Dangerous Deja Vu
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As the attention moved away from JP Morgan’s (NYSE: JPM) rather large 2 Billion dollar trading loss to the IPO of Facebook most forgot the seriousness of what had happened. This is important not because the trade put JP Morgan in financial distress, which it did not, but because this was the type of trading that brought the imminent collapse of the financial markets. This trade demonstrated what was and still is wrong with Wall Street: the un-checked use of bank funds to chase profits regardless of the potential risks.
The trader that orchestrated the trade that has become known as the “London whale” was paid 40 million dollars for his work as the trade was initially profitable. As it turned into a 2 Billion dollar loss the trader was shown the back door keeping his 40 Million and if he needs work again will surely show up at another brokerage house. The issue is not that the Bank takes these very risky bets and pay their executives handsomely win or lose, it’s that they put at risk the deposits of their customers. These are the same customers whose hard earned tax dollars bailed these banks out when they really messed up. Banks have evolved from a safe haven for the cash of depositors to risky profit centers that chase increasing revenues while putting more at risk. We have to go back over 70 years to see how we got here and now where we probably should end up going as regulators finish writing the Volker rule, the most controversial provision of the Dodd-Frank Act.
In 1933, the Glass-Steagall Act created a barrier between how banks could lend money to customers. It created a separation between investment banks and commercial banks with the idea protecting depositors from loans and bonds to companies that at some point might default putting their deposits at risk. This created a competitive landscape where commercial banks and investment banks would compete. Another aspect of the act was that it fragmented the industries political lobbying as the different sectors had different goals. This lasted until the 1970’s when regulations began to be repealed. The deregulation increased banks efficiency and fostered economic growth, but also began a process of consolidation of power. In 1984 the top five U.S. banks controlled only 9% of all deposits. By 2008 that number had increased to 40%.
The consolidation of power also created a consolidation of lobbying power as the different areas of banking began to have the same goals. This added focus allowed them to continue to lobby to have less and less regulations and the ability to chase bigger and bigger profits. In 2009, Bank of America (NYSE: BAC) controlled 12.2% of all American deposits. This one bank controlled more deposits then the 5 biggest banks in 1984. BOA acquired Merrill Lynch at the height of the banking turmoil picking up the once powerful investment bank, becoming the world's largest wealth management company and a major player in investment banking. Wells Fargo (NYSE: WFC) was able to merge with Wachovia during the same time period and is now the biggest bank by market capitalization in the U.S. They outbid Citigroup for Wachovia and in the depths of the crisis were able to save Wachovia from going under and grow all aspects of their business. In retrospect it seems that all the banking sector did was consolidate, further strengthening their position during the financial crisis and using government subsidies to lobby for the moniker of “to big to fail”. This allows them to seek more and more risk in the search for profits, paying their traders handsomely for creating the most profitable trades regardless of the risk. It removes all risk and there is only a reward that increases as risk increases, we all know as humans this creates problems. The potential to make 40 million dollars and have your losses covered is very powerful.
Derivatives trades have become so complex that one needs an engineering degree to understand all the components and how they work. If banks want to pursue this, there should be a division again between commercial and investment banks. The banking industries political lobbying power has become very powerful over the years but now must back off due to the most recent losses. This would be the time to bang legislation through that would protect the depositor from these arcane trades. There needs to be a balance between economic efficiency and protection for those who deposit their hard earned money for safekeeping. The “to big to fail” scenario has already happened, but the sector needs to grow from that and not put their employees and stakeholders in that kind of situation. The most recent trade though demonstrates that without the use of regulation to a certain extent the banks will continue to chase profits, regardless of the repercussions.
mooseelz has no positions in the stocks mentioned above. The Motley Fool owns shares of Bank of America, JPMorgan Chase & Co., and Wells Fargo & Company and has the following options: short APR 2012 $21.00 puts on Wells Fargo & Company, short APR 2012 $29.00 calls on Wells Fargo & Company, short OCT 2012 $33.00 puts on Wells Fargo & Company, and short OCT 2012 $36.00 calls on Wells Fargo & Company. Motley Fool newsletter services recommend Wells Fargo & Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.