This is a guest post on trading from Tusk Trader (check out the newly launched site: www.TuskFund.com), an experienced Bay Street trader who will be writing here until Tusk’s own blog is set up. Tusk had a front row seat to the twists, turns, and almost collapse of our capital market systems a few years ago and provides a unique perspective you won’t find anywhere else. For most people, financial literacy is the elephant in the room. Let Tusk Trader help change that. If you are on twitter, make sure to follow Tusk at @TuskTrader
JP Morgan announced a massive trading loss last week and there are still many ripples being felt this week surrounding that announcement.
Since the start of the financial crisis, the head of JP Morgan, Jamie Dimon has been strutting around Wall Street and the other capital market areas with a swagger that appeared to grow by the quarter. Many hope this loss will bring him back down to earth a bit. He had engaged in a screaming match with the Head of the Bank of Canada, Mark Carney, a little while ago, and that appeared to not make a dent. It took a 2 billion dollar loss to do it, but he does seem slightly more humble.
What I think this massive loss shows is that the government and regulators can do little to prevent the big losses at financial institutions. This is because they can do little to prevent bank leaders from being stupid. You can’t legislate against being gigantically wrong. This loss did not even happen on a trading floor. In happened in a risk department. Rules like the Volcker Rule would do nothing to mitigate risk, these rules just move the risk elsewhere.
Trades like this happen all the time and never make any waves because they are either winning trades, or they are losses that are not big enough to make waves outside of the group of people in the bonus pool. A good rule or good regulation is when the act of the trade or investment is wrong. The profit or loss should not be a factor.
Regulators need to focus on making sure that the leverage a firm uses (whether in trading departments, commercial lending or investment areas) is never out of line for the size of the firm or the capital on hand. Regulators need to limit leverage, draw a line in the sand at the limit, and then let firms do what they will with the leverage allowed.
I believe firmly in capital market regulation, but not the kind the US seems hell bent on cooking up. These politicians seem to think they can stay one step ahead of the market and craft rules that will guide the market where they think it should go. They are wrong and they are creating rules the will just create loopholes somewhere else. I think it will play out in a similar way that interest on a mortgage in the US became tax deductible. The genius politicians thought it would increase home ownership. It seemed like a great idea at the time (and very politically popular). It took 20 years to discover it did not do as intended. All it did was discourage homeowners from paying off their mortgages.
When looking at regulations, one of the biggest red flags to look at is the length of the new proposed legislation. The longer, the more useless. The Frank Dodd act is over 800 pages long. To compare, the Federal Reserve Act (that created the Federal Reserve in the US) is only 31 pages long. It does not take 800 pages to say, “Don’t leverage yourself up to your eye balls” and “ If you can’t take the loss, don’t make the trade”
The next financial crisis cannot be prevented, but the losses can be mitigated. Regulators need to focus on systemic problems, not market ones. When rule makers make rules believing they are one step ahead, all it takes is a crisis to show them that they are 3 steps behind.