The $2 Billion Boo-Boo

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

  • Henry Campbell for TIME

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    It's hard to believe that JP's chief investment office, which made the trades, wasn't designed to be a profit center when the head of it, now set to leave the bank, earned $15 million last year. But even if you buy that, the case underscores that any portfolio hedging carries what's known as basis risk. In the case of a huge bank like JPMorgan, which is several times as big as the world's largest hedge funds, its very size is bound to create a market-moving event when it takes a position large enough to protect itself. "If you are the market," one risk expert told me, "you can't hedge it."

    The other issue is that no one--not even smart guys like Dimon--fully understands the complexities of synthetic derivatives. Aside from underscoring the fact that the "too big to fail" problem is still very much with us, the JPMorgan losses show that risk management is far from an exact science. Indeed, I've never understood why financial-risk modeling has ever been considered much more than rune reading. After all, it involves throwing thousands of variables about all the bad things that could happen into a black box, shaking them up with the millions of positions taken daily by banks and extrapolating it all into a simple, easy-to-understand number about how much is likely to be lost if things go belly-up. What could possibly go wrong, especially when you're relying on past assumptions (the sovereign debt of the U.S. and Europe will never be downgraded!) and don't account for the fact that market-moving events often create their own momentum? Who knew trouble in Greece would make it tough to get a loan in Italy?

    Ultimately, the only way for banks to manage risk is to take on less of it. We're headed into a world where banks will soon be doing just that, either by choice or by regulation. You don't have to read the fine print to know that this will likely result in fewer unexpected $2 billion losses--and fewer $23 million pay packages.

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