gains so that in the last quarter JPMorgan still turned a profit.  This is the way the system should work.  Those who take the risk, take the loss (or gain).  It is a far better alignment of incentives than allowing Washington to gamble trillions, leaving someone else holding the bag.  The losses at JPMorgan have also resulted in the quick dismissal of the responsible employees.  Show me the list of regulators who lost their jobs, despite the massive regulatory failures that occurred before and during the crisis.

According to Calabria, “President Obama has warned that ‘you could have a bank that isn’t as strong, isn’t as profitable making those same bets and we might have had to step in.’  Had to step in?  What the recent JPMorgan losses actually prove is that a major investment bank can take billions of losses, and the financial system continues to function even without an injection of taxpayer dollars.  It is no accident that many of those now advocating more regulation are the same people who advocated the bailouts.  Banks need to be allowed to take losses.  The president also sets up a ridiculous standard of error-free financial markets.  All human institutions, including banks and even the White House, are characterized by error and mistake.  Zero mistakes is an unattainable goal in any system in which human beings are involved.  What we need is not a system free of errors, but one that is robust enough to withstand them.  And the truth is that the more small errors we have, the fewer big errors we will have.  I am far more concerned over long periods of calm and profit than I am with periods of loss.  The recent JPMorgan losses remind market participants that risk is omnipresent.  It encourages due diligence on the part of investors and other market participants, something that was sorely lacking before the crisis.”