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At last, JPMorgan (JPM) shareholders and their political representatives might find out exactly what transpired within the JPM Chief Investment Office. As much as the Wall Street Journal may try to get the story precisely correct, and as hard as JPM executives may try to spin their way out of an inexplicable situation, none of this is being done under oath. And that’s the wonderful thing about what’s to come: investors will actually find out what was being hedged, to what end, and how comfortable JPM is to say that they never took a naked bet on changes in the backdrop of the European economy.

Republican Senator Corker is trying to get ahead of the curve with his request, since JPM’s US$2.45B (and counting) in mark-to-market losses have added import to the demands of those who say the pending “Volcker Rule” is both required, and needs to be toughened. Corker figures that any details from JPM Executives will be better than what is in the public domain today. Smart move on his part.

Last month, I told Kim Parlee on BNN’s Business Day show that the Wall Street Journal’s original “London Whale” story illuminated that the Volcker Rule loophole, which permitted “portfolio hedging” by banks, made a mockery of the rule itself — which was to ban prop trading with bank capital. Banks should be in the business of making loans, and there’s nothing wrong with hedging those loans if you’re worried about your institutions’ exposure to the companies that underlie the loan portfolio. But you can’t effectively hedge that book in the Credit Default Swap market, I said, since you are taking counterparty risk the moment you try to lay off that risk onto some other institution. As we all witnessed with AIG in 2008; you think you’ve bought “protection”, but it turns out that in a global financial crisis there’s no one on the other side of your trade (other than Uncle Sam, of course).

Particularly if you are JP Morgan, North America’s best capitalized bank. If JPM needs to reduce its loan exposure there are only two ways it, or any other large bank, can accomplish same: don’t make the loans in the first place, or syndicate some of your loan exposure to another institution.

When a bank is either “putting on” or “laying off” risk via a CDS midstream, all they are really doing is taking a bet on what’s to come in the short term. And, despite telling the WSJ on April 12th that:

The CIO balances our risks,” Braunstein told media members on a conference call. “They hedge against downside risk, that’s the nature of protecting that balance sheet.”

Braunstein added the bank is “very comfortable with the positions we have” and that all of the positions are “very long term in nature.

It turned out that JPM’s definition of “very long term in nature” can be four weeks when they are offside a trade.

All of this is old news, by now. But the scary thing that has come to light isn’t that banks might lose money on their risk management activities. Mark Carney, Chair of the Financial Stability Board, thinks that goes with the territory. What annoys me is that JPM’s Chief Investment Office was responsible for investing $374 billion of JPM assets, according to the WSJ.

Guess what these assets are? Deposits that aren’t invested in JPM’s loan book. The Chief Investment Office had a goal, according to the report: take these free balance deposits and earn a return higher than the bank’s cost of capital. Whether that means the targeted annual return was 5%, 6% or 8%, JP Morgan’s Board of Directors authorized the CIO Unit to trade in assets that total twice JPM’s equity capital base of $189.7 billion.

When the 10 year U.S. Treasury is around 2%, what type of risks did JPM’s Board authorize its management team to take to achieve these 5-8% annual returns? Last year, JPM earned about US$19 billion in total. If JPM’s CIO until was producing even a 5% after tax return with its asset pool, that would represent almost 100% of JPM’s entire 2011 earnings.

Despite having $374 billion to invest, the WSJ reports that “the CIO unit responsible for the bad trades had weaker risk management controls than other parts of J.P. Morgan.” How can that happen? Where were the regulators? They were probably doing their jobs — right there on the trading desk, keeping a watchful eye. Even then, this all came to pass just the same. As the WSJ reported over the weekend:

The bank’s CIO unit holds many trading positions. Late last year, they included insurance against defaults, or credit-default swaps, by 121 various companies on an index called the IG 9 maturing in December of this year. Meanwhile, the group sold CDS contracts on a similar index maturing in December 2017.

Early this year, however, Mr. Iksil and his group decided to become more bullish on corporate credit, according to traders. So Mr. Iksil began selling more CDS contracts on that corporate-debt index maturing in December 2017, a way to make a wager on the health of companies.

So long as FDIC-insured deposits are invested in anything other than cash, T-Bills, government bonds and personal/commercial/corporate loans, the taxpayer is taking too much risk. That’s the lesson of the London Whale. In fact, the taxpayer is an unwitting pawn in a very distasteful business, where folks can make $15 million a year with Joe/Jill Lunchbucket as the ultimate safety net. Until Regulators, Bank Governors and Politicians get their arms around this reality, none of the rules that have been enacted post-financial crisis are worth the paper they are printed on.

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Source: JPMorgan Losses Expose Absence Of Post-Crisis Regulation