JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon railed against higher capital requirements last year at the same time his bank was using derivatives to hedge more than $1 trillion of loans and bonds.
Those bets, which led to $2 billion of losses, wouldn’t have been necessary if JPMorgan did what banks once did: rely on bigger capital buffers rather than credit-default swaps to hedge against souring loans. One hundred years ago the equity of U.S. lenders was about 20 percent of total assets, compared with 9 percent now, according to data compiled by the Federal Reserve. For JPMorgan, it was 7 percent last quarter.
The bank, which had bought or sold credit-derivative contracts with a notional value of $5.8 trillion as of the end of last year, would have been better off piling up capital the way lenders did last century, said Anat Admati, a finance professor at Stanford University.
“Only equity capital is the true protection against losses, whether from loans or other risks,” said Admati, who has written about bank capital. “Dimon and other bank CEOs lobby against rules that would force them to reduce leverage. Then they try to hide risks through derivatives that offer more ways to borrow and speculate.”
Bankers at New York-based JPMorgan invented credit-default swaps, or CDS, in the 1990s as a way of reducing the capital financial institutions need to hold. The contracts require the seller to pay face value in exchange for the underlying securities or the cash equivalent should a borrower default, allowing firms that buy the swaps to shift some of their credit risk to third-party investors, at least in theory.
In the same decade, U.S. and European banks pushed to revise global regulations to let them reduce the capital they needed to hold against assets that their own models showed as less risky, such as top-rated mortgage-backed securities.
After a financial crisis that led to $1.5 trillion in bank writedowns and losses tied to some of those securities, the Basel Committee on Banking Supervision, which brings together regulators from 27 countries, doubled in 2010 the minimum capital requirement for the largest firms to 9 percent of risk-weighted assets. The committee let lenders continue using their own models to assess risk.
While Dimon, 56, has voiced support for strong capital requirements, he has said some of the rules hurt U.S. banks more than foreign counterparts and assailed proposed capital surcharges for the world’s largest lenders. He quarreled with Bank of Canada Governor Mark Carney at a meeting in Washington in September, calling the Basel regulations “anti-American.”
Brian Marchiony, a spokesman for JPMorgan in London, declined to comment.
JPMorgan, the largest U.S. lender, had $721 billion of loans on its books at the end of the first quarter and held $404 billion of corporate and mortgage bonds, according to regulatory filings. Its bets on credit derivatives tied to investment-grade debt jumped eightfold to $84 billion.
Traders in the bank’s chief investment office bought derivatives to “hedge the company in a stressed credit environment,” Dimon said in a conference call with analysts on May 10 announcing the $2 billion loss.
“JPMorgan has a huge portfolio of loans and corporate bonds, so they wanted to hedge their credit risk in case the economy deteriorated,” said Peter Tchir, founder of New York-based TF Market Advisors, which helps hedge funds devise derivatives strategies.
The bank is thought to have sold protection on an index of corporate debt and bought insurance on the same index to hedge its initial bet, according to market participants who asked not to be identified because the trading strategies aren’t public. The two bets moved in opposite directions this year, causing losses, the people said.
“Hedging is based on a lot of assumptions, and if any of those don’t work, you no longer have the buffer for the loss,” said Kevin Dowd, a visiting professor of business at the City University of London who has written three books on risk management. “The models might not work. The correlations may go in directions you weren’t expecting. New types of risk are introduced as you’re trying to reduce risk.”
Using derivatives as a hedge shouldn’t be a substitute for holding capital, Dowd said.
The swaps banks bought to hedge against Greek bonds almost proved worthless in March when the country restructured its debt. If the terms of the exchange had been voluntary, the CDS wouldn’t have been triggered and banks would have lost 54 percent of the nominal value of their bonds without getting any payment from their hedges.
‘Models Blow Up’
A similar hedging attempt by two Bear Stearns Cos. funds that invested in securities linked to subprime mortgages went awry in 2007, when CDS prices moved in the opposite direction of the underlying bonds. That caused losses on both sides for the funds, pushing them into insolvency.
“Every time models blow up like this, as happened at JPMorgan, it’s evidence that they shouldn’t be able to get around capital regulations using them,” said James Kwak, an associate professor of law at the University of Connecticut and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”
Dabbling in trillions of dollars of derivatives makes the banks black boxes that investors can’t decipher, said George Shipp, manager of the $1 billion Sterling Capital Equity Income Fund in Virginia Beach, Virginia. That’s one reason why the market values of the largest U.S. banks are about two-thirds of their stated book values, he said.
