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The JPMorgan Chase (JPMC) story – in which the bank lost $2 billion on a failed effort to hedge a $400 billion portfolio of assets – has morphed into a Jamie Dimon story, complete with gossip about his private comments at a dinner party. The story is following the usual pattern: regulatory agencies piling on; inaccurate reporting about what the law requires; reporters consulting “experts” with political motivations who don’t know what they’re talking about; politicization of the story so that it becomes relevant to a public issue – in this case the Volcker rule; and then the focus on whether a well-known and respected person will be brought down by the controversy. It’s depressing to watch, but it is missing the point that the Volcker rule would not have prevented the loss and is probably unworkable.
There are a few things about this story that should be considered up front. Banking is a very risky business; only news reporters could think otherwise. A $2 billion loss sounds like a lot, but it’s 1/1000th the size of JPMC’s balance sheet. Hedging is not an option for a bank or any other financial institution; it’s an obligation. Hedges reduce risks, but they do it by taking a risk on a contrary or opposite trade. Hedges can go wrong as easily as proprietary trading, especially if there isn’t a perfect hedge for the particular risk a financial institution is trying to cover; in that case, hedges are complex and can miss the mark. On the other hand, if the bank had not hedged its risk, a turn in the market might have made its losses even larger. Since the portfolio the bank was hedging was almost $400 billion, a substantial loss on a non-hedged portfolio wouldn’t be surprising. The use of derivatives did not make this hedge any riskier than it would have been if actual securities had been used instead, but derivatives are often used for hedges because they are more flexible and can be tailored to specific needs.
JPMC’s loss and Jamie Dimon’s fall from grace in the media is now part of the debate in Washington over the Volcker rule, but this is an artifact of the misinformation that has surrounded this issue. The Volcker rule would not have prevented the loss because it doesn’t prevent hedging. Senators Carl Levin (D-MI) and Jeff Merkley (D-OR) have claimed that the Volcker rule limits hedging to specific risks and prohibits attempting to cover the risk of a whole portfolio. But this is incorrect. The statutory language is clear that hedging is permitted on both single risks and on portfolios of risks – which the act calls “aggregated positions.” Senators Levin and Merkley had proposed an amendment to ban portfolio hedging, but it failed. They are now trying to get the same result by pressuring the regulators who are drafting the rule.
The problem with the Volcker rule is that proprietary trading and hedging look very much alike. Both involve buying and selling fixed income securities or derivatives. At the very least, it is necessary to review all the facts and circumstances about a transaction in order to be sure that it is a hedge rather than a proprietary trade. Attempting to write a rule that distinguishes between these two – prohibiting one, but permitting the other – is a daunting and probably impossible task. The reason that the regulation has been so long in coming is that the regulators are wrestling with this contradiction, trying to figure out how they can write a rule that defines a line for banks to follow. A failure to develop such a rule could paralyze the banks, limiting their hedging activities because of fear that they may be violating the restrictions on proprietary trading. A draft rule, put out several months ago, was almost 300 pages long and contained over 300 questions. The latest indications are that the regulation will not be ready by the July 21 deadline – two years after the adoption of the Dodd-Frank Act. In reality, the regulators should tell Congress that it can’t be done, that the Volcker rule should simply be repealed.
The unworkable Volcker rule is emblematic of the Dodd-Frank Act as a whole. The Democratic Congress that passed this law – and the Democratic administration that largely drafted it – interpreted the financial crisis of 2008 as a failure of regulation. Accordingly, the Volcker rule and dozens of other provisions thrown into the act are commands to the regulators to impose harsh and in some cases punitive regulation on the financial institutions that were seen as taking advantage of the freedom of action they were imprudently given. The true cause of the financial crisis – the housing policy of the U.S. government, implemented through Fannie Mae and Freddie Mac – was completely ignored. It will take an election to undo the Dodd-Frank Act and address the real cause of what happened in 2008.
Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute.
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