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Hedging for Profit

Don't understand 21st century finance? Don't worry. Neither does J.P.Morgan's boss...

ON ITS BEST DAYS the American judicial process is a blindfolded Lady Justice – prosecuting the truly guilty and exonerating the truly innocent, writes Eric Fry from Laguna Beach, California for The Daily Reckoning.

On its worst days, it is a Water Wiggle – whirling around unpredictably, without any apparent connection to guilt, innocence, Constitutionality or the proportionality of alleged crimes to one another.

On good days, guilty parties go to prison; innocent parties do not. On very good days, innocent parties do not even have to go to the trouble of hiring a lawyer and showing up in court. Law enforcement agencies correctly decide to spare them the burden (and potential agony) of proving their innocence before a judge or jury.

On bad days, the exact opposite occurs. Innocent parties go to prison, while guilty parties do not. On very bad days, guilty parties do not even have to go to the trouble of hiring a lawyer and showing up in court. Law enforcement agencies incorrectly decide to withhold charges and spare guilty parties the burden (and potential agony) of defending their guilt before a judge or jury.

Once you string enough bad days together, you get a Water Wiggle – a "system" of law enforcement that investigates and prosecutes alleged crimes capriciously, unfairly and disproportionately. You get a system, for example, that:

  • Prosecutes Hall of Fame pitcher, Roger Clemens, for injecting performance-enhancing drugs into his own body, but does not prosecute a single investment banking executive for fraudulently injecting mortgage-backed securities into the US financial system.
  • Tasers-to-death a Mexican national for sneaking into the US to find work, but provides billion-Dollar bailouts to finance company executives whose extreme incompetence causes thousands of individuals to lose their jobs. (Bring us your tired, huddled masses so that we can beat them to death).
  • Threatens to shut down porn film studios for failure to comply with "condom laws", but turns a blind eye to Wall Street's serial financial rape of the US taxpayer.
  • Fires a 5-year employee of Wells Fargo for shoplifting when she was a teenager, but does not bother to prosecute M.F. Global's former CEO, Jon Corzine, for allowing (or causing) $1.6 billion of client funds to disappear from the firm he controlled.

In other words, once you string enough bad days together, you get a "system" that punishes minor crimes and rewards major crimes...consistently. You get a system that punishes entrepreneurial initiative by rewarding cronyism.

To reward incompetent finance company CEOs with billion-Dollar bailouts, for example, is to punish the employees and shareholders of the prudently operated finance companies that compete with the firms receiving bailouts.

To refrain from investigating and/or indicting Jon Corzine for "disappearing" $1.6 billion of client funds is to punish both the 38,000 M.F. Global customers who are still missing the money they did not deserve to lose and the 1,000 employees who lost paychecks they did not deserve to lose.

To continuously intervene on behalf of politically connected incompetence and sociopathy is to invite the kinds of corruption, recklessness, cronyism and criminal negligence that ruins innocent lives and destroys entire economies.

The US is sprinting down this very last week's "surprising" $2 billion loss at J.P. Morgan Chase illustrates. Morgan's egomaniacal CEO, Jamie Dimon, described the furor over the trading loss as a "tempest in a teapot".

Maybe so, but based on subsequent disclosures about the reckless trading that produced this loss, Dimon looks like a teapot in a tempest – clueless and overwhelmed.

The only surprise about this announcement was that the loss wasn't $4 billion...or $40 billion. But let's give it some time. Morgan's expert traders might still get there.

There's a direct connection, Dear Reader, between the trading losses at J.P. Morgan and the conspicuous non-prosecution of Jon Corzine. In fact, there's a term for this connection. It's called "moral hazard".

Most parents understand the term. They understand that the best way to raise a socially dysfunctional brat is to give him a candy bar every time he whines for something, and to give him a $20 bill every time he bullies a classmate. And yet, incredibly, the Federal Reserve, Treasury and Congress are doing exactly that.

They are creating a generation of "spoiled brat" bankers.