“If I were the king and had absolute power to change rules, I’d ask for more capital,” said Shipp, whose fund avoids investing heavily in bank stocks. “I’d turn the clock back to the 1920s-and ’30s, when capital was multiple-times higher.”
The valuation of Wells Fargo & Co., the fourth-largest U.S. bank, shows investors are willing to pay more for shares of a lender that doesn’t rely as much on derivatives, Shipp said. Wells Fargo, based in San Francisco, is the only one of the six largest U.S. banks with a share price exceeding its book value.
That means investors agree with the company’s estimate of how much money would remain if its assets were liquidated and liabilities paid off and also are willing to pay a premium for the franchise. JPMorgan’s stock price is 70 percent of its book value. Others range from 37 percent to 71 percent.
No Capital Relief
Wells Fargo has bought and sold credit-derivative contracts with a notional value of $75 billion as of Dec. 31, compared with $5.8 trillion for JPMorgan, according to the most recent data available from the Office of the Comptroller of the Currency. Wells Fargo has said it doesn’t use credit-default swaps to hedge its loan book.
“Our view of managing our risk is on a day-to-day basis,” Michael Loughlin, Wells Fargo’s chief risk officer, said at a conference last week. “We either make a loan or we don’t make a loan. We either buy a security or we don’t buy a security.”
That view is shared by TF Market Advisors’ Tchir. Hedges shouldn’t provide capital relief to banks, he said. Instead, firms should be required to hold capital against their hedges as well as their loans. Banks with larger derivatives or loan portfolios should hold even more capital because trying to sell large chunks of any asset will lower prices.
“The only real hedge is to sell,” Tchir said. “All these supposed hedges are really just bets.”
‘Close the Gap’
A progressive capital regime like the one described by Tchir was designed by Allan Meltzer, a professor of political economy at Carnegie Mellon University in Pittsburgh.
The only way to reduce the risk that the largest banks pose to the public coffers when they fail is to force them to hold the same amount of capital they did in the last century, about 20 percent, Meltzer said in an interview. That ratio needs to be calculated on total assets because risk-weighting with the use of models is easily gamed, he said.
“The purpose of regulation is to close the gap between private and public costs,” said Meltzer, who also wrote a three-volume book on the history of the Fed. “With more capital, stockholders will make the management pay more attention to mistakes because they will bear the losses. Now the shareholders rely on the government to bail them out.”
U.S. banks benefit from accounting rules that allow them to net their derivatives positions more than their European counterparts. When Deutsche Bank AG, Germany’s largest lender, reported under U.S. accounting standards, as it did until a few years ago, its total assets were half what they were under international rules.
The accounting benefit is another way U.S. banks lower their capital requirements in addition to buying swaps to hedge credit risk. Unlike Europe, the U.S. has a leverage cap, which limits the amount banks’ assets can exceed capital to 25 times. Thanks to netting, derivatives mostly aren’t counted among these assets. The $71 trillion in notional value of all derivatives bought and sold by JPMorgan, as reported to the OCC, including interest-rate swaps and exchange-traded futures and options, was netted down to $85 billion of assets and $74 billion of liabilities on the bank’s balance sheet.
Netting underestimates the risk of derivatives because it assumes that all parties to the trades can pay up when required. During the 2008 crisis, American International Group Inc. couldn’t meet its obligations on credit-default swaps sold to dozens of banks and had to be rescued by U.S. taxpayers to make those payments possible. Netting also is based on opposite-looking bets supposedly negating each other. JPMorgan’s losses show that such directional assumptions don’t always hold.
The Financial Accounting Standards Board, which sets rules for U.S. companies, has backed away from changing this treatment of derivatives after initially signaling it would adopt more stringent European rules. Meanwhile, the European Union has balked at installing a leverage ratio like the one in the U.S. that ignores risk-weightings, even though that was agreed to by global regulators in 2010.
“We need a simple leverage ratio that can’t be gamed through risk models or accounting gimmicks,” said Kwak, the University of Connecticut law professor. “Otherwise, banks will keep blowing up, and we’ll keep picking up the tab.”