With JPMorgan Loss, Volcker Rule Resurfaces

Robert Siegel talks with Lynn Stout, professor of corporate law at Cornell University, about the JPMorgan Chase trade that has cost the bank more than $2 billion and led to the resignation of the company's chief investment officer.

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ROBERT SIEGEL, HOST:

If you're puzzled by such questions as when is a hedge a hedge and what is an index of corporate derivatives, join the club. And for now, join the tutorial with Lynn Stout, distinguished professor of corporate and business law at Cornell University. Welcome.

LYNN STOUT: Thank you so much for inviting me.

SIEGEL: First, we've heard that JPMorgan Chase bought insurance against a downturn. What did they actually buy? What were they doing?

STOUT: Well, one of the most interesting things is the way they keep insisting on calling this insurance. And when you really get down to it, what they did was they placed a bet or wager. Derivatives are bets. That's not a metaphor. They're literally bets. Now, bets can be used for insurance. For example, if you own a house and you buy fire insurance, you're basically just betting with the insurance company that your house will burn down.

But if your house burns down, of course, you win the bet, but you lose your house. The bet functions as a form of insurance. The problem is that betting can also be used to speculate and to try and make money by predicting what's going to happen to things that you don't necessarily own. And it looks very much like that's essentially what JPMorgan was doing.

SIEGEL: But they bet wrong and then they decided they'd bet wrong and bet anyway and again ended up betting. It was if they bet on the Yankees, then bet on the Red Sox and then bet on the Yankees again.

STOUT: Right. And in the gambling business, we call that hedging a bet. It's like you bet on one horse in the Kentucky Derby to win and then just in case, you get a couple of bets to show or to place. But that doesn't change the fundamental character of what's going on, which is that JPMorgan was trying to use the derivatives markets, not to reduce risks generally, but to try and reap profits.

SIEGEL: Well, if, in fact, JPMorgan Chase was betting in the many billions and ended up losing $2 billion, does that mean that somewhere there are winners who bet the right way and collectively they've made $2 billion.

STOUT: Oh, yes. Whenever anyone loses a ton of money on derivatives, there's someone somewhere who made a ton of money on derivatives. The problem with derivatives isn't necessarily that some people win and some people lose. The problem is when you've got a lot of people betting and gambling that way, what you have is sudden institutional failures when bets go bad.

SIEGEL: What would be a legitimate hedge that isn't a speculative bet?

STOUT: The classic example of what's called commercial hedging is, say you're an airline and you're worried about jet fuel prices going up. If you were to buy derivatives on jet fuel prices, that exactly counterbalanced the jet fuel that you expect you're going to have to buy. That would be a true hedge, a true insurance contract. And by the way, this hedging insurance distinction, Wall Street will tell you it's impossible to make it.

But, in fact, the insurance industry's been making this distinction for hundreds of years. There have been people trying to buy insurance on things they don't own for a long time. And the law has figured out a way to separate the wheat from the chaff.

SIEGEL: But doesn't this become more complicated when people are not just investing in commodities or not just investing in corporations, but in indices on where somebody's composite of what a zillion corporate obligations might yield, where that index stands from day to day?

STOUT: It becomes more complicated and Wall Street has certainly used that in the attempt to dissuade people from trying to get involved in regulating the market. But it doesn't change the nature of the transaction. If JPMorgan were truly hedging risk, how did they end up suddenly losing $2 billion?

SIEGEL: You don't buy any of this. From what I'm hearing, as far as you're concerned, this was unsuccessful, in this case, speculation. When it succeeds, it was speculation.

STOUT: Yeah, and, in fact, this should be obvious to anyone who's been reading the newspapers for the last 20 years. Ever since we started deregulating derivatives, we've had these problems. Remember when Orange County's pension fund went bankrupt? Remember Enron, which failed from betting on energy derivatives? Remember AIG, which failed from betting on mortgage-backed bonds and almost took Goldman Sachs down with it?

SIEGEL: Well, Lynn Stout, thank you very much for talking with us today.

STOUT: You're quite welcome.

SIEGEL: Professor Lynn Stout of Cornell Law School.

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