The Breakdown

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Why lending can be riskier than not lending for banks

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At the L.A. Times, Michael Hiltzik has a Money & Co. post about JP Morgan CEO Jamie Dimon's congressional testimony today. Hiltzik zeroes in on an exchange between Dimon and Sen. Bob Corker of Tennessee:

Corker: "Mr. Dimon, you've said that the biggest risk a bank takes is making loans, is that correct?"

Dimon: "Yes."

Let's unpack this, just for a moment. If what Dimon says is true, he's essentially pleading that his entire industry is operated by hopeless incompetents. 

Which sounds about right. Except that it isn't. Incompetence isn't the problem. Because when Dimon says making loans is a big risk, he's not talking about the risk of losing money. He's talking about the risk of not making money.

Here's what happened with JP Morgan's now $5 billion trading loss, centered on its London office. The bank had an historically immense amount of "excess deposits" on its books — that is, deposits that it wasn't lending out, in the form of various products (Felix Salmon has a chart.). A bank can use excess deposits to "hedge" against the risk of loan defaults. And this is what Dimon says JP Morgan was doing. Because if the bank wasn't hedging but rather making bets with those excess deposits...well, that's potentially a violation, because JP Morgan's deposits are guaranteed by the FDIC. You can't play poker with taxpayer money!

That said, if you can use the hedge to make serious money, then you run the risk of putting those excess deposits to work on the wrong business. Writing loans that return anywhere from 4 to 24 percent is a threat to profits if you can make much more than that on trading operations in the solid square mile of hedge fund that is the City of London's financial center.

Even better, these trading operations can be short-term plays. This solves a problem that JP Morgan has been solving for a number of years and is often credited with inventing the solution to: getting money "trapped" in long-term loans out of those loans and into other moneymaking undertakings. 

It works like this. JP Morgan writes a loan, say for a few hundred million to a major corporation. It doesn't have to keep the total amount of the loan on its books, in case of a default. It just keeps a percentage, some to satisfy its own risk management, some to satisfy regulators. However, if it convinces both itself and regulators that it's hedged that risk, thereby reducing it, JP Morgan can take that unproductive capital and use it for something profitable.

You can see how we're talking about two different kinds of risk here. The old-fashioned loans that JP Morgan wasn't making carried the risk of default. The trades it was running in London carried the risk of not being done. Had JP Morgan flinched at those trades, somebody else could make the money. 

Hiltzik kinda sorta gets this and kinda sorta doesn't (perhaps on purpose, to make his larger point that JP Morgan was, at the very least, using those excess deposits to do the morally incorrect thing):

The most fatuous exchange in Corker and Dimon's nationally televised pillow talk came when the senator asked the banker what would happen if Morgan wasn't allowed, in principle, to do the kind of hedging that produced the big loss. 

"You might have less loans," Dimon said. 

Yet JPM made its derivatives investment with more than $300 billion in spare cash that it had on hand precisely because it hadn't used it for lending. If it had used it for lending, it certainly looks like its risk would have been a lot lower. 

Dimon is actually right here — assuming you agree that JP Morgan was hedging, not speculating. Hedging means less trapped capital and less capital held to satisfy the banks on risk managers and its regulators, and that means more loans. But there's a narrative emerging that suggests JP Morgan was speculating, and it's supported by the somewhat mind-bending notion that the bank wasn't just hedging to offset defaults on loans, but hedging to take the other side of the hedge. 

Complicated, right? But this hedge-within-a-hedge is the ornate trade that JP Morgan is still unwinding, and that has caused it to lose $5 billion.

If you really unpack what Dimon said to Corker, he wasn't pleading hopeless incompetence. He was pleading reckless competence. In other words, our London traders are so good at gaming in their favor the risk of not making money that they got trapped, disastrously, in hubris spawned by their own success. 

Follow Matthew DeBord and the DeBord Report on Twitter. And ask Matt questions at Quora.

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