Ask Mr. Econ… How do banks lose billions of dollars?

Dear Mr. Econ,

JP Morgan Chase recently announced that the bank lost approximately $2 billion. That sounds like a lot of money to me. More recently, JPMorgan Chase announced that the loss might really be closer to $6 or $8 billion. Shortly after, another major bank, Bank of America, announced that it had lost close to $5 billion from trading derivatives. Given the case of JP Morgan Chase, I assume I can expect this number to grow by a factor of 2 or 3, meaning the real amount will be close to $10 or $15 Billion.

With banks losing all this money, should I be worried? And whose money is it these banks are losing? And where did all this the money go? It doesn’t seem reasonable to me that $10 to $25 billion just disappears.



Dear Confused,

This is another great question.

The banks want us to believe that the losses were caused by “rogue traders” who misled their supervisors by not following internal bank rules. The banks want us to also believe they have gotten tough with these delinquents. Even a couple of higher-ups have either agreed to resign or have been fired.

The banks have assured us that they have strengthened their internal controls so that this could never happen again.

And finally, the banks are telling us that these losses are all a natural part of the capitalist system. Some days the banks make a lot of money, and some days they lose a lot of money. To the banks’ way of thinking, this is just normal. More importantly, the banks want you and I to believe that the money they lost was “their money,” and that they have plenty more.

Funny, I think we’ve heard this story before. In fact, as recently as the end of 2008, both the outgoing Bush Administration and the incoming Obama Administration believed that the banking situation was so bad that the banks had to be bailed out or the entire financial and economic system of the world might collapse. In an independent analysis by Bloomberg Financial News Service, it was estimated that what was originally legislated to be a $700 billion bailout ended up costing close to $7.77 trillion – 10 times more than you and I were told. We were assured that if the banks received this bailout, using our tax dollars, the banks would institute very strict controls so that this would never happen again. Now, less than four years later, we’re staring at the same situation.

Major banks, the U.S. Treasury and the Federal Reserve Bank/System have not opened their reports and balance sheets to Mr. Econ. While I’m not convinced that the situation is as bad as we were told in 2008, it is in my opinion a bad situation, and my sense is that you and I will be paying for the banks’ mistakes again. Here’s why.

First, $25 billion is a lot of money. Not enough to cause the entire financial and economic system to collapse, but large enough to cause real problems and real pain for ordinary folks. Second, Wall Street operates on a “herd” mentality. If one bank is doing something, then other banks believe they better get in on whatever it is or they will be left behind. In other words, I highly doubt that the losses are limited to only two banks. More likely, many banks were involved in placing bets on the upward or downward movement of a market basket of stocks, other securities products like derivatives, and foreign currencies. The total amount of bank losses in some cases has been estimated at more than $40 billion. We’ll have to wait for final tax and Security and Exchange Commission reports to see what the final number actually is.

This explains where the money “disappeared” to. The types of trades that caused the banks to lose the money are more like bets. The banks are betting that a stock, an index, a mortgage pool, foreign currencies or other things will either go up or down. Whatever side of the bet JP Morgan Chase took, someone else had to take the other side. This could be another bank, a hedge fund, foreign investors, an insurance company, or very wealthy people. As the banks lost money, these other bettors made it.

Third, we were previously assured in 2008 that banks would prepare and prevent this from ever happening again. But four years later, it is happening again. The banks say these losses are just a normal part of the banking business, so this could be on-going.

Finally, we must look at whose money was lost. And this is where the bad news comes. The banks that lost the money have told us that they were gambling with their own money. But where do banks get “their” money?

If you have been reading this column for the past couple of months, you might remember that we discussed how commercial banks traditionally took in deposits for checking and savings accounts, and made loans to individuals and small businesses. Investment banks used the capital of rich partners or wealthy individuals to gamble that their money could be invested in large businesses in order to make more money through loans and investments in things like steel mills, auto companies, and other large industrial firms. In the 1970s, the line between these two types of banks was blurred when regulators failed to enforce provisions of the Glass Steagall Act. Hence, commercial banks were underwriting investments in large corporations, and investment banks were allowing the general public to deposit money in their banks using products that looked a lot like checking and savings accounts. Then finally in 1999, at the urging of President Bill Clinton, Congress abolished the Glass Steagall Act.

What this means is that a bank like JP Morgan Chase conducts business as both an investment bank (the original purpose of the JP Morgan part of the bank) and also like a traditional commercial bank (the original purchase of Chase) with whatever money they have on hand.

The danger is that a lot of this money the bank is playing with is depositor money, money that people like you or me or small businesses put into checking and savings accounts. Therefore, if enough people went to the bank to demand the money they had on deposit, it is possible that the bank would not have sufficient cash on hand to cover the demands of the depositors. They can’t “call” loans from mortgages or small banks, so the banks turn to you and me, the tax payers, through something called the Federal Deposit Insurance Corporation (FDIC).

The FDIC was set up so that if banks made prudent investments in things like home mortgages or small business loans, and an economic catastrophe like a recession/depression or natural disaster struck, and those loans could not be repaid, the FDIC would step in and insure depositor accounts up to either $250,000 or $500,000. Hence, you and I would not lose our life savings.

FDIC insurance is paid for by premiums banks pay, and pass on to the depositors in the form of fees. So if banks today need to go to the FDIC, the fees we pay will go up. Also, because of the historic number of bank failures, the FDIC is basically broke so Congress will be asked to bail out the FDIC much like it bailed out the banks in 2008.

In other words, JP Morgan Chase and other banks have been allowed to use the money you and I deposit to make bets and gamble on very speculative financial products. And when it turns out they put money on the wrong side of the bet, you and I, the taxpayers, through the FDIC and congressional bailouts, will be paying to cover their gambling habit.

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