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The Hidden Culprit Behind JPMorgan's Losses: The Fed

Two weeks ago, JPMorgan Chase (NYSE: JPM  ) CEO Jamie Dimon announced that the bank had suffered multibillion-dollar losses on structured credit products in its Chief Investment Office (CIO) unit. One question that has come up repeatedly since then: Less than five years after the worst banking crisis since the Great Depression, how could this happen? That's the wrong question. Here's the right question: In the current environment, how didn't it happen sooner? Let me explain why.

Over-reaching for yield
Ben Bernanke has been quite explicit that one of the goals of the Fed's extraordinarily accommodative monetary policy is to entice investors to take more risk. Mission accomplished. Witness the stock market rallies that followed the announcement of each round of quantitative easing during the past couple of years. The trouble is that reaching for yield, i.e., seeking out and investing in higher-yielding assets, can quickly turn into over-reaching. In fact, I'd argue that this is almost certain to happen in an environment of negative real interest rates.

"Negative" doesn't suit me
That's right; investors who own U.S. Treasuries will lose money on an inflation-adjusted basis. For evidence of this, just have a look at what has happened to the real yield on TIPS (Treasury Inflation-Protected Securities), which now sits at nearly negative half a percentage point:

In that context, investors may be heavily tempted to do stupid things to reach for yield, whether they are individual investors or traders tasked with managing a bank's excess deposits. Perhaps I misunderstand the potential consequences of higher short-term rates; however, since it is a lack of demand for, rather than supply of credit that is constraining growth, it's difficult for me to imagine that a Fed policy rate at 2% instead of 0%-0.25% would be all that harmful to the economy. (If you have a differing, considered opinion on this, please let me know in the comments section below.)

It's not all on Ben
Perhaps you think I'm being too kind to the bankers at JPMorgan, absolving them of all responsibility in this fiasco. Not so. First, let me be clear: I'm not putting this entirely at the Fed's doorstep, but I certainly do think a zero-interest-rate policy raises the risk of this type of incident. Furthermore, whether or not this was a hedge (which seems to me unlikely), JPMorgan's CIO made a grievous error in misjudging the risks associated with a position of the magnitude that it had built up. When your position is so big that you are the market, liquidity risk trumps all others -- that's risk management 101.

I've also been critical in the past of JPMorgan, specifically. Only last June, I asked if the bank wanted another financial crisis, arguing that it was acting irresponsibly by lobbying against capital surcharges for systemically important (i.e., "too-big-to-fail") institutions.

Never mind too-big-to-fail, these banks are plainly too-big-to-manage. Dimon -- whom I still regard as the best global bank CEO -- has just provided us with the strongest possible evidence of that fact. My preferred solution would be to break these organizations up, but I have long since given up hope that regulators will ever impose that. Barring that, we must make these banks robust to losses or a deteriorating operating environment. In that regard, lower leverage is capital, so to speak. Banks that receive an implicit subsidy from taxpayers should be penalized through higher capital requirements.

Jamie comes around... under duress
Last August, in a blog post on The Economist's website, I wrote that "the Fed was right to suspend normal dividend payouts by top banks in the aftermath of the crisis, and it was wrong to allow JPMorgan Chase to raise its dividend in the first quarter of this year. The Fed should consider a quiet halt to share repurchases at all of the large banks."

On Monday, Dimon told investors at a Deutsche Bank conference that the bank is suspending the $15 billion share repurchase program that the Fed just approved in March. In justifying the decision, Dimon said: "We made a commitment to our regulators and ourselves: We are supposed to be on a glidepath to Basel III [capital requirements]; we want to be on that glidepath."

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Fool contributor Alex Dumortier holds no position in any company mentioned. Click here to see his holdings and a short bio. You can follow him on Twitter. The Motley Fool owns shares of JPMorgan Chase. The Motley Fool has a disclosure policy.

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Read/Post Comments (7) | Recommend This Article (12)

Comments from our Foolish Readers

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  • Report this Comment On May 23, 2012, at 1:21 PM, robhammerling wrote:

    i think the bigger culprit is the ws compensation system where traders have no personal risk & comp is based almost entirely on their upside performance. we have seen blow-ups like this forever and it wont change unless traders have personal liability for losses. obviously, the bank is going to be on the hook for the lions share but if a trader stands to lose their house, they will take a more responsible approach to risk. will that cut down on some upside, absolutely, but it a fix that can be made tomorrow and would still keep the talented traders making money

  • Report this Comment On May 24, 2012, at 10:50 AM, whereaminow wrote:

    "My preferred solution would be to break these organizations up"

    That was the market's preferred solution as well. And was further reinforced by the overwhelming (10-to-1, 20-to-1, more?) popular opposition to the bailouts.

