Tossing blame for JP Morgan trade? Don’t forget the Fed. by Cyrus Sanati @FortuneMagazine May 14, 2012, 2:16 PM EST E-mail Tweet Facebook Google Plus Linkedin Share icons FORTUNE — Who is to blame for JP Morgan’s growing multi-billion dollar trading loss? While it is easy to just fire and demonize the traders and managers who executed the trades, as JP Morgan did this morning, such a move seems woefully inadequate in this case. Meanwhile, pointing the figure at the hedge funds that made millions betting against JP Morgan may feel good, but it isn’t right either. They were just attempting to make money and rebalance the dislocation in the market created by the bank’s massive positions. No, the roots of this blunder seem to stretch well beyond Wall Street, beginning in Washington with the Federal Reserve’s low interest rate policy. Linking the Fed with this event might seem like a stretch, but consider how the low interest rate policy has zapped bank profits. It has forced them to take greater risk and, to quote JP Morgan CEO Jamie Dimon, to also do “stupid” things, all in an attempt to make a quick buck. But while this issue may have its roots at the Fed, the banking sector also bears some of the blame. Apparently Dimon and his cohorts failed to get the memo that they can no longer run their bank like a hedge fund. The big commercial banks should operate more like a boring utility and return to simple lending, leaving the really risky stuff to alternative asset managers. Dimon was his usual brash self last week when he disclosed that the bank had managed to rack up $2 billion in trading losses. He didn’t go into much detail as to how the traders lost that much money, only to say that the losses were rooted in the bank’s chief investment office in London where traders made bad bets on synthetic derivatives. Monday morning saw the first casualties from the affair. JP Morgan announced Monday that the head of the CIO, Ina Drew, left the company. Two of her lieutenants, Achilles Macris and Javier Martin-Artajo, were also booted, according to news reports. The man who executed many of the trades, Bruno Michel Iksil, aka the London Whale, is also expected to be out on the pavement sometime this week. MORE: JPMorgan’s trading debacle: $2 billion is just the start But is it fair to blame the traders? Sure, they came up with the trading strategy and pushed the button, but they seemed to have had the backing from the C-Suite in New York. If they didn’t the bank would have labeled them as rogue traders and played the victim card. The trouble here derives more from what they were invested in and how they went about doing it. The CIO’s mission is to invest the billions of unused deposits locked up in the bank’s vault. Normally, the bank invests that cash into super safe and liquid investments, like US Treasury bonds. While the team did make those safe and very low yielding bets, they also decided to crank up the risk and invest a large amount of money in higher yielding corporate bonds. This is where things get sticky. They then decided to hedge the bonds using a credit default swap index that tracks corporate bonds, a person familiar with the bank’s trades told Fortune. That is not necessarily a risky bet, but it seems the traders made it so. That’s because instead of hedging the bonds to the current iteration of the CDS index, it hedged it using an older and far more illiquid iteration of the CDX index, a London trader with knowledge of the situation told Fortune. It isn’t clear why the group chose to use the older and less liquid index in its hedge as opposed to the more liquid current iteration. By placing big bets tied to an illiquid security, JP Morgan JPM set itself up to a basis point attack by hedge funds. The trades were so large that all the hedge funds did was take opposite positions and wait for the market to move just a few basis points in their favor in order to collect millions. MORE: Sheila Bair: Why it’s time for higher interest rates So the execution was lousy and the hedge funds picked up the pieces, therefore they were behind this loss, right? Maybe in the narrowest sense, but this trade is a symptom of a larger, more destructive, problem. The banks have always taken risky bets in the past, but it was with their own capital. What happened here was the bank was gambling with its depositors’ cash – money that should be safe and loaned out to the general public to help expand businesses and help people buy homes. But it isn’t easy for banks to make a profit by simply lending today. The Fed has instituted a long period where the benchmark interest rate is nearly zero. This is bad news for the banks, since they derive a huge chunk of their income off interest payments. With the rates so low, it’s hard to make the high profits that analyst have grown used to expecting from a large multi-national bank. The banks are now forced to act out in order to make a buck. New regulations, namely the Volcker Rule, have rightfully barred the big commercial banks from investing their own capital alongside their clients, so JP Morgan, and most likely the other big commercial banks, have started to look to their own depositors’ cash as fodder for their gambling addiction – a huge no-no in the investment world. This pool of cash, which is managed by the CIO, has grown to whopping $300 billion, giving them a lot of cash to play with. MORE: JPMorgan’s losses: No major victory for Volcker Rule To justify increasing their risk, JP Morgan admitted that it started to use a different measure by which they gauge how risky an investment is, something called, Value-At-Risk. This new calculation, which no one outside of JP Morgan apparently knew about up until last week, allowed the bank to increase its risk without setting off alarm bells. Obviously the risk it took was far more dangerous than anyone thought. A simple hedging exercise designed to protect something as benign as a corporate bond blew up in their faces. So the banks clearly are to blame here as well, but the motivation to take such a bold move came from the low interest rates, nurtured by the Fed. The whole idea that low interest rates spur economic activity and increase lending is one of the most important axioms in economics. But it seems one can go too low for too long. The banks are more likely to hold on to their capital now thinking they can make more money playing in the markets. One bad idea has therefore caused another one to sprout, which is now spreading throughout the financial sector. The government in this case will try to crack down on the banks, but what about the Fed? Unless all angles are explored here then the system runs the risk of yet another blip, which would sadly make JP Morgan’s losses look tame.