Why Wall Street Needs Government Regulation To Save It From Itself

The inherent problems and contradictions of Wall Street trading make government intervention a necessity.

The fiasco at JPMorgan Chase is most disturbing because it reflects the inherent riskiness of modern financial trading. Few articles have pinpointed this as the problem. It is the reason strong regulations and high capital requirements are necessary; you can’t outsmart these inherent contradictions.

JPMorgan ran its trading operation out of its risk management group, which was supposed to offset risk, not take on new ones. But even if you are trying to implement a pure hedge—that is, minimize risk—there are two big issues here. One is the inefficiency of markets and the lack of adequate information. You can buy or sell a security—usually a derivative, or a leveraged security based on the ups and downs of another security—to hedge a position, such as a portfolio of bonds you think might readily fall in value. This was the Chase situation.

However, the first problem with this is that the hedge is not necessarily properly priced, because the markets are inefficient and prices are not transparent to all. It is often too cheap. Second, the counter-party—the seller or buyer on the other side of the transaction—may not meet his or her commitment. This is what happened when AIG sold insurance (credit default swaps) to Goldman Sachs and then couldn’t pay it off without a government bailout when markets collapsed.

The next big issue is the human one. Judging from press accounts, JPMorgan wasn’t trying merely to hedge. In truth, there are no pure hedges or people wouldn’t make money at all. Nothing can eradicate risk completely. Rather, JPMorgan looked like they were taking long and short positions on balance—that is, trying to win bigger by guessing the direction of the markets, not just hedge.

Again, there are two problems within this larger issue. First is the inalterable human temptation to make a big killing, especially when the individual bankers are being paid big bonuses to do so and suffer relatively little if they guess wrong. Call this asymmetric incentive. They may even have changed their own yardstick, or value at risk, to seem like they were taking less risk. No doubt they had some kind of argument to do so.

The second is a more subtle one. Traders usually believe that at some point securities prices will revert to their long-term values compared to each other. This was the philosophy behind the hedge fund Long-Term Capital Management (LTCM). It is very likely the traders at JPMorgan doubled down rather than try to unwind their positions, believing that markets would soon adjust to some historical averages and prove them right. The people at LTCM bought when others were selling, certain that they could hold on until markets adjusted. They could not.

These basic facts of Wall Street life are inescapable. Thus, the JPMorgan fiasco is a repeat of what happened time and again in 2007 and 2008, such as with AIG, and what happened in the 1990s with LTCM, and many others.

Why did Jamie Dimon think he knew better? The repetition even extends to the fact that the risk manager and the trader were friends. The same was true at Citigroup before it lost a ton of money, to the surprise of its own management, as mortgage markets began to crack a few years ago.

These are fundamental, baked-in problems for Wall Street trading. Some, like today’s Wall Street Journal, will say losses are a part of capitalism and capitalists learn from their errors. The main lesson here is that they don’t learn and they can’t.

This is a job for government. Tough regulations are needed. If these firms and their employees had to absorb their own losses, perhaps there would be justification for some of these risks. That banks like JPMorgan are supported by FDIC-insured funds, that they have shareholders, and that they are so big their losses will always be guaranteed by the taxpayers, are all reasons that strong regulations are necessary. Their losses were a failure of regulation once again, reflecting the continued need for strong capital requirements, a broader Volcker rule, and transparency and margin requirements in derivatives trading. Some of that is coming. Clearly, it is not here yet and may not be here at all.

Roosevelt Institute Senior Fellow Jeff Madrick is the Director of the Roosevelt Institute’s Rediscovering Government initiative and author ofAge of Greed.

Cross-Posted From The Roosevelt Institute’s Next New DealBlog

The Roosevelt Institute is a non-profit organization devoted to carrying forward the legacy and values of Franklin and Eleanor Roosevelt.


Start your day with National Memo Newsletter

Know first.

The opinions that matter. Delivered to your inbox every morning

Liz Cheney

Rep. Liz Cheney (R-Wyoming)

Former Rep. Liz Cheney (R-WY) made a point Sunday to be transparent with graduates of her alma mater, Colorado College, Politicoreports.

Keep reading...Show less
{{ post.roar_specific_data.api_data.analytics }}