Heads I win, tails you lose TWO BILLION DOLLARS

JP Morgan Chase’s $2 billion foul-up sheds interesting light on Wall Street’s derivative problems – and opinions on the matter seem split.

Sartre over at the Daily Business Report says that – prepare yourself – this is a taste of what’s to come. Banks have literally trillions of dollars at risk in derivatives. This $2 billion loss is just a taste of what will happen if the too-big-to-fail banks are allowed to continue to gamble with unregulated derivatives.
This argument makes sense. Derivatives are bets. Often a relatively small loss (and $2 billion here is relatively small) occurs because of a much larger bet – one possibly in the 10’s or 100’s of billions of dollars, or more. Hence, what makes the $2 billion truly scary is that this loss most likely resulted from bets that were unconscionably large.

The Wall Street Journal’s Jonathan Macey has a different perspective. He points out that “losing money isn’t a crime.” Finance involves some risk and the inevitable result of taking risks is winning or losing money. JPMorgan Chase still has $127 billion in equity. This $2 billion mess-up was a big mistake. But JP Morgan Chase can afford to lose $2 billion. Then Macey asks whether Federal regulators would be able to better manage this risk than JP Morgan Chase’s mathematicians. In fact, it could be argued that the Federal Government should first learn how to balance its own budget before it goes interfering with JP Morgan’s derivatives.

Should the Government penalize JPMorgan Chase for losing $2 billion? Isn’t $2 billion itself a big enough fine? JPMorgan Chase has very natural incentive not to mess up like this. But I stray from my main point…

Heads I win, tails you lose

George W. Bush and Ben Bernanke established a precedent that certain institutions, like JP Morgan Chase, are “too big to fail.” President Obama an Congress have supported this. It means that if one of these institutions were to fail (as many of them almost did three years ago), the Feds would come in, cover their losses, and bail them out. Therefore, the Federal Government, and the American People, have an inherent interest in preventing the big banks from losing too much money. On the other hand, the stockholders and managers have an interest in these big banks earning high profits. Together, these two incentives – “heads I win, tails you lose” – hold great potential for catastrophe, because, in essence, the Wall Street risk-takers know that they get to keep profits, but that – in a catastrophe – the Government will cover their losses.

The $2 billion loss was a relatively small mess-up, small enough so that the Federal Government didn’t have to cover it. However, it suggests that mess-ups can happen, and that we, the American taxpayers, could be stuck holding the check. Remember the S&L crisis of the 80’s and 90’s, when savings and loans banks were disproportionately loaning money to risky real-estate ventures, while being protected by Federal Government guarantees (FSLIC)? Same “heads I win, tails you lose” problem. That one didn’t turn out well.

In summary, Wall Street can’t expect a “too big to fail” mentality while resisting Federal regulation. After all, shouldn’t the Government have the ability to help banks avoid making stupid mistakes that will cost the taxpayer an absurd amount of money? On the other hand, the Government could simply decide to cut the big banks loose, and let them do stupid things and lose as much money as they want, with the implicit understanding that Government bail out is no longer an option.

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About Mark P. Holtzman

Chair of Accounting Department at Seton Hall University. PhD from The University of Texas at Austin. Worked at Deloitte's New York Office. BSBA from Hofstra University.

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