Fans of the Harry Potter series (and their moms) know all about Lord Voldemort. The evil wizard is the archenemy of young Harry Potter and his name is a play on the French phrase "vol de mort", meaning "to flee from death." The murderous Voldemort reigns in a fantasy world of wizards and witchcraft.
Meanwhile, on the other side of the pond, there is JP Morgan Chase & Co. (NYSE:JPM) - a straight-laced American financial institution with a reputation for safety and strength. JP Morgan Chase was one of the few major US banks to withstand the 2008 bank meltdowns. For investors who watched their savings, homes, jobs and economy implode just a few years ago, the stability of JP Morgan Chase has been as soothing as a nice cup of tea.
The teapot explodes
So imagine the surprise of investors when it was discovered last month that a sophisticated system of derivatives wizardry within JP Morgan Chase's own trading account had grown so big that it was threatening the bank's "fortress" of a balance sheet. The senior executive in charge of these trades? A London-based trader who had become so powerful, he was known among the industry as Voldemort.
A tempest in a teapot... that was how JP Morgan Chase's CEO Jamie Dimon explained all the media fuss when word first got out about Voldemort's trading positions. Mr. Dimon tried to downplay the size and scope of the trading risk. Unfortunately for Mr. Dimon, not to mention shareholders and depositors of JP Morgan Chase, the teapot exploded.
From hedging to speculating
Like all banks, JP Morgan Chase loans money to its clients and makes investments in others. With every loan or investment, there is a risk that the bank will lose its capital. At all times, the bank must know how much money it has on hand and how much it has at risk. If there is too much lending exposure, the bank must balance itself by hedging these risks with alternative investments. On the other hand, if the bank has a surplus of deposits, it needs to invest that money so that it is not just sitting there losing value to inflation and interest rates. This is called portfolio hedging and it is the reasonable and responsible thing to do, even for individual investors.
According to JP Morgan Chase, Voldemort, in his role of trading for the bank's chief investment office, was merely hedging the bank's portfolio of corporate bonds. JP Morgan lends money to corporate clients and likely holds a lot of high-risk junk bonds for those companies. To offset this risk, Voldemort chose to invest in super-safe investment grade corporate bonds. A lot of them. Some say $100 billion worth of them. He did this, not by buying bonds from companies flat out, but rather through a complicated and aggressive strategy of selling credit default swaps on an index of investment grade corporate bonds.
Of course, you can't buy that much of anything without your colleagues and competitors noticing and there are two sides to every trade. Other traders started to bet against Voldemort, thinking that if he was wrong, they could gain a lot of money. In order to strengthen their positions, both Voldemort and his rival traders made even more investments - for and against - the underlying bonds in the index, trying to affect the bond prices. In other words, hedging their hedges. Yet, with so much money involved, Voldemort's position became riskier and riskier. This was no longer hedging, it was speculating (some might call it gambling).
Oops, we made a profit
Sometimes, when a bank invests in the stock market for the purpose of portfolio hedging, the investments pay off in the form of a hefty profit (don't you hate when that happens?). In fact, these in-house trading teams (usually comprised of the most skilled traders in the industry) have been known to rake in a lot of profit for their employers. It gets pretty easy to cross the line between conservatively investing to protect the bank's balance sheet (portfolio hedging) and aggressively investing to boost the bank's bottom line (proprietary trading).
So what's wrong with a little profit, you ask? If a shoe store ends up making more money by investing in the stock market than it does selling shoes, who are we to judge? The only money at risk is that of the shoe store's owners. Banks however, are public companies, with obligations to the people who have entrusted them with their money: depositors, shareholders and often (in the case of banks propped up by government bail-out money) taxpayers. As a result, banks have an ethical responsibility to treat the money that is not their own with extra care and prudence.
Oops, we made a loss
As the saying goes, a billion here, a billion there, pretty soon you're talking about real money. As rival traders increasingly bet against Voldemort's strategy, he had to keep piling more money into it to cover the losses and keep his system from failing. Finally, JP Morgan Chase said, enough. Mr. Dimon announced in a press conference that the bank had messed up and the trading error had so far cost them $2 billion - maybe more once all the bets are in.
For a company the size of JP Morgan Chase, a $2 billion loss is not the end of the world. Analysts expect the company will still deliver at least $4 billion in after-tax profits this quarter alone. However, the company's sterling reputation and Mr. Dimon's credibility have been severely tarnished. Shareholders pulled out and the stock price dropped by 9.3% in one day - wiping out about $14 billion in shareholder equity.
The Voldemort and the Volcker
After many financial institutions around the world went bankrupt in 2008 due to the aggressive use of derivatives in the credit market, the US government set out to introduce 'the Volcker rule', a much-argued about piece of pending legislation, that would disallow banks from exactly the kind of trading Voldemort was doing on behalf of JP Morgan.
As one politician said, "The argument that financial institutions do not need the new rules to help them avoid the irresponsible actions that led to the crisis of 2008 is at least $2 billion harder to make today."
Only in America you say? Pity...
Canadian banks have always been more conservative than their American cousins, however we would be naÃ¯ve to think that proprietary trading and speculating doesn't happen here. There have been instances where Canadian banks have experienced large proprietary trading losses - but never to the point of severely impacting a bank's capital.
It may just be that we are more culturally low-risk. It is not as if Canada has more stringent rules or oversight when it comes to proprietary trading - we don't. In fact, three of Canada's top officials in banking regulation have spoken out against the Volcker rule for fear of the unintended consequences and restrictions it will place on Canadian banks with global operations. Mark Carney, Governor of the Bank of Canada and Chairman of the Global Financial Stability Board; Jim Flaherty, Minister of Finance; and, Julie Dickson, head of the Office of the Superintendent of Financial Institutions (OSFI) have all gone on record opposing the creation of new regulations, preferring the status quo in Canada.
Good old Canadian values
It would seem that Canadian banks take a certain pride in old-fashioned values. The CEO of Toronto-Dominion Bank (TSX:TD) Ed Clark said, "What fundamentally happened in the mid-90s is that banks - particularly the ones that were securities dealers - started to drift away from saying 'I'm here to help my clients,' to saying 'Geez, I can make money taking deposits and investing them and speculating with them and get proprietary profits. I think it's a very unfortunate drift."
Interestingly, TD now has more American branches than Canadian. With their faith in JP Morgan now lost, Americans might really take a shine to the look of a friendly, risk-averse Canadian bank - not only on their corner, but in their corner.