When is a hedge not a hedge?
That’s the question regulators from the Federal Reserve to the Office of the Comptroller of the Currency are confronting after JPMorgan Chase & Co. reported a $2 billion trading loss from a credit-derivatives position Chief Executive Officer Jamie Dimon called a “hedge.”
Regulators are under pressure to respond to JPMorgan’s loss as they finish writing the so-called Volcker Rule, which restricts banks' proprietary trading and is the most controversial provision in the Dodd-Frank Act. They’re scrutinizing the so-called hedging exemption in the proposed regulation and probably will narrow the exceptions for trades banks say are designed to mitigate risk, according to two people familiar with the matter.
JPMorgan’s loss “will reinforce the position of those who want to be tough,” Representative Barney Frank, a Massachusetts Democrat and co-author of the financial-overhaul legislation, said in a telephone interview. “I do think it will mean Volcker will not allow” such trades.
The rule, named for former Fed Chairman Paul Volcker, is intended to reduce the chance that banks will put depositors’ money at risk. Dodd-Frank, signed into law in 2010, largely left regulators to define the provisions, and in October, they released a proposal for the rule, which is scheduled to take effect in July. In April, the Fed said banks would have two years to implement it, as long as they make a “good faith” effort to comply with the ban on proprietary trading.
Pool of Investments
Under the proposed version, bankers would be permitted to do “risk-mitigating hedging activities” for “aggregate positions.” That means using derivatives or other products to reduce the risk of an entire pool of investments, as opposed to a single transaction or position.
The JPMorgan loss has ignited a debate whether aggregate or portfolio hedging is appropriate at all and how to define and spot these trades.
Frank said he hopes regulators will prevent such positions, allowing banks to hedge only against specific investments to offset potential losses.
“Aggregate hedging isn’t hedging, it’s a profit center,” he said. “They are talking about making money out of it,” when “hedges break even.”
In the wake of JPMorgan’s loss, regulators “clearly” are looking “more skeptically at the claim about portfolio hedging and what does the word ‘aggregate’ in the law mean you have to do,” said Karen Shaw Petrou, a managing partner at Federal Financial Analytics, a Washington research firm.
Wall Street has aggressively lobbied against the Volcker Rule. The five regulators implementing the provision received over 17,000 comment letters -- the most for any part of the law. Bankers devoted the majority of their efforts to aspects other than hedging, such as allowances for trading by so-called market-makers who buy and sell securities to establish prices and whether banks can take positions in sovereign debt.
JPMorgan employs 12 lobbyists and spent $7.6 million on these activities in 2011, according to the Center for Responsive Politics in Washington. Dimon led Wall Street bosses in a closed-door meeting with Fed Governor Daniel Tarullo on May 2 to press the central bank to ease regulations, including the Volcker Rule.
Dimon publicly challenged Ben S. Bernanke in June 2011 on tougher oversight, asking whether the Fed chairman had “a fear like I do” that overzealous regulation “will be the reason it took so long” for banks, credit and job creation to recover from the financial crisis.
Fed spokeswoman Barbara Hagenbaugh declined to comment.
The KBW Bank Index of 24 financial stocks has dropped 14 percent since July 2010, the month Dodd-Frank was passed, compared with a 16 percent gain in the Standard & Poor’s 500 Index of stocks. JPMorgan shares have underperformed both, tumbling 21 percent to $31.93 on June 1.
Bank lobbyists now say they’re on hold in reaction to the attention JPMorgan has attracted. Their complaints may only strengthen the call for tougher rules, said Oliver Ireland, a partner at Morrison & Foerster LLP.
“The problem with this event is it doesn’t do the industry’s credibility any good, so it’s not clear the industry pushing a lot harder now would do any good,‘‘ Ireland said. ‘‘It may create a backlash.’’
Dimon, who asked regulators in a February letter to loosen up their definition of portfolio hedging, said on a May 10 call with analysts that JPMorgan’s chief investment office made ‘‘egregious mistakes’’ by taking flawed positions on synthetic credit. He previously pushed the unit, which oversees about $360 billion, to seek profit by speculating on higher-yielding assets, ex-employees said in April.
The positions were ‘‘done with the intention to hedge the tail risk for JPMorgan’’ and could result in an additional $1 billion loss or more as they’re wound down, Dimon said. ‘‘But I am telling you it morphed over time; and the new strategy, which was meant to reduce the hedge overall, made it more complex, more risky, and it was unbelievably ineffective.’’
