James Rickards is a hedge fund manager in New York City and the author of Currency Wars: The Making of the Next Global Crisis from Portfolio/Penguin. Follow him on Twitter: @JamesGRickards.
Of all the tricks Wall Street uses to pull the wool over the eyes of regulators, Congress, and everyday Americans, none is more effective than the pretense that the strategies used in finance are so complicated that few outside the banking industry could possibly understand them. Wall Street CEOs ask to be treated like nuclear engineers and say "trust us" when it comes to the complexity of their tasks. In fact, no trust could be more misplaced and no claim to superior knowledge could be further from the truth.
The $2 billion loss announced at J.P. Morgan last week is the latest example. Management, starting with CEO Jamie Dimon, would have the public believe that the loss was due to a complex hedging strategy involving hard-to-value instruments and embedded risk that eluded the best and brightest minds at the bank until it was too late.
This is nonsense. The trade was a simple bet on the difference, or "spread," between the price of a group of bonds and an index based on those bonds. In theory, those two prices should be about the same. In practice, they may vary due to factors such as the relative liquidity of the bonds and the index. At a certain point, the J.P. Morgan trader, known as the "whale," took a view that the index was expensive and the bonds were cheap. In effect, by selling the index and buying the bonds, the whale would own the spread. As the spread comes back to normal, the whale reaps enormous profits and finally unwinds the trade by selling what he bought and buying what he sold at better prices.
The problems begin when the trade is done in huge size. Others in the market such as hedge funds smell blood. Instead of bringing the spread back to normal they begin to widen it by buying the index and selling the bonds. Whether this makes fundamental sense is irrelevant. What matters is that if they inflict enough pain on the whale in the form of daily mark-to-market losses, he will eventually have to get out of the trade by selling it back to the hedge funds. Sooner than later, the original spread will return to normal, but it will be too late for the whale.
Jamie Dimon has been working around the clock to explain that this loss is not life threatening. He makes the point that the loss represents only part of J.P. Morgan's earnings and that capital is not impaired. What he does not explain is that J.P. Morgan's "earnings" are actually not earnings but are a form of theft from savers, retirees, and others pursuant to the Federal Reserve's zero interest rate policy.
The Fed has engineered a massive wealth transfer from everyday Americans to large banks. They do this by holding interest rates near zero. Savers get nothing for their hard earned savings. However, banks get free money because they pay almost no interest. Banks then invest the money in Treasury notes and earn the difference. The Fed permits this to rebuild the capital of the banks. The Fed doesn't mind hurting everyday Americans if they can prop up bank capital.
Even if you favor Fed policy, it is unconscionable that the bank earnings derived from small savers should be squandered on a leveraged bet that a rookie trader could see was flawed. If the bet had worked out, the whale would probably already be shopping for a Lamborghini to buy with his bonus.
Apart from the risk in the trade, a more fundamental question is why it was allowed in the first place? What purpose was served? No new loans were created. No new jobs were created. Absolutely nothing of value to society was derived from this trade. At best, it was a form of gambling for the whale and his colleagues. Next time they should go to Las Vegas and skip the drama.
And please spare me the Kudlowesque lectures about "free market capitalism." Banks don't operate in the free market because their liabilities are guaranteed by the taxpayers. Banks are public utilities designed to make commercial loans and should have no more freedom to make derivatives bets than the Post Office.
Banks are propped up by taxpayer guarantees and fatten their earnings at the expense of everyday American savers. Then they risk those earnings on bets that serve no purpose but to enrich the greedy executives who make them. When things go wrong those executives cry that markets are too complicated to manage. In fact, the bet is no more complicated than putting money on red at roulette. As a last resort, the executives hide behind the flag of free market capitalism when in fact they are the new welfare queens with government subsidies galore.
The whole thing is a disgrace. If Jamie Dimon had an ounce of decency, he would resign now. Not because his acts were criminal, but because he presides over a corrupt institution that extracts wealth from the many and directs it to the few with no value added and not even a nod in the direction of the hard-working American victims of this scam.