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JPMorgan's (NYSE:JPM) troubled trade in its London-based CIO unit is well known. What is not properly understood, and particularly by regulators, is the source of the problem. JPMorgan is selling insurance and gambling contracts in an unregulated market.

CDS Are Insurance

Credit default swaps are insurance, and should be regulated as such, with a requirement of insurable interest for the buyer and adequate capital for the seller.

Briefly, insurance may be defined as the transfer of risk for a consideration, or premium. The insurance business has been in existence for centuries, and its underlying principles are clearly understood. It is a business affected with the public interest, and effective methods of regulation have been developed and are in place globally, with certain exceptions.

The exception with which we are concerned is CDS. Congress, aided and abetted by the machinations of Larry Summers, made them exempt from regulation by means of CFMA (the Commodity Futures Modernization Act of 2000).

Not only were CDS made exempt from regulation as insurance, they also got a pass from regulation as gambling. CFMA carefully exempts them from the provisions of "bucket shop" laws, passed in the wake of the financial crisis of 1907 to prevent gambling in the financial markets.

In simpler times our forbears noted that gambling in the financial markets creates economic turmoil, recessions and depressions, and outlawed it. Our elected servants in Congress have more and better wisdom, it seems, and have placed gambling in financial markets beyond the reach of the law.

Insurable Interest and Moral Hazard

Both life insurance and fire insurance require that the buyer have an insurable interest in the subject matter of the insurance. The reasoning is simple: otherwise, the transaction would create moral hazard.

Lack of an insurable interest in fire insurance would lead to arson for profit. Similarly, lack of an insurable interest in life insurance would lead to murder for profit. Moral hazard is created when the buyer of insurance is motivated to desire a loss.

JPMorgan sold protection referencing CDX IG NA Series 9, a somewhat obscure synthetic index, essentially a portfolio of CDS. The problem here is, adroit speculators, noting the size of the position, took opposing positions and drove losses for JPM. The speculators have no insurable interest in the index nor in any of its constituents. Their sole concern is to make money if the index moves in the direction of their bet.

JPM was using excess U.S. deposits to speculate, so that now the FDIC is in effect backing this gambling activity. Meanwhile, we have numerous very clever hedge funds who are actively seeking to create losses on the reference entities.

Definition of Loss

Insurance contracts seek to define losses in ways that make the insured whole, but do not place him in a better position than he would have been in had no loss occurred. This is the principle of indemnity, and avoids moral hazard.

CDS are cash settled upon the occurrence of an event of default (EOD), and the obligations are supported by the exchange of collateral as the values involved fluctuate prior to loss. In effect, CDS as written are insuring market values, which do not correspond with actual economic loss.

Losses for Credit insurance are properly defined as the payment of principal and interest when due under the original terms of the debt. That is, the holder of credit insurance should be placed in exactly the position he would have occupied had there been no loss.

Tranches

Some sources have suggested that JPM's wagers involved relatively low and narrow tranches. With 125 original constituents, and tranches 3% wide, the occurrence of a small number of EOD's could have a magnified effect on JPM's losses. The opportunities for gamesmanship increase accordingly.

The Dimon Principle

CEO Jamie Dimon, on the hastily arranged conference call announcing the loss, declared that whether or not the trade violated the Volcker Rule, it violated the "Dimon Principle."

All of this discussion of rules and principles is good. I would suggest that the Dimon Principle should include the principle of indemnity, and due consideration of insurable interest. Specifically, the bank had no legitimate reason to be issuing gambling contracts. Indeed, the Dimon Principle might be made subordinate to these considerations.

A Simple Solution

The answer here is very simple: CDS are insurance, and should be regulated as such, with a requirement of insurable interest for the buyer and adequate capital for the seller.

CFMA's regulatory exemption for CDS needs to be repealed in its entirety. CDS should be explicitly defined as insurance when backed by an insurable interest, and as gambling when naked.

A Ban on Synthetic Securities

The banking industry has artfully contrived to entice would-be bond buyers to sell CDS protection on the reference entity, reasoning that some buyers prefer to take their exposure in synthetic form and it is far easier to create CDS than it is to actually locate and buy bonds.

The result was the Abacus CDO's, made famous by Goldman Sachs and the Fabulous Fabrice.

Synthetic securities should be banned. They are fundamentally dishonest transactions, financial WMD's disguised as bonds.

Size of JPM's Problem

The size of a CDS position can be expressed in notional terms, or in terms of the fair value of the contracts. Here is a snip from the OCC website, where the derivative positions of banks are tracked:

(Click to enlarge)

Looking at the two far right columns, JPM has $170 billion fair value of CDS assets, supporting $166 billion of liabilities. That's a 2% spread between the two numbers.

As investors, we don't have answers to some important questions. How much protection has JPM sold to customers who didn't have an insurable interest in the reference entities? How much protection has JPM bought for its natural long positions? How much has JPM hedged its synthetic long positions with corresponding shorts? Who are the counter parties?

Avoid JPMorgan

JPMorgan is by all accounts a well-managed bank, and came through the financial crisis better than its peers. However, it has a larger CDS book than any of its peers. We don't know what's inside the black box.

There have been indications that big egos were involved in JPM's CIO troubles. Lehman Brothers had some big egos involved. Big egos and leverage don't mix well.

I personally would avoid trading this one, in either direction.

Agitate for Change

Our elected servants have a duty here, which they have breached, to protect the economy and financial system from the dangers of gambling in financial markets. Write them, call them, and talk to them about CDS. If they won't listen and act, vote them out.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.