JPMorgan profited in 2011 by betting that credit conditions would worsen. Then in December, the European Central Bank provided long-term loans to euro-zone banks, igniting a bond rally and leaving JPMorgan’s bearish bets vulnerable. So the chief investment office made offsetting bullish investments using credit-default-swap indexes that are thought to expire at the end of 2017, according to market participants.
The office put on another bearish trade to protect against short-term losses using contracts due in 2012, market participants said. Losses may have mounted when prices between the two indexes became distorted because JPMorgan was such a big seller of insurance. The trader who built the credit-derivatives positions, Bruno Iksil, was nicknamed the ‘‘London whale’’ because the investments became so large.
Credit conditions subsequently deteriorated, and hedge funds increased purchases of the 2017 contracts, sending those higher than the 2012 index and boosting JPMorgan’s losses.
The company’s investments can’t ‘‘be described in any way as a hedge,” Michael Platt, co-founder and CEO of BlueCrest Capital Management LLP, said in a May 21 interview with Bloomberg Television. “I think it’s a trading loss. They deliberately put the positions on. The London whale, who has subsequently been harpooned, put the positions on.”
Geneva-based BlueCrest manages $32 billion and took a “small” position against JPMorgan, Platt said.
Gone Too Far
U.S. Commodity Futures Trading Commission Chairman Gary Gensler and U.S. Securities & Exchange Commission Chairman Mary Schapiro both acknowledged May 22 the difficulty regulators face in allowing some risk-mitigating hedging and then trying to determine when it’s gone too far.
“The challenge when somebody uses a word like ‘portfolio hedging’ is that it can mutate and morph into many things beyond hedging specific positions,” Gensler said May 21, 10 days before the CFTC held a round-table discussion about narrowing exemptions in the Volcker Rule.
An administration official told reporters on May 22 that regulators will use the JPMorgan loss as a real-life example to inform the final rule. Regulators feel pressure to react and will scrutinize the hedging exemption, according to another person who works for an agency involved in the writing of the law who wasn’t authorized to speak publicly and declined to be identified.
More stringent regulations are sure to be unpopular with bankers. “You wouldn’t want to make a big change based on one event,” said Tim Ryan, president and CEO of the Securities Industry and Financial Markets Association, Wall Street’s main lobbying group. “This is a complicated proposal.”
Lawmakers are using JPMorgan’s loss for “political expediency,” and it’s unlikely that portfolio hedging actually will be banned, predicted Douglas Landy, a partner at Allen & Overy LLP in New York.
Banks do need the ability to mitigate risks in their portfolio using derivatives, said Ernest Patrikis, a partner at White & Case LLP.
“It’s insanity to think that they shouldn’t be doing it,” said Patrikis, former general counsel at the Federal Reserve Bank of New York. Regulators may consider options such as forcing financial institutions to “demonstrate more fully” their positions or restricting how they can hedge, he said.
The Financial Stability Oversight Council, created by Dodd-Frank and led by Treasury Secretary Timothy F. Geithner, discussed JPMorgan’s loss and the Volcker Rule at a May 22 meeting, Treasury spokesman Anthony Coley said. It’s “premature” to conclude whether the rule “would have prohibited these trades and the hedging activity” the bank conducted, Bryan Hubbard, a spokesman for the comptroller’s office, said May 14 in an e-mailed statement.
Senators Jeff Merkley, an Oregon Democrat, and Carl Levin, a Michigan Democrat, who co-wrote the Volcker provision, said JPMorgan’s trading losses underline why hedging on a portfolio basis should be barred in the final version.
“Pressure from lobbyists during the rule-making process gave rise to regulatory loopholes that would allow proprietary trading to be hidden within market-making, risk-mitigating hedging and wealth management, among other areas,” the senators said in a May 17 letter to the Fed and other regulators.
The Senate Banking Committee has begun hearings on JPMorgan and its implications for regulatory changes. The bank regulators and Neal Wolin, Treasury Department deputy secretary, will testify on June 6; Dimon will testify June 13. Dimon also will appear before the House Financial Services Committee on June 19.
The main impact of JPMorgan’s sour trades will be to speed up work on finalizing the Volcker rule, said Brian Gardner, senior vice president in Washington at investment bank Keefe Bruyette & Woods Inc.
Regulators “are under the gun to finish” in a way that is “totally unreasonable, which is to make sure there are no losses at banks,” he said. “They’ve basically been assigned mission impossible.”