    At no time in American history has the government allowed the banks to succeed or fail on merit. We should give it a shot one day, if we're going to pretend this is a society based on capitalism and merit.

    David in Liberty

  • Report this Comment On May 24, 2012, at 10:51 AM, PedalHard41 wrote:

    not a banker, nor financial whiz, but to me it's rather simple. The Fed (Benny-boy) have monetized the US Debt, and the repercussions are horrendous... more and more big financial institutions will have huge losses. BTW, Benny-boy stated he'd never monetize the debt, liar, liar... Who is biggest holder of the US Notes, etc... We The People own the debt, if you have any deposits in the biggie banks, it's used to cover the notes, bonds, etc China and the Middle East are distant place holders...

  • Report this Comment On May 24, 2012, at 11:19 AM, talan123 wrote:


    We did give it a shot by letting banks fail during the 1930's depression era. 9,000 of them did fail 1930s, and over 4,000 of them failed in 1933. Depositors, the people who had money in said banks, lost $140 Billion dollars in wealth or about $2.5T in modern money.

    It's not possible to have a functioning economy without a fixed banking sector.

    As JP Morgan? They are actually forced to do their jobs instead of letting the Fed just hand them money with them taking a piece off the top. Let them get money the old fashion investment way, invest in businesses and get return by putting people back to work.

  • Report this Comment On May 24, 2012, at 11:35 AM, whereaminow wrote:


    -----> We did give it a shot by letting banks fail during the 1930's depression era. 9,000 of them did fail 1930s, and over 4,000 of them failed in 1933. Depositors, the people who had money in said banks, lost $140 Billion dollars in wealth or about $2.5T in modern money. <-----

    Banks failed in the 1930's under a central banking and note monopoly system that had inflated credit in the 1920's beyond what the specie deposit of customers would allow. The entire banking system broke because of decades of government intervention.

    Let me be more precise. At no time in American history has the market been allowed to regulate the banks on its own, promoting and demoting based on merit, free from government protection of privileged bankers.

    ----->It's not possible to have a functioning economy without a fixed banking sector<----

    This comments makes no economic sense. There is nothing fixed in economics, and any attempt to have a fixed sector only produces disaster.

    David in Liberty

  • Report this Comment On May 24, 2012, at 12:30 PM, dadepfan wrote:

    A completely unregulated free market does not remain free for long. Short-term greed and short-sighted "maximize profits today" strategy will always kill the future. There are too many ways to game an unregulated system, and too many who are willing to do so. Sensible regulation aimed at a healthy economy in the long term is a must.

    Unfettered capitalism is a winner-take-all system, and the end point is one person owns everything.

  • Report this Comment On May 24, 2012, at 12:41 PM, whereaminow wrote:


    Those are common attacks on the free market that have no basis in theory or historical observation. I understand that they are popular ideas with the masses, but that doesn't mean they are correct. Conventional Wisdom is generally wrong on about every topic.

    No company with any chance of survival in a free market economy can focus on short-sighted immediate profit. In fact, no person on Earth who cares about their capital stock does this. Why do you get an oil change? Because someone tells you to, or because you want to preserve the life of your care? You wish to preserve your capital stock. That's the nature of private property. Only in community property is it natural to behave as you describe, as was pointed out "Tragedy of the Commons."

    Only when government intervention creates moral hazard and restrictions on competition can companies engage in short-sightedness. They receive incentive to do so. The result is predictable.

    Capitalism is not a "winner-take-all system." This is just drivel that the OWS crowd loves to repeat. The division of labor makes all participants better off. The increase in capital stock makes all in the economic sphere of activity more productive, and hence makes society more wealthy. If what you say is true, society would have made no material progress in the last 400 years.

    There is no objective way to determine what is sensible regulation. Regulation outside of the market is a violent intervention that must, by its very nature, be arbitrary.

    Finally, Big Business LOVES regulation. It keeps costs high enough to crush small competitors. You cannot rail against Big Business and advocate regulation without running into the Law of Non-Contradiction.

    David in Liberty

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