Dimon under fire: What caused JPMorgan’s Whale-sized trading losses

On Wednesday, Dimon, CEO of JPMorgan Chase (JPM), will testify in front of the Senate Banking Committee. It’s Dimon’s first trip to Capitol Hill – he’s scheduled to return next week – since revealing in early May that his bank lost $2 billion on trades made by a unit of the bank that is supposed to lower the bank’s loses, not add to them. Since then, the red ink has probably grown. Based on the cost of the contracts JPMorgan’s London Whale was trading, the bank’s loss could now be as large as $8 billion. Dimon is expected to tell the committee that his bank did not have the proper risk controls in place.

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The most likely, and given how these hearings go, most frequent question Dimon will get from senators is whether the bets were really hedges. From the beginning, Dimon has maintained that the trades, which were made in the bank’s chief investment office, were meant to mitigate losses elsewhere at the bank. Dimon has said the hedges didn’t work, and that they weren’t properly monitored, but that’s all he’s been willing to concede. Indeed, for years, JPMorgan has repeatedly stated in financial statements filed with the Securities and Exchange Commission that the sole purpose of its chief investment office, which is the source of JPMorgan’s current woes, is to hedge the bank’s risks. So saying otherwise would probably open JPMorgan up to shareholder lawsuits, and potential actions from regulators.

But one look at the unit’s numbers and you get the sense that there was a lot more going on besides hedging. Back in 2008, for instance, JPMorgan’s CIO office had a portfolio of $113 billion. At the same time, the bank had $744 billion in loans outstanding. During the next two years, the bank cut its lending portfolio by $50 billion to $693 billion. As a result, you would expect the firm’s CIO to cut its portfolio as well. With fewer loans, there is less of a need for hedges. But that’s not what happened. Instead, the CIO’s portfolio nearly tripled to $324 billion from 2008 to 2010.

You could argue that after the financial crisis markets got riskier, so upping your hedging would make sense. But if that’s the case then you would also expect the unit’s portfolio to drop in the past year or so, as the U.S. economy has recovered, the financial crisis has eased and mortgage loan defaults have slowed. Instead, the CIO portfolio has continued to grow, reaching $360 billion at the end of the first quarter.

In part, what’s going on is not Dimon’s fault. The root cause of JPMorgan’s trading loss is not out of control traders, or portfolio models gone bad, or a greedy, an asleep-at-the-wheel CEO. At its root, JPMorgan’s problem stemmed from a general desire from individuals, companies and regulators for less risk. People and companies were looking for safety. So they kept more money at the bank. And in the world of Too-Big-To-Fail, the bigger the bank you put your money in, the safer you are. JPMorgan is now the biggest bank in the U.S.  In the past four years, JPMorgan’s deposits have grown nearly $400 billion to $1.1 trillion. At the same time, regulators are pushing it and other banks to boost their capital. One way to do that is to lend less. The result is that JPMorgan ends up with a lot of extra cash.

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The question is what do you do with it. Well, you could lend more, and raise capital another way, say by selling shares. But that generally causes your stock price to drop, so banks are reluctant to do that. Or you could do nothing with it, leave it in cash, and your return on equity, a closely watched bank metric, will fall. Cash generates no return. That is also likely to make your stock drop.

The third choice is to put your cash into riskier investments and try to boost your bottom line. This is the route it appears Dimon took, and got burnt. But he’s not alone. Mike Mayo, a bank analyst at Credit Agricole Securities and the author of the recent book Exile on Wall Street, calls JPMorgan’s blow-up the “canary in the coal mine for the next several years.” Before the financial crisis, Mayo was early in saying that the banks were taking on too much risk in their lending portfolio. Now he says the same is true of the banks’ investing portfolios.

Mayo recently went back more than 50 years and compared how banks invest their cash today versus back then. In 1960, banks had 75% of their excess cash in Treasury bonds. Just 3% of their portfolios were in corporate bonds. The rest, 22%, was in municipal bonds. These days, the average bank has just 6% of its portfolio in U.S. government bonds.  Municipal bonds make up just 8% of the portfolio. Corporate bonds now make up 29% of the portfolio. The rest is in agency mortgage bonds. As a result, banks are taking on a lot more credit risk than they once did

As a result, the average bank portfolio now yields 2% more than if it was fully invested in Treasury bonds. That compares to a rate premium of 1.4% a decade ago, and just 0.5% in the 1990s. Before that, the average bank portfolio tended to have a lower yield than Treasury bonds.  Mayo estimates if banks went back to investing their excess cash like they did two decades ago, bank earnings would drop by a collective $25 billion a year. “No question in my mind that this risk is not all prudent,” says Mayo. “If and when rates go up, we will see that.”

What’s more, while the Volcker rule could help to lower the risks banks can take, it’s not going to make the issue go away. Even if every bank closes its trading desk, they will still have to figure out what to do with their excess cash from deposits. And at a time when bank earnings have slowed, it’s going to be hard to talk banks out of the higher yields.

The JPMorgan losses should serve as a warning to other banks. But it probably won’t. And that’s why the London Whale’s losses, despite the fact that they are relatively small compared to JPMorgan as a whole and don’t really threaten the bank, are important. To steal a phrase from Citigroup’s former CEO, banks are still dancing, they’re just doing it to a different tune.