J.P. Morgan Chase (JPMC) just recently announced that they lost $2 Billion in a hedge fund that was specifically designed to hedge against losing money. Let me get this straight, a banking company, which manages billions of dollars in assets, just lost $2 Billion because it could not manage its money, and turn a profit on “safe” investments. What does this mean for the rest of us when professional investors cannot turn a profit? Does this spell doom for the banking system as we know it as many analysts are making this story out to be?
Why is this a big deal?
First off I want to blame the media which is calling for the heads of the CEO, and everyone at JPMC because this really is not some national crisis that it is being made out to seem. Banks and companies can have bad quarters, and when you control over $2 trillion in assets, and less than a quarter of that are in hedge funds ($525 billion), and a one-time loss of less than 1% for an investment is not that bad. Because the number is $2 billion, and people hate banks thanks to things like “Occupy Wall Street”, etc. it is considered huge news to try to make people think these people are incompetent.
The core investment philosophy at JPMC is to make money for the shareholders of the company. This means that when the company makes a misstep, people will look harder at their company, and scrutinize everything for years to come. This is what happened here, JPMC has $350 billion in hedge funds. Let me say that again, JPMC has $350 billion dollars in money invested in hedge funds trying to make more profit for the company through traditional means. They lost $2 Billion (0.5%) in a quarter instead of making a profit. Will they recover from this misstep? Yes. Did anything permanent happen to the company? Nope. Will they be profitable this quarter? Probably. So what is the big deal?
A bank tries to make a profit by lending money, and earning interest on that money. It is as simple as that. While some things like bad debt (people not repaying their loans) and other items can cause a loss of profits, they hedge their bets in other markets to try to minimize their losses, or even make more. I don’t know about you but hedge funds scare the heck out of me. I am an investor with several funds in my portfolio, and through co-mingling of funds, I probably have money invested with JPMC. Why is a bank not doing “bank like” things and putting a significant portion of its assets into traditional banking (loans, etc.)?
Why do banks use hedge funds?
The recent legislation passed by our leaders in congress has made it hard for bankers to lend money. They cannot lend more than certain percentages of their overall assets, they cannot take on more risk, they can only lend to certain people, etc. All of this is done to make sure we don’t have another financial meltdown. Well what is a bank to do? They cannot lend to people, companies, so where are they to turn with billions of dollars in cash assets to earn them a profit and return to the shareholders. Derivatives and hedge funds. Thanks Congress for limiting banking and not letting them do what they were meant to do, lend money.
Finally, the main thing that banks fear is risk. Bank’s use hedge funds to “hedge” their bets so that if the economy tanks, they are protected, if the economy booms, they are part of it. They own lots of different hedges. It is like being an investor and having you assets allocated in many different types of stocks/funds so that you are not over exposed in certain areas if that market tanks. Banks fear risk, so they do whatever they can to limit the risk, and maximize profits.
What can be done about this?
Okay, so a bank made a bad investment in a hedge fund, and lost some money, and will probably still turn a profit this quarter. Yes it won’t be as much profit as they are used to, but still it is a profit. The main issue that banks, and pretty much every public company runs into is that they have to meet the numbers. The numbers are given to them by analysts and the board of directors. If they don’t meet those magic numbers, then the company is “crap” and they take a 10% or more hit in their stock price. So why is this an issue?
Because banks want to make money, but they limit their risk, and must earn ever higher yields (profits) for the assets they control, they must limit the risk and get “guaranteed” returns. This means that banks are not doing what banks do, lending money as that is risky. If banks would look at their overall portfolio and invest money with “safer” investments (for example, infrastructure projects, with government backing), they will have lower yields on those investments, and probably make less money, however it would be more guaranteed money and less risk. That does not sit well with shareholders who want the biggest bang for the buck each quarter.
What do you think about the $2 billion loss?