JPMorgan Chase’s multi billion-dollar trading debacle may be small relative to the bank’s capital and profits. But this is not a simple private business transaction that the public should ignore. JPMorgan is not Joe’s Hardware. The big bank enjoys a privileged position in the U.S. economy, and anything that reveals serious inner failings is of public concern.
Moreover, the inner failings revealed in this particular incident demonstrate that the activities and institutional culture that brought us to the edge of an economic abyss four years ago still are common.
To understand the whole debacle, it first is necessary to understand the myriad roles a mega-institution like JPMorgan plays in the global financial system. For six decades after the financial meltdown of the early 1930s, U.S. public policy was to separate these roles. But we reversed that policy in the 1980s and 1990s. That is a major reason the complexity and interconnectedness of JPMorgan now is as large a problem as its total size.
Consider the following historic classifications of financial institutions:
A “commercial bank” is a financial institution that takes deposits from the public and makes loans. This is what most people think of when they hear the word “bank.”
An “investment bank” carries out the initial issue of new stocks, bonds and other financial instruments. It also might advise corporations on mergers, acquisitions and other financing activities. But from 1933 to 1999, investment banks could not take deposits, just as commercial banks could not underwrite securities issues.
“Brokers and dealers” administer sales of existing stocks and bonds from one set of owners to another. Just as for real estate brokers, financial sector brokers match up sellers and buyers, but never own the stock or bond itself. Dealers usually own quantities of popular stocks and bonds, buying directly from those who want to sell and selling directly to those who want to buy. But they are not allowed to own large amounts of such instruments in the hope of making a profit for their own account from the instrument increasing in value.
“Primary dealers” are a select subset of bond dealers who are accredited to handle the initial issuance of new U.S. Treasury bonds. And in normal circumstances, at least, the Federal Reserve trades with these primary dealers as it buys or sells bonds in its “open-market operations” to increase or decrease the money supply and thus lower or raise interest rates and change overall liquidity in financial markets. JPMorgan is such a primary dealer.
“Investment funds” do buy stocks, bonds and other investments for the purpose of making a profit from changes in the value of financial instruments. Historically, this meant they bought stocks and bonds, hoping for favorable returns in the form of dividends, interest and price increases. But with modern derivative securities, it is equally possible to make a profit from some apparently adverse event such as stocks or bonds going down or a loan being defaulted on.
Such investment funds may operate primarily for third parties like pension funds or private investors. The Minnesota State Retirement System and mutual funds like Fidelity or Vanguard are in this group. But investment funds also may exist for the benefit of a small number of individuals. George Soros, who made billions betting on the collapse of the European currency system in 1992, and John Paulson, who made even larger amounts from the mortgage-backed security debacle, are good examples.
In the past, financial functions were divided among different kinds of firms. Commercial banks did not underwrite new securities issues or act as brokers. Investment banks did not accept deposits. Brokerages did not underwrite new stock and bond issues.
Moreover, only commercial banks were eligible for FDIC insurance of deposits and, in most circumstances, only commercial banks could borrow directly from the Federal Reserve.
Over the past 20 years, however, all that has changed. JPMorgan does all of the above. And other large institutions like Citigroup, Goldman Sachs, Bank of America and Wells Fargo similarly are involved in most such activities, if not all.
If Joe’s Hardware gets into financial difficulty, neither Joe, nor anyone else to whom the business owes money, can go to a government entity for an emergency loan. If the store goes broke, there is no government guarantee of its liabilities like the FDIC guarantee of the first $250,000 of each depositor’s account. And if Joe’s crashes, it won’t send financial waves rushing through the rest of the world economy. But if JPMorgan failed, all these factors would be in play.
The fact that JPMorgan’s losses in this one deal are small relative to its capital and earnings is immaterial. The latest incident demonstrates that, just as with Bear Stearns, Lehman Brothers and AIG, top JPMorgan management had neither any idea about — nor effective control over — the true risks being run on their watch.
Exactly what JPMorgan did to get into trouble is complicated. Look for that in the next column.