Clearing The Bull: JP Morgan And Derivatives Derangement Syndrome (DDS)

The headline writers are at it again as just about every publication that can spell the word derivatives is bemoaning JP Morgan’s $2 billion credit derivatives loss. Meanwhile, on planet Earth, the EU continues to sink under hundreds of billions of dollars of debt.

JP Morgan’s $2 billion credit derivatives loss is, in reality and the greater scheme of things, a non-story.  It’s a 1% loss on a $200 billion investment portfolio. It is a 0.1% impairment of a $2 trillion balance sheet. This is minor when compared to the hundreds of billions of dollars in junk and distressed Eurozone sovereign debt.

It is apparent that there are many who still think that the subprime crisis was all about derivatives but nothing could be further from the truth. The fact of the matter is that the subprime crisis was about debt and the extension of too much credit. Had the likes of Greenspan and Mervyn King (amazing he still has a job) raised interest rates and spiked the credit bubble in a timely manner, the last financial crisis would not have been nearly so devastating.

What is even more alarming about the subprime crisis is that the credit and debt issues that brought it about are nothing new. An even cursory review of history shows that just about every major crisis over the past 40 years has been about the expansion and extension of credit and liquidity in one form or the other—LDC debt, junk bonds, Japanese asset price bubble, dotcoms and the subprime mortgage debacle.

Yes, derivatives are very risky, they should be handled with care and one day they probably will cause an almighty disaster. However, the fact is that day is yet to come.

This basic lack of understanding of the causes of financial crises is critically important for two reasons. The first reason is that if governments and regulators are unable to properly diagnose a problem there is absolutely no reason to expect that they can come up with an appropriate solution.

Thus, while I am supportive of initiatives such as the Consumer Finance Protection Bureau (CFPB) and some aspects of the Dodd Frank Act, the reality is more legislation, more regulations, more governance and more controls cannot forestall another crisis. The failure to understand that is at the very heart of the weeping and wailing and gnashing of teeth over derivatives that we see and hear today.

The second reason is even more fundamental and more critical. While banks do bear a very significant responsibility for our recent history of financial crises, the bigger issue has been the failures of governments in respect of both politics and macroeconomic policy.

If there is one singular fact that we should have learned from the 20th century it is that governments, and extremist governments in particular, are far and away the most destructive force on the planet. We can sum this up in three names—Hitler, Mao and Stalin—and not say anything further on the matter other than the fact that they knew nothing about derivatives.

However, today it is the failure of governments that present the biggest risk to life as we know it—not bankers and derivatives. As such, we are duty bound to pursue this topic on the dangers of governments even further.

Within the EU, we have witnessed the partial failure of democracy in Greece and Italy. Everywhere, extremist parties of both the right and the left are on the rise. As countries sink deeper and deeper into debt and austerity, and as democracy weakens, these extremists are being strengthened and nationalism is on the rise.

Governments, even reasonable governments, will face severe pressure from these extremist and nationalist forces, further undermining democracy and increasing international tensions. Moderate governments therefore even if they win elections, might still be prone to extremist actions. So for example we see France and Germany both trying to undermine the Schengen Treaty which guarantees the free movement of people within Eurozone borders.

Herein lies the important lesson for those writing the shrill and extravagant headlines about JP Morgan and credit derivatives. Global macroeconomic imbalances, from the abandonment of fixed exchange rates through to the OPEC oil crisis, Japanese trade surpluses and the current trade imbalances with China, have been the principal drivers of financial crises in the modern era. The greater the inability of governments to rectify these global macroeconomic imbalances the more likely we are to succumb to further crises—both financial and political.

Instead of trying to show that bankers are the lowest form of human life, journalists and editors need to focus on the wider and more fundamental issues that imperil us. Given the gravity of the situation it is indeed unfortunate that they are yet to rise to the task. If they are to do so it appears that they will have to first overcome their DDS.

Jonathan Ledwidge is the author of the book Clearing The Bull: The Financial Crisis and Why Banks Need a Human Transformation. Use this link to give your opinion on the performance of banks post the financial crisis.

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