We’ve Been Warning Since Last August That The Banking Sector Is In Trouble

It is no secret that JP Morgan suffered a $2 billion trading loss on May 10. That’s old news. What I want to talk about today is what caused this back-breaking loss?

It wasn’t that JP Morgan simply made a bad trade by buying or selling stocks and bonds. It was that the bank entered into very complicated transactions involving derivatives to hedge its overall position in the market.

Typically, hedging means you’re trying to limit losses. In this instance, apparently JP Morgan had the hedge in position, but then chose to reduce one side of the transaction as the markets moved higher. Talk about stupid.

The markets then moved the other way, leaving the bank exposed.

This explains how a big bank ended up taking big losses. But that’s not the end of the story. There’s a good chance JP Morgan’s loss may be bigger yet. Here’s why…

JP Morgan continues to hold sizeable positions in the exact securities that lost money. That’s because these positions are so large that, if the bank went to sell them, it would drive the prices down dramatically.

So here sits a very large bank, with large, losing positions, that it can’t sell to anyone. Or at least, it can’t sell them to anyone quickly. And the investments may go up in price (unlikely), or they could drop further… much further.

Herein lies the problem with size.

After the credit crisis of 2008-2009, when taxpayers had to bail out banks, there was a general cry to pare down the size of large banks. No one wanted a recurrence of banks demanding the backing of the U.S. government lest the entire financial system fail.

What has happened since that time? The largest banks in the United States have gotten bigger. According to the Federal Reserve of Dallas, in 2011, the top five banks in the U.S. controlled over 50% of the assets in all banks. Obviously our attempt to regulate such large banks, and encourage them to shed assets, has not worked.

So now we’ve got bigger banks that must take on bigger investment positions and hedging operations simply to make a difference to their bottom line.

If JP Morgan had an investment loss of $2 million instead of $2 billion, it could simply have been a rounding error. Of course, a gain of just $2 million would not have made a difference to the company either.

This is where Dodd-Frank, the ensuing Consumer Financial Protection Authority, and all the other initiatives of the last few years, have clearly missed the mark. The point of these regulations was to better protect the investor, the depositor and the greater public from not only the activities of these banks, but also the sheer size of these institutions.

Our lack of protection became obvious in the fall of 2008 when the credit crisis seemed to threaten the entire banking system. Now it’s rearing its ugly head again with JP Morgan. What happens if the bank’s loss balloons to $10 billion, or even $20 billion? What happens when the loss is not at a strong bank like JP Morgan?

The right answer should be, “I don’t care because I’m not a stockholder in JP Morgan or the other banks.” But we all know that’s not the answer.

Today, if a weaker bank incurred such a loss, all of us, as taxpayers, would be footing the bill in the name of “too big to fail.” But enough is enough. It’s time to draw the line in the sand.

Split up the banks… today!

How many warnings do we need before we understand the risk these large institutions pose? Or do we simply wait around for the next catastrophic loss and bailout?


Rodney

 

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JP Morgan’s stock lost 9% between May 10 and May 11. This, of course, was when Jamie Dimon first announced the $2 billion (and counting) trading loss attributed to the now infamous “London Whale.” Read More >>

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Categories: Economy

About Author

Rodney Johnson works closely with Harry Dent to study how people spend their money as they go through predictable stages of life, how that spending drives our economy and how you can use this information to invest successfully in any market. Rodney began his career in financial services on Wall Street in the 1980s with Thomson McKinnon and then Prudential Securities. He started working on projects with Harry in the mid-1990s. He’s a regular guest on several radio programs such as America’s Wealth Management, Savvy Investor Radio, and has been featured on CNBC, Fox News and Fox Business’s “America’s Nightly Scorecard, where he discusses economic trends ranging from the price of oil to the direction of the U.S. economy. He holds degrees from Georgetown University and Southern Methodist University.