The danger of dark markets

Updated

COMMENTARY

Chris Hayes
Story of the Week
Chris Hayes,
on Up w/ Chris Hayes

JP Morgan Chase CEO Jamie Dimon has spent nearly all of this past week alternately apologizing, explaining himself and artfully dodging specific questions about his company’s $3 billion loss this quarter on a single trade made out of their London office.

Let’s be honest, it provokes a certain inevitable schadenfreude watching someone as imperious and self-regarding as Jamie Dimon have to say things like “We made a terrible, egregious mistake,” “We were sloppy,” “We were stupid,” “We hurt ourselves and our credibility.”

So much of the argument that Wall Street makes about its role in the economy is that it is the repository of the smartest people on the planet, the brilliant minds who see farther and think quicker than us mere mortals in media or government and in fact, this why they cannot and should not be regulated. Because only they understand what they are doing.

Except, of course when they don’t understand what they’re doing and end up with a new exposure of $150 billion, and $3 billion in losses in five weeks and counting. Dimon himself is well aware of how all this looks and has been whining that this episode, ”plays right into the hands of a whole bunch of pundits out there.”

He’s right. JP Morgan Chase has been one of the most strenuous opponents of the Volcker Rule, a component of the Dodd-Frank bill that would make big, federally insured, too big to fail banks like JP Morgan Chase stop engaging in risky trading of the sort that blew a $3 billion hole in their balance sheet. Now, JP Morgan Chase’s balance sheet is enormous, and they can lose a whole lot more than $3 billion.

This was basically the point Mitt Romney tried to make in minimizing the episode:

 “This is, in the normal course of business, a large loss but certainly not one which is crippling or threatening to the institution.”

 But that misses the point. Through a combination of sloppiness, ego and zealous pursuit of returns, a bank celebrated for its prudence and risk management ended up with a huge directional bet and massive exposure. If, say Greece had defaulted in the last few weeks or there had been some other shock to the system, JP Morgan Chase could been Lehmann brothers all over again. And lord knows how much would have fallen once those dominoes started toppling. 

 There’s a reason that Jamie Dimon reportedly got nauseous and couldn’t breathe when he first saw the details about the size of the exposure. There’s a crucial lesson here about transparency and financial capitalism, and the danger and allure of dark markets. You see, we may be just finding out about all this now, but starting in January, the existence of the so-called London Whale became the focus of obsessive gossip and rumor among hedge fund traders. Someone in JP Morgan Chase’s London office, it turned out to be a trader named Burno Iksil, was buying up ungodly amounts of a certain kind of credit derivative, so much of it that he was single-handedly moving the price and various traders who were on the other side of these trades were losing money. They weren’t happy about it.

Eventually a number of them anonymously talked to a Bloomberg reporter (a Bloomberg reporter, who just happens to be married to a credit derivatives trader).  And once the London Whale had been exposed in the press, he responded by doubling down, trying to intimidate the traders by buying even more of the security. But now that they knew what he was doing, and that he was more or less out on a limb, they could call his bluff and force him to retreat and charge a very, very steep price to climb back down to safety. Hence, the massive losses that are now at $3 billion and climbing.

Now, here’s what’s so weird about this story: the secrecy, the shadows and rumor, the incompleteness of the information both for market participants and for regulators and for the public. And the fundamental reason for this is that the financial instrument in question, a credit derivative, is traded “over the counter.” Trading something over the counter means that it isn’t listed on an exchange, like, say Apple stock. No, it’s sold between traders, over email, with no central intermediary, and no public pricing information. Maybe you remember that during the run-up to the financial crisis a small unit of insurer AIG, in London bought and sold $446 billion of a certain kind of this derivative, a credit default swap, ultimately blowing up the company and almost the world economy. 

That’s why Dodd-Frank calls for many of these securities to be moved to an exchange, where market participants and regulators would have access to clear and steady data about supply, demand and prices. Those regulations are being formulated right at this moment and the banks are fighting a savage battle to weaken and resist them.

They’re doing this because a) they think they’re smarter than the idiots that would presume to regulate them and b) it’s lot harder to make a killing in a transparent market.

Think of how much easier it used to be for used car dealers to rip people off. In fact, the used car market is quite literally our model for a sketchy business, full of predators and untrustworthy con artists. The problem in the used car market was that while the seller had a good sense of what a “fair price” for a given vehicle was, the buyer didn’t. But then along came the Kelley Blue Book which made prices transparent, and now a variety of Internet tools that allow buyers to look up a vehicle’s entire history. It’s now a whole heck of a lot harder to rip people off, which is great for consumers, but inevitably sucks for shady dealers.

Transparency is a necessary precondition of well-functioning markets, but it is also the enemy of profit. It’s not that Wall Street is smarter than us, or the government. It’s that they know so much we don’t. It’s dangerous, valuable knowledge they hoard and it is why, quite literally, they make the big bucks.

The danger of dark markets

Updated