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Will JPMorgan Chase's $9 Billion Whale Land in Taxpayers' Laps?

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As the losses mount from JPMorgan Chase's (NYSE: JPM  ) trade-gone-bad, Jamie Dimon has been clear that the bank will not be permanently injured, and that taxpayers will not be expected to step in to clean up the mess. Besides the notion that the too-big-to-fail banks laugh in the face of risk, secure in the knowledge that they will never really go under, there is another reason for his statement. It seems that those dicey derivatives were not marking time in the investment unit of the bank, but were stashed in the retail, FDIC-backed portion.

A recent article by The Nation author William Greider points out that JPMorgan stores its risky derivatives in a FDIC-backed subsidiary, which could ostensibly leave taxpayers in charge of refunding losses. This is rather old news, but bears repeating as Dimon wears himself out repeating that this trading mess will have no impact on taxpayers.

Other big banks hold derivatives in subsidiaries, too
The last time this issue received such an airing was when Bank of America (NYSE: BAC  ) announced last fall that it was moving the bulk of its derivatives business acquired from its purchase of Merrill Lynch from the bank holding section to the commercial side of the street. At the time, the total value of derivatives held by BAC was nearly $75 trillion, with $53 trillion of that amount already residing within FDIC insured territory. In what was obviously not its first transfer, more -- or possibly, all -- of the remaining derivative pile was scooted over to its insured subsidiary.

B of A was reamed by the media at the time, and the FDIC wasn't especially happy about the move, either. The Federal Reserve, however, thought the transfer was just peachy, as it would take some pressure off the bank holding company -- which had just suffered a rating downgrade, hence the transfer to a safer, better-rated haven. To be fair, Bank of America was not alone in this type of activity; at that time, almost the entirety of JPMorgan's derivative portfolio valued at $79 trillion was housed in is retail subsidiary.

At this point, according to Greider, B of A's derivative grand total sheltered in its subsidiary stands at about $47 trillion, while JPMorgan's is around $72 trillion. Citigroup (NYSE: C  ) shelters almost all of its $53 trillion as well, and Goldman Sachs (NYSE: GS  ) holds $44 trillion in a retail subsidiary of its own. Morgan Stanley (NYSE: MS  ) holds only 5% of its $50 trillion in derivatives in an insured unit.

How taxpayers might get left holding the bag
Obviously, since the Federal Reserve sanctions it, this practice is not illegal. It does, however, set up a scenario in which tax money might be called upon to make bank customers whole if they lose money because of unsustainable losses from bad trades. Both Greider and Felix Salmon note that parking these derivatives in FDIC-insured subsidiaries allows the banks to dip into deposits to pay off counterparties of these derivatives. If all the deposits on hand are used up, the FDIC will have to step in to replace depositors' funds.

Is this situation likely to occur? History shows that trades of esoteric banking products like derivatives can go terribly wrong, and that the government is more than willing to step in and bail out institutions in trouble to stem a wider panic. It is not yet known, at least publicly, what the losses are at JPMorgan in regard to the latest trading calamity, and it could easily go over the recent estimate of $9 billion.

Dodd-Frank to the rescue?
It isn't difficult to see why banks, with all the coddling and special treatment they have received over the past few years, think they can do pretty much whatever they want, however risky the activity may be. With the Fed egging them on to soften the blows administered by rating cuts, there seems no good reason for them not to do it.

The "living wills" being drawn up by banks as a blueprint for the feds to wind them down in an orderly fashion, should the need arise, may be of some help. As the FDIC works out the details of the special bank-only bankruptcy code, some analysts have noted the FDIC's efforts to solidify Dodd-Frank's prohibition against having taxpayers foot any of a failed institution's clean-up bill. What better way to insure that only stakeholders and long-term creditors carry the load than to tweak language regarding how bank holding companies handle their riskiest derivatives?

Meanwhile, everyone will be waiting with bated breath for JPMorgan's financial report, when we all find out how much the bungle has cost -- so far. Since some parts of the trade are not easily disposed of, the true extent of the debacle may not be known for quite a long time.

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Fool contributor Amanda Alix owns no shares in the companies mentioned above. The Motley Fool owns shares of JPMorgan Chase, Citigroup, and Bank of America. Motley Fool newsletter services have recommended buying shares of Goldman Sachs. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.

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