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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