JPMorgan Inside the Whale

CAMBRIDGE – It has been a bad few weeks for JPMorgan Chase (JPM), the multinational financial-services firm that by some measures is America’s biggest bank. Two of its traders were indicted, and the bank agreed to a billion-dollar fine for failing to report the extent of its London Whale losses fast enough and accurately enough. Now it faces even bigger fines – perhaps exceeding $10 billion – for mortgage activities, mostly by two of the financial firms, Bear Stearns and Washington Mutual, that it bought up during the financial crisis.

The conventional wisdom is that the United States government would not have gone after JPM had these setbacks and errors become salient during the financial crisis. The London Whale trades, for example, were from early 2012; had they occurred in 2008, when the financial system was fragile, JPM, it is said, would have gotten a legal pass.

This view seems well founded, because the government was then propping up the big banks in a concerted effort to overcome the financial crisis. Weakening the big banks further seemed likely to deepen and prolong the crisis. So JPM, according to this view, has been unlucky: too many of its legal problems postdate the financial crisis or came to light well after it erupted.

That, however, is not the only way to view JPM’s – and the economy’s – luck. If the $6 billion London Whale losses had occurred in 2008 instead of 2012, then, yes, the government would not have piled on with fines and criminal indictments. But what would JPM’s trading partners have done in 2008, when the economy was in turmoil, if the losses hit then?

The financial marketplace was quite wary and tense in 2008, owing to the collapse of Lehman Brothers and the government bailout of mega-insurer American International Group (AIG). With major financial institutions’ exposure to the previously over-priced mortgage market unclear, financial transactions froze up. Those who dealt with Citibank, for example, worried about its exposures and losses. Were they under control, or were they just the tip of an iceberg? If Citi was facing bigger losses than those already known, could it make good on new obligations to trading partners and lenders? Better to avoid Citi, some financial players thought.

JPM’s London Whale trades – bets on the future state of the American economy that JPM could not reverse without big losses – were of a type that the bank could readily have made in 2008. The losses, initially put at $2 billion, soon tripled.

So imagine that JPM had made these kinds of bets during the financial crisis in 2008, realized that they were mistakes, and found that it could not reverse them easily. JPM then announces a $2 billion loss, and CEO Jamie Dimon calls the problem a tempest in a teapot (as he did in 2012).

But the announcement of a $2 billion loss in that setting of economic turmoil would have made JPM’s counterparties jittery. Was it just $2 billion? Was this a big problem in an otherwise sound institution, or was there an iceberg beneath the surface. After all, AIG was an AAA-rated firm that turned out in late 2008 to have assumed more risk than it could handle. How can we be sure, market players might have asked, that JPM is not in the same boat?

Now consider how destabilizing it would have been had the same escalating series of announcements that JPM issued in the wake of the London Whale trades come during the financial crisis: It’s not $2 billion, but $4 billion; no, it’s not just $4 billion, but $6 billion. Sorry. Had that happened, Dimon would have needed to withdraw his comment that the problem was just a tempest in a teapot, and doubts would have arisen, in the midst of the crisis, about just how good JPM’s well-regarded risk-management practices really were.

In that setting, what JPM called its fortress balance sheet would suddenly have looked highly vulnerable, and the bank could have found itself under far more damaging attack than it has in the last year. But the attack would have come from investors, not regulators. And once some traders refuse to deal with a bank, the damage can become self-perpetuating, as losses mount and other traders follow suit.

Worse, the economy might have suffered further. During the crisis, financiers rightly pointed out that JPM and several other major firms were islands of stability in the financial storm. But had the London Whale losses occurred then, JPM would not have been on the list of sound financial institutions, undermining confidence further and potentially making the crisis that much worse.

Indeed, JPM runs one of the two major private operations for settling major trades of government debt. If a shadow falling over JPM from its trading desk had extended to its capacity to settle government debt properly, the economic fallout could have been severe.

Napoleon is reputed to have said that he wanted lucky generals. No matter how good a leader is, success is not assured and pure chance plays a larger role than many care to admit. No matter how well managed JPM was, both it and the US economy are lucky that what has befallen it in the last year did not happen – as it well could have – in 2008.

Mark Roe is a professor at Harvard Law School.

Copyright: Project Syndicate, 2013.

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