May 14, 2012
Losing Money Isn't a Crime—A Commentary by Jonathan Macey ’82
The following commentary was published in The Wall Street Journal on May 14, 2012.
Losing Money Isn't a Crime
By Jonathan Macey ’82
Regulators, politicians and news reporters are hysterical at the news of J.P. Morgan's recent $2 billion trading loss. The Securities and Exchange Commission is investigating to see whether laws were broken.
We appear to be on the verge of making it a crime for a business to lose money. The truth is that nobody should care about J.P. Morgan's loss—nobody except J.P. Morgan stockholders and a few top executives and traders who will lose their bonuses or their jobs in the wake of this teapot tempest. The three executives with the closest ties to the losses are already out the door.
After the $2 billion in losses, J.P. Morgan still had $127 billion in equity. This means that J.P. Morgan could lose another $100 billion and creditors would still have an equity cushion that could absorb 10 times the losses that the bank suffered on this trade. The trading loss wasn't close to apocalyptic even for shareholders. J.P. Morgan's shares dropped 9.28% in the wake of the loss. A shareholder with a $100,000 investment in J.P. Morgan would see the value of his investment reduced to $90,720, hardly a financial Chernobyl.
It is no coincidence that all of the hue and cry over this loss is being made just when regulators are on the verge of issuing their final interpretation of the so-called Volcker Rule, which makes it illegal for banks to take proprietary positions in securities. Perhaps the outcry over J.P. Morgan's trading losses is an effort to create the crisis atmosphere needed to succeed in making the final version of the Volcker Rule extremely rigid. Politicians already are using the loss as a pretext to regulate. Congressman Barney Frank even went on TV to say that he hopes the final version of the Volcker Rule will prevent the kind of trading that led to the massive loss at J.P. Morgan.
Mr. Frank neglected to mention that J.P. Morgan was hedging. The sole purpose of hedging is to reduce risk. The particular trades that J.P. Morgan was making were designed and intended to protect the bank's balance sheet against losses from its exposure to the apparently increasing risk of some of its European assets, including approximately $15 billion in European distressed debt.
Outlawing or restricting hedging will make the banking system more, rather than less, risky. That is why the Volcker Rule does not outlaw hedging, at least not yet. When it made the trades that lost the $2 billion, J.P. Morgan was firmly of the view that its trades did not violate the Volcker Rule. Moreover, since the trades were part of a hedging strategy, the $2 billion decline in the value of the investments that constituted the hedge must be balanced against gains in the assets against which they served as a hedge. While we don't know the exact amount of these gains, J.P. Morgan has reported that there were such gains, and that the ultimate loss likely will be about one-half of that reported.
The real lesson of what J.P. Morgan CEO Jamie Dimon has called the bank's "egregious failure" in risk management is that hedging is far more difficult to do in real life than it appears to be in theory—because the real world is a complicated place. The trades that J.P. Morgan made were extremely complex, and it certainly appears that they did not work the way that they were supposed to. But the reason that markets work better than central planning is because market participants learn from experience, and they learn fast and thoroughly because they suffer significant losses when their investments, whether they be hedges or not, turn out badly.
Thus, far from serving as a pretext to justify still more regulation of providers of capital, J.P. Morgan's losses should be treated as further proof that markets work. J.P. Morgan and its competitors will learn from this experience and do a better job of hedging the next time. They will learn because they have to: In the long run their survival depends on it. And in the short run their jobs and bonuses depend on it.
The second lesson from J.P. Morgan's failed hedging effort is that politicians and regulators are opportunists who will use any pretext to increase their power and influence. Rahm Emanuel, the former chief of staff to President Obama, once famously said that one should never let a crisis to go to waste. It appears that the current regulatory class is of the view that even crises that are not serious must be exploited.
Mr. Macey is a law professor at Yale and a member of the Property Rights, Freedom, and Prosperity Task Force at Stanford's Hoover Institution.