a fail whale by kun530/flickr

There is still little publicly available information about what exactly the trade involves, but we know the following:

1. they built up a huge long position on US corporate credit, and overpaid for it (due to the sheer size of the position distorting the market.)

2. they have already incurred a 2 billion dollar loss on it, despite the fact that it has largely not been unwound and/or hedged.

3. The further cost of unwinding it and/or hedging it and/or holding it to maturity can be estimated between three and eight billion dollars, and that is … if the credit quality of US corporates does not deteriorate.

4. The Whale’s London office managed to put on this massive trade without the added risk showing up in Morgan’s risk management models.

5.Regulators did not react until last week, despite Hedge Funds raising the alarm as early as February.

So what can we glean from these points?

JPMorgan can likely – hopefully – absorb these losses, thanks to its sheer size and Ben Bernanke’s generosity at the Fed discount window. But what if a somewhat smaller, less diversified, bank had put on a similar trade? Say, a Morgan Stanley or a Société Générale? A trade with a potential loss of 10 billion dollars would have caused larger downgrades, causing higher collateral calls from counterparties, causing more liquidation of assets at firesale prices, causing further losses, and would have raised their cost of funding in the interbank market and on the bond market, and would have harmed their brand and caused star traders in other units to move towards the exits as their prospective bonuses shrink measurably, thereby hurting the future earning prospects of the bank as a whole, in turn tanking their share price and credit quality with all the negative feedback loops that entails. I.e it would have caused a full-on bank run, on a systemically important institution in an already economically volatile environment. In short, it would have been a catastrophe.

The only reason the financial system has not collapsed is that this occurred at Morgan, and not somewhere else.

A second thing worth noting is that, unlike the massive UBS and Société Générale losses of the past few years, this one seems – so far – to have been completely above board and involved no outright fraud. And that should not be a source of comfort. On the contrary, it shows that traders can find ways to put on massive, systemically dangerous, trades without triggering the internal risk controls of even the best-run banks, by using complex next-to-impossible-to-model derivative products (in this case, tranched derivatives of credit derivatives). If a star trader’s position doesn’t make the in-house risk model budge, then he gets the go-ahead. And if he peppers his trade with enough impossible-to-model instruments, then he will find a way to smuggle it through the bank’s risk controls. The only thing stopping a smart trader is his … self-restraint.

A third point, and the most worrying point, concerns the reaction of the regulators. Faced with a clear massive distortion in the derivatives markets, and despite loud cries from Hedge funds, they did not react for three months,  until last week, when – presumably subsequent to JPMorgan’s consent – the Fed convened a meeting of the big banks to establish the nature of their mutual exposure. In short, the regulators have not changed their policy of letting the big banks regulate themselves, limiting their own role to that of tax-payer funded mop-up crew after the party is over and the bankers are sleeping off their hang-overs. Moreover, it now transpires that nothing in Dodd-Frank is remotely relevant to stopping this kind of behavior.

Something has to change.