Question: Derivative Losses at JPMorgan Chase

JPMorgan Chase (sometimes referred to by its short name, JPMorgan) was one of the largest banks in the United States and the only major bank to remain profitable during the 2008 financial crisis. In May 2012, the bank surprised the financial community and the American public when it announced that one of its derivative trading groups had lost an astonishing $2 billion of the bank's money. Derivatives were financial instruments that derived their value from changes in the price of commodities (such as wheat), the level of interest rates, or an underlying asset such as mortgages. They were bought and sold-usually by big institutions such as pension funds or sovereign wealth funds-which were essentially making a bet on whether the prices of the underlying assets would go up or down. The leading creators and brokers of derivatives were five large Wall Street banks-JPMorgan, Goldman Sachs, Morgan Stanley, Bank of America, and Citigroup. These banks also traded derivatives for their own investment portfolios, seeking to profit from their own insights into market movements.

The derivative business produced about $20 billion in revenues for the five major banks in 2010. Within minutes after JPMorgan's announcement of their losses, the company's stock lost almost 10 percent of its value, wiping out about $15 billion in market value. Fitch Ratings downgraded the bank's credit rating by one notch and Standard & Poor's cut its outlook of JPMorgan to "negative," indicating that a credit-rating downgrade would follow. Other banks were caught in the decline in confidence. Morgan Stanley, Citigroup, and Goldman Sachs stock all closed down about 4 percent. Critics of the banking community were quick to jump on the reported JPMorgan losses. "It just shows they can't manage risk-and if JPMorgan can't, no one can," said Simon Johnson, former chief economist for the International Monetary Fund. When Congress had debated financial regulatory reform in 2010, it considered imposing government rules on the trading of derivatives. Trading in some kinds of derivatives (particularly those whose value was tied to mortgages), which were largely unregulated at the time, had profoundly destabilized the U.S. and world economies in 2008, and Congress sought to avoid a similar situation in the future.

For this reason, it sought to extend government oversight. Unlike stocks and bonds, which were traded on public exchanges such as the New York Stock Exchange, most derivative deals were private agreements between two parties. Congress proposed instead that derivatives be traded in public "clearinghouses" run by intermediaries, where regulators could scrutinize these transactions. The big banks, including JPMorgan, had argued vigorously against this, saying that intermediaries could reveal sensitive pricing information or the structure of the deal, potentially benefiting rivals and reducing the banks' profits. But in 2010, Congress decided to extend government regulation over the derivatives market, despite the industry's opposition. In addition to requiring regulated trading through clearinghouses, the Dodd-Frank Act also included a provision called the Volker Rule. This rule, named after a former head of the Federal Reserve, Paul Volker, who had suggested it, said that banks could not trade derivatives for their own accounts-something they had commonly done before DoddFrank. The purpose of the rule was to prevent banks from taking on excessive risk by making big bets-and leaving taxpayers on the hook to bail them out if something went seriously wrong, as it had in 2008. An exception was made for derivatives trading done to hedge risk in a bank's own portfolio. In 2012, the Securities and Exchange Commission was still trying to figure out exactly how to implement this part of the law-and what exactly a hedging trade was, as opposed to some other kind-so banks were still largely free to do what they wanted. Bank lobbyists were still busy arguing for a loose interpretation of the rule. JPMorgan's huge losses startled both Congress and regulators, and again posed the question of what kinds of regulations were necessary. Many wondered if the bank's (and its shareholders') losses could have been avoided if a strict interpretation of the Volker Rule had already been in effect.

"It is premature to conclude whether the Volker Rule in the Dodd-Frank Act would have prohibited these trades," said Bryan Hubbard, spokesperson for the U.S. Office of the Comptroller, referring to the fact that the specific rules had not yet been written. Representative Barney Frank, coauthor of the Dodd-Frank Act, commented, "When a supposedly responsible, well-run organization could make such an enormous mistake with derivatives, that really blows up the argument, ‘Oh, leave us alone, we don't need you to regulate us.'" To Frank, the losses underscored the continuing need for strong government oversight. Weeks later, after an internal investigation by the bank, JPMorgan chief executive officer Jamie Dimon announced that three high-ranking executives were leaving the company: Ina Drew, who ran the risk management unit that was responsible for the company's derivative losses; Achilles Macris, who was in charge of the London-based desk that placed the trades; and Javier Martin-Artajo, a trader and managing director of Macris's team. Dimon also said that the trading positions taken had produced losses that could go as high as $5 billion. Later, others estimated that the losses could be as high as $9 billion. Unlike the banking crisis a few years earlier, these losses would be absorbed by the bank-or its shareholders-and a bailout, which would have passed the costs along to the taxpayers, would not be needed. At the company's annual meeting a few days later, Dimon addressed the issue of increased regulation. While he continued to criticize the cost and complexity of added regulation, he said he supported most of the proposed regulatory rules, including some of the Volker Rule, but did not elaborate further.

Discussion Questions

1. Does this case indicate that JPMorgan and the federal government were in a collaborative partnership or working at arm's length? Why do you think so?

2. Which stakeholders benefited, and which were hurt, by JPMorgan's actions in this case? For those that were hurt, wasn't this a risk they were willing to take?

3. Were the regulations of derivatives trading legislated by Congress in 2010 an example of economic or social regulations? What were the arguments in favor of and opposed to these regulations?

4. Do you believe the government should have regulated the trading of derivatives further, and why or why not? If so, what kinds of regulations would you favor?