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The Dimon Fiasco: A Stark Lesson on Why Finance Needs Government Regulation

Wednesday, 16 May 2012 11:44 By Jeff Madrick, Next New Deal | Op-Ed
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JPMorgan Chase's trading losses are a perfect example of why we need increased government regulation of banks.

Many people see the $2 billion in trading losses announced by J.P. Morgan Chase as the quintessential example of why strong regulation is needed. There is a lot of irony in this story. It is a true story about the importance of government.

When Sandy Weill, the rough and tough entrepreneur, ultimately built a financial conglomerate from many pieces—including Salomon, Smith Barney, and Travelers Insurance—into Citigroup, Jamie Dimon, someday to be the outspoken CEO of J.P. Morgan Chase, had always been at his side. A bright and dutiful young man, Dimon stayed with him when Weill was consigned to a number two role at American Express after selling his firm, Shearson Loeb Rhoades, to the credit card giant in the early 1980s. He was with him in San Francisco, when Weill was charged with slimming down American Express’s subsidiary, Fireman’s Fund. Weill’s expertise was making companies lean and mean, which often entailed ruthless lay-offs. Dimon ran the numbers for Weill and participated in the implementation of the lean and mean philosophy.

When Weill finally left American Express, Dimon again went with him. Finally, they found the consumer finance company Commercial Credit Corp, which made high interest loans to low-income consumers, including early subprime mortgages, much like the old Money Store. According to biographers, Dimon liked the industry because it was unregulated. He and Weill took over the company, fired lots of people, issued a stock offering quickly, and used it to rebuild the Weill dynasty, which would soon include Smith Barney, Shearson again, and, the giant Travelers Insurance in 1993.

But Weill still had no serious investment banking presence, so he turned his attention to Salomon Brothers, king of risky bond and currency trading, the birthplace of what later became Long-Term Capital Management, and maker of much money and several major trading losses. How risky was this trading firm?

Dimon was skeptical. But here is the irony. Weill sent Dimon to study how Salomon made its money, and the originally hesitant Dimon said he now believed the risks could be controlled. Immediately after the acquisition in 1997, however, Weill was clobbered by Salomon losses due to the East Asian financial crisis and many more to come. Weill quickly limited trading exposure at Salomon. Dimon must have learned that losses are inherent in such businesses.

Dimon was finally at Weill’s side when Travelers merged with Citicorp to form Citigroup, becoming a massive financial giant. He left soon after in a personal dispute as Citigroup took on more and more risk, more and more debt, and adopted unethical practices that were later unearthed by Eliot Spitzer, which resulted in more fines than for any other company.

Dimon wound up running J.P. Morgan Chase, where he emerged as a hero after limiting mortgage market risks before the crisis that felled so many. He became the most respected of Wall Street’s leaders, and he was arguably the best of them. But Wall Street trading profits are too tempting, and individual Wall Street traders too hard to control. Even with tight oversight, they often go their own way. And they often lose hundreds of millions and sometimes billions of dollars in the process.

Dimon may have known precisely what his London trader, the “Whale,” was doing. I doubt it. But it’s likely the so-called “London Whale” had been making big bucks for the firm for a long while. Giving him more line would only be natural.  

Herb Allison, former president of Merrill Lynch, is a strong skeptic of commercial and investment banks’ trading operations. He even thinks over time they may all lose money. What happens is that they make plenty along the way, then lose it in a big bust.  As author Michael Lewis divulged, a Morgan Stanley trader, Howie Hubler, lost $9 billion in 2007 and 2008. Nevertheless, Hubler left Morgan with millions of dollars, and later returned to work on the Street.

Dimon, among the most cautious of executives, couldn’t control this trading animal with a life of its own, either. That’s the important conclusion. A Volcker rule to limit speculative trading for banks is necessary. They are using federally insured money to finance much of their banking operations, enabling them to leverage other facets of the company. They are using shareholder money, not their own, to take risks, yet they take enormous bonuses when all goes right. And they are implicitly using taxpayer money, because if they lose too much, they will be bailed out by the federal government. They remain too big to fail.

Serious capital requirements must be implemented against such trading, and banks must also change banker compensation procedures further. For traders, it’s a heads I win, tails you lose proposition. And so it is with the bank CEO as the firm’s overall earnings rise and are socked with a blow only every once in a while. These compensation plans have changed under pressure from the federal government to some degree. But probably not enough. The firms’ partners and employees have to be on the line for losses over time.

All this is a case study in why finance needs more government rules and regulations than most other industries. The omnipresent claim that such rules undermine liquidity in markets is almost laughable. In truth, we have a lot of liquidity when we don’t need it and little when we do—such as after the Lehman Brothers catastrophe in the fall of 2008. As regulations were eliminated and weakened after the 1970s, finance became more unstable, crises more frequent, and trillions of dollars were invested down the rat holes of speculation and fantasy, while Wall Street employees made countless millions. Yes, finance is important to economic growth, but only if government controls it properly. Otherwise it can be and has been damaging.      

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