JPMorgan losses revive worries that Washington is unable to regulate Wall Street

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Two men speak outside JP Morgan Chase & Co headquarters in New York, May 14, 2012.

By John W. Schoen, Senior Producer

Too big to fail is bumping up against too big to regulate.

The spectacular multibillion-dollar trading losses at JPMorgan Chase (JPM), still being tallied weeks after a risky trading strategy began to unravel, have renewed concerns that the largest U.S. banks remain too massive to regulate and that the government may not be up to the task.

As federal regulators and bank officials sift through the financial wreckage, the total losses from the bank’s failed wager on a type of credit hedging derivative are unknown. That’s because JPMorgan is holding onto some of its losing bets, hoping they gradually recover some of their lost value.

But the bank’s self-inflicted wounds have severely dented its credibility among customers, regulators, Congress and credit rating agencies. Shareholders have lost more than $15 billion as the stock has plunged more than 11 percent since the bank announced trading losses of $2 billion and counting Thursday.

The top bank executive in charge of the trading unit, Chief Investment Officer Ina Drew, has announced she is retiring, and two senior traders who were instrumental in executing the failed strategy are also leaving. The bloodletting may not end there.

CEO Jamie Dimon will face a host of questions from angry shareholders at the company's annual meeting in Florida Tuesday. Among them will likely be questions about Drew’s compensation, which topped $30 million over the last two years, according to a regulatory filing. That made her one of the highest-paid officials at JPMorgan.

Dimon, who until last week enjoyed a reputation as one of the banking industry’s best risk managers, now faces stepped-up pressure from proponents of tougher bank regulations. Dimon has led his industry's push to try to water down those regulations, including the so-called Volcker rule that proposes to restrict banks from making trades that would be considered too risky. Opponents of the rule say that it would stifle profits at banks, which would be forced to raise fees for customers to make up for the lost revenues.
“The issue here is the power of the banks and whether or not we're going to regulate those banks and put a cop back on Wall Street,” Sen. Carl Levin, D-Mich., and a proponent of tougher bank regulations, told NBC News. “The issue is whether we are going to stick with the law as written, which will prevent us from bailing out banks again. And the only way to do that is to make sure they don't take the kind of risks that were taken here.”

Proponents of tougher oversight also want to see rules that would require banks to trade credit hedges on an open market. Some have argued that would have helped identify losses like JP Morgan’s bad bets before they posed a wider risk to the system.

Dimon should also step down from his role as a top official at the New York Federal Reserve Bank, one of JPMorgan’s chief regulators, said Elizabeth Warren. Warren, an architect of the Consumer Financial Protection Bureau created by the Dodd-Frank Wall Street reform regulations, is a Democratic candidate for Senate from Massachusetts.

"We have to say as a country, no, the banks cannot regulate themselves," Warren told CBS News.

"They are financial institutions that run the risk of taking down everyone's job, run the risk of taking down everyone's pension, run the risk of taking down the entire economy and that means it is appropriate to have some government oversight," she said.

At the heart of the debate is a set of rules governing whether bankers should be allowed to use shareholders’ and depositors’ money to buy and sell complex, risky investments that were created to offset a variety of other financial economic and credit risks. Opponents of the practice argue that the use of these “synthetic” investments only serves to promote the kind of money-losing bets JP Morgan traders made with other people's money.

“The term ‘synthetic’ doesn't belong in the same sentence with the word ‘bank,’” Camden Fine, CEO of the Independent Community Bankers of America, told CNBC. “What we have here is high-risk trading activities conjoined with commercial banking. In the old days when you put $1 in the bank, you were at least going to get your dollar back. Today the bank is using house money for all kinds of trading activities.”

Stephen Roach, former Morgan Stanley Asia non-executive chairman, discusses what it will take to get the markets and economy moving again and restore investor confidence, on the heels of JPMorgan's recent loss.

Others argue that JPMorgan's losses only serve to underscore that banking, by its nature, is risky. If the bank had lost $2 billion on a loan to a large company that went bankrupt, for example, no one would be questioning the need for more regulation, said BankUnited CEO John Kanas.

“We're in the business of taking risk,” he said. “These people were trying to mitigate a risk. It was an error in judgment.”

But Kanas is among those who argue that the concentration of risk among a relatively small number of very large banks has created a new challenge for those would want tighter government regulation.

"If Jamie Dimon and his crew can't understand what this was, you have banks that are too big to manage, banks that are too big to regulate," he said.

JPMorgan’s losses come as Congress and Wall Street continue to wrestle over details of Dodd-Frank -- sweeping regulations that were designed to prevent a repeat of the worst financial industry crisis since the Great Depression. Wall Street lobbyists have spent two years trying to water down the final rules they’ll have to play by under terms of the 2,300-page law.

Proponents of stricter regulation argue that the biggest banks -- JP Morgan has more than $2.2 trillion in assets -- remain “too big to fail,” leaving taxpayers on the hook for future government bailouts. Dodd-Frank tried to solve that problem by allowing regulators at the Federal Deposit Insurance Corp. to shut down even the largest banks if they believe a bank posed the kind of threat to the system inflicted by the 2008 collapse of investment bank Bear Stearns. But doubts remain about whether the FDIC has the financial resources to cope with a major bank failure.

“If you broke up Bank of America, you could break it into six or eight pieces and every one of those pieces would be bigger than Bear Stearns,” said Austan Goolsbee, a University of Chicago professor and former White House economist. “The banks pay into the FDIC fund. The question is have they paid enough into the fund so if major catastrophes happen the fund can cover it.”

Even if JPMorgan loses more money on its recently reported bad bets, the more than $4 billion at risk can easily be absorbed from the bank's ongoing profits. But the loss has renewed concerns about the banking systems’ vulnerability to wider financial shocks such as the further unwinding of the European debt crisis.

“Maybe if one of these banks got in trouble the FDIC could handle it,” said Kanas. “But generally this happens when there's a cluster. There would be five or six of these banks in trouble. Then what do you do?”

JPMorgan’s size -- it is the nation's largest bank -- also worked to the bank’s disadvantage in the very trades that got it into trouble.

The losses resulted from a series of bad trades involving credit default swaps, a market JP Morgan pioneered in the 1990s, which allow banks and investors to insure against the risk that a corporation or government won't repay its bonds. JPMorgan traders amassed a large holding of swaps on more than 100 corporate bonds, along with side bets on an index that tracks the performance of those bonds.

But the bank’s holdings got so large it began to move the index itself, creating a target for smaller hedge funds who began betting against JPMorgan’s traders. When the bank’s bets began going south, it was unable to find buyers for them.

“When you are that big and when your hedging position is that significant in any one index you are going to dominate the market,” Barbara Ridpath, CEO of the International Centre for Financial Regulation, told CNBC. “Therefore people are going to play against you because they’re going to be able to see you. So you’re too big to hide.”