Friday, May 11, 2012

Why Aren't There Any Lines at JPMorgan Chase with Depositors Trying to Pull Their Money Out?

All the details are not out on the mammoth multi-billion dollar trading losses that JPMorgan Chase has experienced, but this doesn't seem to be a situation where a rogue trader was taking positions on his own.

Indeed, JPMorgan CEO Jamie Dimon said in his conference call last night that the losses were the result of a "flawed, complex and poorly reviewed," position.

It appears that what happened was that a trading model was poorly constructed.

During my speech at the Fed, I warned about such models:
Please allow me to begin with methodology, I hold the view developed by such great economic thinkers as Ludwig von Mises, Friedrich Hayek and Murray Rothbard that there are no constants in the science of economics similar to those in the physical sciences.

In the science of physics, we know that water freezes at 32 degrees. We can predict with immense accuracy exactly how far a rocket ship will travel filled with 500 gallons of fuel. There is preciseness because there are constants, which do not change and upon which equations can be constructed..

There are no such constants in the field of economics since the science of economics deals with human action, which can change at any time. If potato prices remain the same for 10 weeks, it does not mean they will be the same the following day. I defy anyone in this room to provide me with a constant in the field of economics that has the same unchanging constancy that exists in the fields of physics or chemistry.

And yet, in paper after paper here at the Federal Reserve, I see equations built as though constants do exist. It is as if one were to assume a constant relationship existed between interest rates here and in Russia and throughout the world, and create equations based on this belief and then attempt to trade based on these equations. That was tried and the result was the blow up of the fund Long Term Capital Management, a blow up that resulted in high level meetings in this very building.

It is as if traders assumed a given default rate was constant for subprime mortgage paper and traded on that belief. Only to see it blow up in their faces, as it did, again, with intense meetings being held in this very building.

Yet, the equations, assuming constants, continue to be published in papers throughout the Fed system. I scratch my head.
As more details come out, I suspect we will learn that the model used to create this trade included the assumption that some variable would not move beyond certain parameters, that is, a variable was assumed to be somewhat constant.  And viola, reality smacked that idea around a bit and blew up the portfolio.

I repeat, there are no constants in the world of human action, any portfolios designed around the idea that such constants exist are vulnerable to being blown up at any time. Just ask Jamie Dimon.

On an even more important note, one has to ask why there aren't any lines outside JPMorgan Chase, since clearly the bank allows blithering econometric modelers to run naked through the bank, with the ability to put billions of depositor/bank money at risk.

The answer is moral hazard. JPMorgan depositors know that the FDIC will back them up, even if there are even greater toxic trading bombs that could go off at the bank .

If depositors had the fear that they might not be able to get their money out, they sure as hell wouldn't keep their money with such a pyrotechnic outfit. It would be pulled pronto and put with a conservative run bank.

In the wake of the JPMorgan loss, government officials will babble on about new regulations that will be needed to be put in place to stop banks from doing such trading. But these new regulations will benefit the politically connected at the expense of conservative banks, who do traditional banking. The connected, like Jamie Dimon, will gain even further advantages and opportunities to blow up even more money. 

In other words, no new regulations need to be implemented, the government via the FDIC, just needs to stop backing up depositor money. Pull the comfort of a government guarantee and people will pay closer  attention to their money and put it at conservative banks and big swinging dicks like Jamie Dimon won't be able to find jobs in the banking sector. Diomon and the like will find a job where they can truly help the economy by, say, running a souvlaki truck in midtown Manhattan.


  1. Frankly, Bob, I wouldn't trust Dimon to order lunch at a souvlaki truck let alone work at one.

  2. To paraphrase the Aenid-"beware of Greeks running American banks", and, in engineering school we learned about the "variable constant", aka finagle factor.


  3. It's already starting:

    Henry Blodget is out with this masterpiece calling for government to step in and takeover banks when they make poor decisions, as well as reintroduce Glass Steagall.

    You know what might work better Henry? Getting rid of the onerous laws that prevent hostile takeovers of companies. Things like bonuses and risky investments have skyrocketed since the 80's when these types of laws were put in place.