Just three years after the depths of the 2008-9 Credit Crisis, Wall Street's power brokers remain as remorseless as ever, as self-entitled as ever and, therefore, as fearless as ever. That's not a good thing.

Three years after a crisis that nearly toppled the US financial sector, JP Morgan is playing the same old if nothing had changed. The official chitchat from Washington and Wall Street about "risk" and "regulation" has changed quite a bit since 2008, but Wall Street's behavior is just as deplorable and dangerous as ever.

As the chart above shows, the "gross market value" and "gross credit exposure" of global Over-The-Counter (OTC) interest rate derivatives has jumped to its highest levels since 2008.

If you don't understand what these data points mean, don't feel bad. Jamie Dimon doesn't seem to get it either. (But if you'd like to understand what these data points mean, check out this report from the Bank for International Settlements.)

The only thing you really need to know about the global derivatives market is that risk exposures are increasing, not decreasing. JP Morgan's balance sheet tells the tale. According to Morgan's latest quarterly report, the firm was a net seller of credit protection – to the tune of about $206 billion, up from $116 billion as of Dec. 31. In other words, it nearly doubled its risk exposure. Morgan calls this speculation "hedging". Unfortunately, it is hedging without a hedge, which is the same thing as speculating.

The newly "retired" Chief Investment Officer of JP Morgan, Ina Drew, was supposed to be hedging other exposures at the firm. But hedging is not supposed to produce billion-Dollar losses. That's why it's called "hedging".

"[Ina Drew's] position over the years has always been around hedging," explains Dina Dublon, a former JPMorgan CFO who worked with Drew for 22 years, "but hedging for profit as opposed to hedging just to counter losses."

Ah yes..."hedging for profit"...also known as "speculating".

"The sheer size of this trade," says Barry Ritholtz, editor of the Big Picture and recurring speaker at the annual Agora Financial Investment Symposium in Vancouver, "makes it far more accurate to describe this as speculation than hedging. The loss was the tell. A true hedge would have been offset by the underlying position that was being hedged – so any loss should have been insignificant. Even a minor correlation error should not lead to a $2 billion hit.

"If we are going to define this trade as a hedge, then there is no other conclusion to reach except that everything at a huge bank is a hedge. And once you define everything as a hedge, well then, nothing is a hedge."

In other words, Dear Reader, nothing has changed since 2008. Absolutely nothing. The only reason Dimon is around to lose $2 billion of the shareholder's capital in 2012 is because the federal government (i.e., we taxpayers) bailed him out in 2008.

Therefore, Dimon understands the rules of this rigged game very well. He knows he can conduct mega-billion-Dollar speculations because he knows that JP Morgan could never bankrupt itself, no matter how recklessly it conducts its business. The US central planners would not allow it. Morgan could build bonfires with $100 bills in front of all its branches every night, and it still would not be able to burn through the federal government's commitment to keeping it alive.

Jamie Dimon, along with the rest of the coddled Wall Street predators, knows he is just as free to jeopardize the US financial system as he was in 2008. He and his counterparts at Goldman and elsewhere are just as free to place their monstrous heads-I-win-tails-you-lose bets with non-consenting US taxpayers as they were in 2008. No one will stop them.

Vibrant economies and civilized societies rely on law and order. And law and order relies on a foundation of fairness – a basic understanding that bad things are bad and good things are good. But when the powers of government begin to affirm that bad things are okay and good things are irrelevant, all hell breaks loose.

If America is to regain her former glory, she must first regain the integrity to prosecute criminality, no matter how many politicians know the criminals on a first-name basis...and she must regain the courage to let incompetent capitalists fail so that competent capitalists can arise to take their place.

If America is to regain her former glory, she must regain the integrity to prosecute guys like Jon Corzine and the courage to let guys like Jamie Dimon fail.

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Eric J.Fry has been a specialist in international equities since the early 1980s. A professional portfolio manager for more than 10 years, he wrote the first comprehensive guide to American Depositary Receipts, International Investing with ADRs. Today he reports on Wall Street from California for the renowned Daily Reckoning email service.

See full archive of Eric Fry articles

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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