JPMorgan Chase’s $2 billion failed credit risk hedge is different than the investments that led to the corporate credit union crisis. However, there are also similarities, according to industry investment experts. Specifically, overleveraging and a drive for income that compromised risk management.
Jason Haley, fixed income strategist for ALM First Advisors, admits he wasn’t in his current position during the corporate crisis, so his knowledge regarding the specific securities that led to the corporate meltdown is limited. However, he said high-leverage investments like the JPMorgan Chase deal could cause big losses anywhere, even at credit unions.
“It was highly leveraged, so any changes in the underlying securities can have a huge effect and lead to big mark-to-market losses,” he said. “Any investor could get themselves in over their heads, even with a simple agency product, if they don’t have good risk management or regulatory oversight. There can always be someone who makes imprudent decisions even within regulations.”
Brian Hague, president/CEO of CNBS LLC, said the motivation behind the investments made at JPMorgan Chase and large corporate credit unions was the same: income.
“Financial firms create, from the top, perverse incentives that reward risky behaviors,” Hague said. “Even the corporates are like this. Bonuses don’t come out of reducing risk, they come out of making a whole lot of money.”
However, comparing the investment brainpower behind JPMorgan to corporate credit unions “would be like comparing Einstein to a D-student,” he said.
JPMorgan Chase is a huge, extremely sophisticated and complex financial organization, Hague said, and on some level, they knew exactly what they were doing.
“It’s kind of like when somebody goes to Vegas and bets big on just one number,” he said. “They know they’re betting and not hedging. They just picked the wrong number.”
A corporate insider, who asked to remain anonymous, said the losses at JPMorgan weren’t as bad as corporate losses when comparing the size of the loss to capital and assets. While WesCorp posted more than $2 billion in losses, the former California corporate’s balance sheet was less than 2% the size of JPMorgan’s. While big in absolute terms, JPMorgan’s investment was manageable compared to the size of the megabank.
“Don’t discount the fact that JPMorgan is enormously big,” he said. “At $2.3 trillion in assets, it’s more than twice the size of the whole credit union industry. JPMorgan would have to lose more than $26 billion to make it equivalently as bad as our $12 billion corporate crisis.”
Hague agreed with that comparison.
“This is a blip on JPMorgan’s balance sheet,” he said. CEO Jamie Dimon said the losses may be as high as $3 billion, but this is a company that made a $19 billion profit last year. This loss dropped their core capital from 8.4% to 8.2%, another area where there is no comparison to the corporates because they weren’t nearly that well-capitalized.”
Both corporate and natural person credit unions can invest in interest rate derivatives, “a relatively safe way to hedge” against losses, Haley said. However, credit unions aren’t permitted to invest in the large scale series of indexes and credit default swaps that hedged against European debt, which tripped up JPMorgan.
“That’s the big difference between large banks and credit unions,” Haley said. “Banks have fewer restrictions on investment decisions. If you look at what is permissible for banks of that size, it looks like JPMorgan was running a hedge fund instead of a depository institution.”
NCUA spokesman John Zimmerman called permissible credit union swaps and the JPMorgan investment “entirely different animals.”
According to current corporate regulations, corporates are allowed to do some foreign investment and some derivatives, Zimmerman said. However, so far none of the corporates have asked the NCUA for the ability to do so.
In January of this year, the NCUA put forth an advance notice of a proposed rule requesting comment to “identify the conditions for federal credit unions to engage in certain derivatives transactions for the purpose of offsetting interest rate risk.” The comment request follows an original request on the same topic in 2011, and this year is asking additional questions regarding the conditions under which the NCUA may grant authority for a federal credit union engage in derivatives transactions “independently,” which means without program oversight by a third-party provider, the NCUA wrote in the Federal Register. The comment period ended April 3.
“Nothing is happening with that right now as far as drafting a rule,” Zimmerman said. He said he doesn’t think the NCUA will shy away from increasing the ability of credit unions to invest in derivatives as a result of the JPMorgan losses.
“It’s a pretty big gulf from what credit unions are doing and JPMorgan,” he said. “We are always aware of risk, but what they did will not affect us.”
Bank regulators may pull back the reins on some risky investment practices, but Hague said he thinks at the end of the day, not much will change.
“This is great campaign fodder, couldn’t happen in a better year,” Hague said. “Both sides will get their sound bites, but if we have any increased regulation, it will be so watered down, it won’t be effective.”
Trading, especially derivatives, has become so complex, Hague said he doesn’t think regulators understand them enough to effectively regulate them.
Haley said the loss will have a negative impact on banking lobby, because so many considered JPMorgan to be the industry standard for risk management.
“It gives the proponents of the Volcker Rule all the ammo they need to make final rule as stringent as possible,” he said. “But, regardless of what happens, it will be difficult for regulators to truly differentiate between what is proprietary trading and hedging, which makes Volcker ineffective in my opinion.”
Both Haley and Hague agreed that “too big to fail” is a bigger issue than proprietary trading.
“Dimon passes [the loss] off relative to size of his balance sheet, but to the average American, that’s not going to play real well,” Hague said. “Three billion dollars is a whole lot of money, and it strengthens the argument of too big to fail. If $3 billion is nothing to you, you’re too big for our financial system to try to protect.”
Haley said the whole issue of Volcker Rule was to reduce systemic risk to markets, but stopping proprietary trading won’t reduce that risk.
Bruce Fox, chief financial officer of the $2 billion Catalyst Corporate FCU, said in his opinion, proprietary trading is the bigger issue.
“The losses were in JPM’s bank portfolio,” Fox said, which is considered proprietary trading.
Both investors agreed that the losses aren’t likely to impact the profit credit unions receive on investments, despite bank claims that regulatory fallout could increase infrastructure costs that they would have to pass on to others or decrease market liquidity. Additionally, reduced investment income at big banks isn’t likely to cross over to commercial banking balance sheets and result in higher bank fees or other bank product and service repricing that could be beneficial to credit unions.
Fox said Catalyst has not heard from member credit unions concerned about accounts or investments the corporate has with JPMorgan. Catalyst Corporate has a settlement account with JP Morgan, he said, but deposits in the account are guaranteed.
Haley said he has heard from clients concerned about investments, but he said he tells them JPMorgan is one of the healthier banks out there right now, and headlines regarding the loss instead stem from “egg on Dimon’s face.” Haley said he’s more concerned about problems in Europe affecting the American economy than losses by JPMorgan or other U.S. banks.
Hague said his clients haven’t expressed much concern about JPMorgan.