  4. This shows how much volatility still prevails on hedging side. Cannot imagine the worlds renowned institutions failing. It is very clear the US Government allowed the institution of this stature to freely do whatever they feel. It is merely a poor risk assessment. Lehman Brother is another example. Today in our country State Bank of India would have gone through similar turmoil had it not due to strong Government controls. We criticize Indian Government many time but should thank for strong controls. In that sense our financial institutions are in very strong and less volatile than US financial Institutions. Slow and steady India can rise provided we control corruption.

  5. The Austrian school's philosophy abbreviated:
    I'm a human being, not a thing, you creeps.

  6. Maybe its time to separate the two banking systems again, like we had for almost 80 years of financial stability.

    1. like when we went off the gold standard in 1971, like the savings and loan crisis, like the mexican banking crisis, like long term capital markets, like the internet bubble? Yeah those were the good old days.

  7. "Flawed, complex and poorly reviewed". Now THAT is an understatement.

  8. I don't know how exactly the FDIC works when a claim is made...but knowing the FDIC is backing up my deposits does not calm any concerns I would have. If there was a problem at a bank-how long would it take for me to get my money back? Most people live paycheck to paycheck and could now afford to wait. They would miss car payments. Mortgages and other bills. I would have serious doubts as to whether the FDIC could even handle a mass influx of depositor claims. They have never had to experience this in a wide scale so how does anyone know their "systems" actually work?!

  9. As a non-Austrian economist I have learned quite a bit from the scholars in that tradition. In particular your point about not assuming constancy must be acknowledged. Bob Lucas won his Nobel for stating this formally (ironic, isn't it?) among other contributions. But of course, it was not a new insight. What could also refer to the German historical school of Economics of more than 100 years ago (Schmoller etc.)

    What surprises me then is the almost religious belief that you and many others here have about the constancy of the relation between money growth and inflation. This seems to be one equation NOT subject to your general, well-taken, point. What makes this different?

    1. You must be mixing Austrians up with Milton Friedman and the Chicago school. Austrians, including myself, make a point that money growth and price inflation are not directly correlated. See for example, Murray Rothbard's America's Great Depression.

      Further, you can search this blog for "desire to hold cash balances" as a factor influencing price inflation.

      Moving on to Schmoller, he was from the German Historical School that battled the methodological positions held by the Austrians.

      Finally, Lucas did not get his Nobel Prize for a 'formal' exposition that there are no constants in the science of human action, but for his incorrect rational expectations theory.

    2. Lucas' 1976 paper (the famous "Lucas critique") certainly did not hurt his chances of winning the Nobel prize and was based on rational expectations theory, surely. But ultimately he was making the same, or at least a very similar, point about few political constants, at least.

      I don't see where you say anything different about Schmoller than what I have said. They may have battled the Austrian school (that's clearly not my point) but certainly also where very much non-mainstream in their disdain of formal models a la Marshall or Walras, say.

      In your very own post from May 7 2012, titled "What's Ahead For the Economy", you seem to strongly imply that money growth and price inflation are directly correlated, at least the way I read it.

      You write: "If he [Bernanke] accelerates money growth again, we will head higher with strong price inflation. If he keeps it at current levels will eventually go into a slow stagflation type economy, if he really slows the money growth from here, like he did in the summer of 2008, the economy will crash." You also claim to "watch money supply growth very closely." If your forecast seems to rely basically on this one time series, isn't that a model with a constant in an equation linking money growth and price inflation?

      That looks like a pretty strong direct channel from money to both growth and price inflation, is it not?

    3. Thanks for taking me out of context. In the very May 7 post you cite, I reference the desire to hold cash balances as a factor in determining price inflation in addition to money printing:

      " The demand to hold cash balances is an important factor in determining the price level. But as the Fed continues to print, price inflation starts to heat up and pushes corporations to spend the money. That said, at any moment, all money is being held in cash balances somewhere. It's the urgency to spend that counts."

      Your other points are equally, half stories.

  10. Mr. Wenzel: When I read your statement on Long Term Capital Management and the fact that the Fed is still using equations, I kept hearing Norman Dodd say (what was told to him by Thomas Cochrane, a J.P. Morgan crony), "We shall never see sound banking in the United States again."

  11. "Flawed, complex and poorly reviewed". Now THAT is an understatement.