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JP Morgan Debacle Reveals Fatal Flaw In Federal Reserve Thinking | The Baseline Scenario

In the spring, JP Morgan passed the latest Fed stress tests with flying colors.  The Fed agreed to let JP Morgan increase its dividend and buy back shares (both of which reduce the value of shareholder equity on the books of the bank).  Jamie Dimon received an official seal of approval.  (Amazingly, Mr. Dimon indicated in his conference call on Thursday that the buybacks will continue; surely the Fed will step in to prevent this until the relevant losses have been capped.)

There was no hint in the stress tests that JP Morgan could be facing these kinds of potential losses.  We still do not know the exact source of this disaster, but it appears to involve credit derivatives – and some reports point directly to credit default swaps (i.e., a form of insurance policy sold against losses in various kinds of debt.)  Presumably there are problems with illiquid securities for which prices have fallen due to recent pressures in some markets and the general “risk-off” attitude – meaning that many investors prefer to reduce leverage and avoid high-yield/high-risk assets.

But global stress levels are not particularly high at present – certainly not compared to what they will be if the euro situation continues to spiral out of control.  We are not at the end of a big global credit boom – we are still trying to recover from the last calamity.  For JP Morgan to have incurred such losses at such a relatively mild part of the credit cycle is simply stunning.

The lessons from JP Morgan’s losses are simple.  Such banks have become too large and complex for management to control what is going on.  The breakdown in internal governance is profound.  The breakdown in external corporate governance is also complete — in any other industry, when faced with large losses incurred in such a haphazard way and under his direct personal supervision, the CEO would resign.  No doubt Jamie Dimon will remain in place. [++]