J.P. Morgan and the Volker Rule

J.P. Morgan has acknowledged losing $2 billion last quarter, and analysts have estimated its loss at 50% above that amount. As a bank, its deposits are insured by the FDIC, i.e. by taxpayers’ money.

Something went terribly wrong in J.P Morgan’s case.  For decades following the Great Depression, banks were prohibited by the Glass-Steagall Act from engaging in speculative investments that put commercial deposits at risk. However, J.P. Morgan Chase is “déjà vu all over again.”

The media continues to say that J.P. Morgan’s loss is small compared to its total assets, even if it increases to $4 or $5 billion. What analysts have not said is that J.P. Morgan holds an estimated $15 billion of the government bonds of Greece, Portugal, Ireland, Spain and Italy. Imagine what would happen if those countries should default? J.P. Morgan would be history – except that it is still too big to fail! So in all probability, the federal government will bail it out one more time.

Banks are special institutions with limited power. Technically, they should only be allowed to manage commercial deposits, not speculate with them. This is because deposits are insured by FDIC (meaning taxpayers).

In the midst of the Great Depression, the Glass-Steagall Act was passed in 1933. It was intended to prevent banks from acting as brokerage firm and commercial banks at the same time. Back then, banks would underwrite initial public offerings (IPOs) and use commercial deposits to cover the shortfall or prop up the stock, if the offering was not successful. Glass-Steagall forced banks to divest of brokerage and investment operations, if they wanted to continue receiving ordinary commercial deposits. In other words, if they wanted the federal protection of a bank, they were forced to act like a bank.

Banks began sidestepping Glass-Steagall in the 70s and 80s when flexible interest rate products were introduced, and bank sought to keep up with the inflation-adjusted return on savings. By 2007, Glass-Steagall was a memory and what remained of it was repealed in 1999.

Following the repeal of 1999, commercial banks invested freely and on their own behalf (i.e. Proprietary investment) in mortgage-backed securities and credit default swaps. As those investments unraveled, the banks burned through depositors’ money and when those funds were exhausted, they sought a government bailout. Once again, commercial banks crossed the line between banking operations and investment speculations. To steal a quote from the much-beloved Yogi Berra, it was “déjà vu all over again.”

The lesson was not learned. In particular, the fundamental cause of the 2007 recession was banks investing heavily in mortgage back securities and credit default swaps. Banks used commercial deposits and their own assets.

The Volker Rule is scheduled for consideration by the House or Senate in July 2012. The bill would prevent banks from engaging in proprietary trading or sponsoring hedge funds or private-equity  funds – all of which are considered speculative activity. The rule was crafted in 2010 and is named after former Federal Reserve Board Chairman Paul Volcker, who argues that proprietary trading not only puts the bank at great risk, but also has the potential to create a conflict of interest with regular clients.

Unfortunately, no matter how much J.P Morgan loses; it is still likely to be bailed out by the government. The bailout has come in small doses since the great recession because the Federal Reserve (by keeping interest rates at close to zero) has made it possible for large banks to borrow money at low-cost and clean off their books the mess created by mortgage speculation. As long as this happens, there is no incentive for banks to behave differently.

The Volker Rule may not be all that we would wish for, but it is a lot more than we have presently.