At Jamie Dimon’s hearing before the Senate on Wednesday, the JPMorgan CEO proved that even the most cynical observers underestimated the depths of the financial industry’s duplicitousness.
The hearing revealed that JPMorgan appears to have found a solution to the pesky problem of the Volcker Rule. No, it’s not buying off members of the Senate Banking committee, though given what passed for “questions” in the hearing, that is certainly Plan B. JPMorgan’s solution is far simpler. It has relabeled proprietary trading: it’s now called “portfolio hedging.” This is a convenient rebranding, because portfolio hedging is explicitly allowed in the current draft of the Volcker Rule.
The Volcker Rule (which was part of the Dodd-Frank Wall Street Reform bill) has a noble goal: create a firewall that bars banks that enjoy FDIC insurance from risky, speculative gambling. On Wall Street, gambling with the firm’s funds is known as proprietary or “prop” trading.
The banks hate the Volcker Rule because prop trading is very profitable when you’re on the right side of a bet. And when you’re a “too big to fail” bank on the wrong side of a bet, the government will bail you out, and the Fed will secretly give you billions of dollars in emergency loans. The Volcker Rule aims to prevent the need for these bailouts by prohibiting banks that enjoy customer deposits and FDIC insurance from making these risky prop trades.
But the Volcker Rule’s current draft is full of exemptions, including one for hedging. What is at stake in the yet-to-be-written final version of the rule is what, exactly, will be considered “hedging.”
A “hedge” is an offsetting trade you make to reduce risk on an initial trade. A true hedge works like a seesaw: if my original trade goes up in value, my hedge trade goes down in value—and vice versa. If I buy shares of Apple stock, and I worry that Apple’s stock price will go down, I can hedge this trade by purchasing what’s called a put option. A put option on Apple will increase in value as the price of Apple’s stock decreases (put option up, Apple stock down). The put option works to hedge the risk of my Apple shares losing money.
One of the central battles over the Volcker Rule today is whether its hedging exemption should allow what’s called “portfolio hedging.”
In one corner, we have Senators Jeff Merkley and Carl Levin who warned in their Volcker Rule comment letter that the portfolio hedging allowance was a loophole that could be used to hide prohibited proprietary trading. In a recent letter to the regulators, the Senators crowned the portfolio hedging exemption the “JPMorgan Loophole.” Occupy the SEC also warned of the dangers of portfolio hedging in its comment letter (full disclosure: I was a co-author of the letter), as did Americans for Financial Reform.
In the other corner, we have… JPMorgan! The New York Times reported back in May that JPMorgan lobbied hard for the inclusion of portfolio hedging in the Volcker Rule. Why would JPMorgan be lobbying so hard for a portfolio hedging exemption? The hearing on June 13 showed us why—and it vindicates the critics of portfolio hedging.
Yves Smith at Naked Capitalism was the first to this story, with the aptly titled post Dimon Testimony Whopper: CIO’s Gambling on Disaster = “Portfolio Hedging”. The hearing proved that Jamie Dimon has such a maddeningly loose interpretation of “portfolio hedging” that it could be used to justify any prop trade. The most damning section of Dimon’s testimony in this regard was his exchange with Senator Mike Crapo:
Senator Crapo: What is a proper hedge in the context of the Volcker Rule distinction that we’re trying to make?
Jamie Dimon: Portfolio hedging, which I think should be allowed, is something that would protect the company in bad outcomes…
Crapo: And that would be something like going short in the——
Dimon: Going short credit if you think there might be a credit crisis would be one way of doing that, yes.
In this exchange, Senator Crapo asks Dimon to define what a “proper” hedge is in the Volcker Rule. Dimon jumps straight into lobby mode, calling out portfolio hedging as a proper hedge that should be allowed to protect JPMorgan from “bad outcomes.”
This was a very slick bit of verbal gymnastics by Dimon, and it is critical to the future of regulations like the Volcker Rule that Congress and the regulators understand the implications of these statements. To free his firm from the constraints of the Volcker Rule, Dimon has interpreted “portfolio hedging” to allow for any bet against “bad outcomes.”
Creating a brand new trade to protect against “bad outcomes” is not a traditional definition of a hedge by any stretch of the imagination. A hedge is not merely a place to guard against bad things happening to the firm. A hedge is meant to offset an existing risk. There must be two things on the seesaw. And when the value of the original trade goes down, the value of the hedge goes up. This inverse relationship between two positions is precisely what distinguishes a hedge from a bet. It may seem like splitting hairs, but this distinction is crucially important, because if you can define a hedge to simply be “something that would protect the company from bad outcomes,” there is no trade, no bet, that you could not redefine as “a hedge.”
Ever more telling is the next exchange, in which Dimon says that an example of a “proper hedge” under the Volcker Rule would be “going short credit”—in other words, betting that the value of bonds would decrease—if you think a credit crisis is on the horizon. The kind of trade that Dimon describes here is exactly the kind of proprietary trades that hedge funds make. In fact, there is an entire hedge fund strategy devoted solely to making this kind of trade: the Global Macro Strategy (It is worth nothing that, despite their name, hedge funds have nothing to do with hedging. Hedge funds are private firms that do nothing but prop trading).
What is so egregious about Dimon’s statement is that going short credit because you think credit is going down is a flat-out bet. If you’re putting on a trade because you have a prediction (“you think there might be a credit crisis”) you are making a bet. It is no different than placing a bet on a horse race or a sports game. A hedge is a seesaw—there must be another side, and there is no other side in Dimon’s example.
The imaginative Dimon would have you believe instead that JPMorgan faces the “risk” that they will not make a ton of money on a global credit crisis. What a terrible thought! And to hedge this “risk,” they put on a large short credit position. Therefore, all trades are “hedges” against the “risk” of not doing that trade, so… all trades are exempt from the Volcker Rule! Problem solved!
Later in the hearing, Dimon tells Senator Jeff Merkley, “We are not in the hedge fund business.” But it was too late. Dimon had shown his hand.
While Dimon’s insufferable arrogance may have caused him to reveal the depths of his firm’s camouflaging of prop trades, one wonders if our Congress will be able to pressure the regulators to close the portfolio hedging loophole Dimon worked so hard for. It seems unlikely, given how many of the Senators on the Banking committee clearly care less about their own re-election chances than they do about pledging allegiance to Jamie Dimon. We can only hope that the regulators have more sense.