The $2 Billion Boo-Boo

JPMorgan's derivatives debacle is reason enough to toughen the Volcker rule

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Henry Campbell for TIME

At the end of every e-mail you get from Wall Street investment advisers and brokers is the phrase "Past performance is not necessarily indicative of future results." Would that anyone read the small print. JPMorgan Chase came through the financial crisis relatively unscathed only to stomp on a land mine in the form of a bungled series of risky derivatives trades. The derivatives positions were designed to hedge the firm's portfolio against slower economic growth, but they proved too complex to manage, resulting in a $2 billion--and growing--loss for the bank. According to a number of reports, the U.S. Department of Justice has opened an inquiry into the trades. (DOJ won't officially confirm or deny, as per usual, until there's a public filing.) The FBI has begun a preliminary investigation into the deals, which are financially just a bruise for the bank. JP is still expected to post a $4 billion profit in the next quarter alone.

But the write-down represents a major loss of face for CEO Jamie Dimon, the Teflon banker who has lobbied hard against re-regulation in the post-meltdown era. Justly famous for his command of banking detail, Dimon was forced to eat a huge helping of humble pie, admitting that the offending trade had been "flawed, complex, poorly reviewed, poorly executed and poorly monitored."

A few weeks back, Dimon told investors that concerns over the London trading group in charge of the deals were "a complete tempest in a teapot." DOJ will be interested to find out if he knew the losses were coming and lied about it on the call, or if those around him knowingly misinformed him before he spoke to investors. Either would be a criminal offense. And both are unlikely, given the public scrutiny of the industry lately and Dimon's reputation, but it might be possible that traders in London were trying to hide the initial losses, hoping they could make their money back before the bosses noticed. Making a stupid trade is legal. Lying about it isn't, but as one former prosecutor told me, it happens all the time.

Let's assume the risky trades, which involved complicated derivatives that Warren Buffett once called "financial weapons of mass destruction," are legit. The problem is that the resulting losses have totally undermined Dimon's arguments for watering down or eliminating the Volcker rule, which would prohibit banks from proprietary trading--that is, risking their own capital. Thanks in large part to Dimon's personal lobbying, the proposed rule currently allows for "portfolio hedging." That means banks could set up synthetic derivatives like the ones that backfired in JPMorgan's effort to try to hedge its loan portfolio, as long as they don't actively try to make a profit from them. (Historically, the problem for banks is that they borrow short and lend long, so they are exposed to interest-rate risk.)

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