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Banks: Back to Risky Business?

J.P. Morgan’s $2 billion trading blunder may be embarrassing for the bank, but for regular investors still scarred by the 2008 financial crisis it raises a broader concern: Has risky trading returned to Wall Street?

J.P. Morgan CEO Jamie Dimon / Photo: Getty Images

J.P. Morgan’s losses stem from so-called derivatives, complex financial instruments that banks use both to hedge risk and speculate. The bank said on Thursday that it made a series of aggressive bets on the continued economic recovery using derivatives tied to the values of corporate bonds,  but that they backfired last month. Derivatives, of course, are the same investments widely credited with playing a major role in the near collapse of the global banking system four years ago; they’ve been under scrutiny from Congress and regulators ever since.

While regular investors may see J.P. Morgan’s misfire as a return to the reckless trading practices of the mid-2000s, some market pros counter that those strategies never really went away. So far this year, outstanding derivatives pegged to bonds amount to $27 trillion, according to the Depository Trust & Clearing Corporation. That’s down from $29 trillion at the end of last year, but above $25 trillion in 2009, when the market bottomed out.

Banks, in other words, may be scaling back on risk in other areas, but they aren’t curbing the use of derivatives. “Just about every size bank uses some sort of derivative to manage at least their interest-rate risk,” says Jonathan Miller, head of derivative strategy at Waverly Advisors, an investment research firm in Corning, N.Y.

This latest Wall Street stumble comes as many investors remain jittery about the market in general, and banks and brokerages in particular. Investors withdrew more than $163 billion from domestic stock funds over the 11 month-period through March, according to the latest data from the Investment Company Institute. Meanwhile, more than half of investors say they don’t trust banks, according to a recent study by Edelman, a global public relations firm. J.P. Morgan’s trading losses will likely harden those feelings, says Jim Leonard, senior securities analyst at Morningstar. “It’s definitely scared people – there are some jitters out there and rightfully so.”

It also comes just weeks before new legislation aimed at reining in banks’ trading practices goes into effect. The Volcker rule, scheduled to kick in this July, seeks to limit risky trading among banks that receive deposits from consumers. Banks have fought against the rule, claiming it would hurt liquidity. (On a conference call Thursday, J.P. Morgan CEO Jamie Dimon said the trades leading to the $2 billion loss did not violate the new rules.)

Should investors fear more trading blow-ups ahead? Experts say it’s unclear whether J.P. Morgan’s misstep is an isolated event, but they predict it could sideline more investors — at least for now.  Unless an investor has a large appetite for risk, they’re better off steering clear of banks, says Peter Cohan, president of a financial consulting firm who tracks financial stocks. “[It’s] a big red warning flag to anyone who thinks that it’s safe to dip their toes back in the shark-infested waters of bank investing,” he says.

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    • According to my estimates and using the known fact of the index betting, I conclude, from the following facts:
      “The Markit CDX NA IG 9 index maturing in 2017 stood at 128 on May 10, just before Dimon announced the losses, up from 112 at end-March, according to Markit. Higher values for the index indicate the market sees credit quality as having deteriorated, which hurts JPMorgan. On May 11, the index jumped to 139, and on Wednesday, it traded near 150.”,
      that Chase has exposure of at list $50 Billions, in order to lose $2-3 Billions so far.

    • Back? Did you say, back?

      I don’t thing the TBTF banks ever left the Hotel Risky Bidness.

    • Why shouldn’t the banks go back to risky business? TARP demonstrated that the federal government is perfectly willing to socialize their losses and remove all moral hazard associated with risk. This is exactly why “too big to fail” is an abomination that this country should refuse to acknowledge. The best defense against improper risk is to allow the Darwinian mechanism of the market kill off those that are “too big to fail” but are also “too stupid to live”.

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