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How Exactly Did JPMorgan Pass a Fed Stress Test?

News of the investment bank's $2 billion loss through a poorly crafted hedging strategy sent a shockwave throughout the global marketplace, once again putting regulatory bodies under the spotlight.

The bombshell news that JPMorgan — the gold standard for risk management on Wall Street post-2008 — could lose $2 billion through an ill-conceived hedging strategy raises some alarming questions about the risks that still abound throughout the global financial system.

Unlike most of the pundits who'll use this to fuel the argument that the Volcker Rule is a necessary measure, a defiant Jamie Dimon contended on a conference call that although the strategy that caused this staggering loss was "flawed, complex, poorly executed and poorly monitored," it still would have been allowable under the Volcker Rule, which is slated to take effect July 21.

The bank's Chief Investment Office (CIO) is at the epicenter of Wall Street's latest crisis and is now paying dearly for the outsized positions taken by its London-based trader Bruno Iksil, who's also known by the unflattering nickname the 'London Whale.' One of Iksil's former colleagues told Reuters that JPMorgan's CIO desk doesn't do proprietary trading, but instead takes positions in the form of trades, credit default swaps, and other investments in order to rebalance the risks on the bank's balance sheet.

Meanwhile the bank is characterizing the doomed strategy that Iksil orchestrated as a hedging strategy gone bad. And media reports say that before all is said and done, the losses now weighing down JPMorgan's synthetic credit portfolio could actually rise by $1 billion. So much for the value of being hedged.

And for that matter, when exactly does a hedge actually become a wager? And have the regulators figured out how to answer that question?

According to Nicholas Dunbar, the author of the 2011 book " The Devil's Derivatives: The Untold Story of the Slick Traders and Hapless Regulators Who Almost Blew Up Wall Street ," this latest Wall Street saga is an example of how instruments that are supposed to help banks cover their losses, instead breed a level of false confidence. And rather than being mere hedging tools, they're actually a type of bet, albeit a complicated one.

"You can see this in JPMorgan's statement where they said this was a hedge and not a gamble. It was, but they convinced themselves it was a thing that was making them safer," Dunbar explains. "It's really a bet on something happening in the market, be it a default or a change in price of something."

He says the problem with derivatives is that they convince banks that risk is being reduced, when in fact those instruments can actually do the opposite because it's never a perfect hedge. "The definition of what a hedge is, is so subjective that it ends up allowing people to mislead themselves or for banks to be misled," Dunbar explains.

At this point it's still unclear whether or not JPMorgan's use of credit default swaps were actually a hedge. But Dunbar is far from alone in the view that these were actually prop bets.

Looking ahead it remains to be seen whether this type of strategy will be permissible once regulators finally nail down how the Volcker Rule will function. Guidelines set by the Financial Stability Oversight Council under Dodd-Frank consider any position without a hedge to be proprietary trading. So how exactly are they going to regulate this? Following this news there almost certainly will be a populist cry for them to take a more restrictive stance on how prop trading is defined.

But their task is far from simple. Regulators will need some sort of mechanism to track a bank trader's book to make sure their positions are always hedged. Because I've been told on more than one occasion that there are ways for banks to covertly maneuver around the prop trading ban.

Nevertheless, the most alarming aspect of this episode is the simple fact that JPMorgan managed to pass the Federal Reserve's stress test in March despite having a ticking time bomb sitting on its balance sheet. This raises legitimate questions over whether the regulatory framework we put in place following the crisis will be effective enough to address the potential disasters that are still lurking throughout Wall Street.

Because if it can happen to Jamie Dimon, it can happen to anyone.

As the Senior Editor of Advanced Trading, Justin Grant plays a key role in steering the magazine's coverage of the latest issues affecting the buy-side trading community. Since joining Advanced Trading in 2010, Grant's news analysis has touched on everything from the latest ... View Full Bio

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