Wall Street's dirty political hedge

The US inquiry into JP Morgan's trading loss has given fresh evidence of a relationship between Wall Street and Washington that poses significant risk to America's financial system.

When a group of companies becomes the biggest funder of both political parties the independent administration of government regulation can become questionable.

This democratic system dilemma was obvious this week as the US inquiry into JP Morgan’s $US2 billion trading loss uncovered very strange practises by both the regulators and Morgan – practises that are likely to be duplicated all over Wall Street.

These behaviours indicate that the US investment banks are getting around the regulations designed to stop them taking risks that endanger the US financial system and therefore the global system. The whole issue is likely to become an important part of the 2012 presidential campaign.

The Democrats and Barack Obama are using the revelations as evidence that Wall Street has proved itself incapable of managing risk on its own and needs more regulation. The Republicans and Mitt Romney counter that losing trades are just as important as winning trades in a developed economy.

But if either party wants to seriously de-risk the US financial system, they need to weaken the dirty relationship between politics and the private sector that undermines any regulation they write, no matter how strong or weak.

The lid was opened on the Wall Street practises during the hearings conducted by the Senate Banking Committee. On Wednesday night (Australian time), Federal Reserve Governor Daniel Tarullo argued that the trades in question would have been flagged to regulators earlier had the hotly debated Volcker rule – which prevents banks from proprietary trading that doesn't relate to a client’s needs – been in place.

"If a firm said, ‘We are doing this as a hedge’, they would be required to explain to themselves internally as well as to the primary supervisor, what the hedging strategy was... and how they would make sure it didn't give rise to new exposures," the senior Fed official told the committee.

Tarullo went on to say that he expects the investigation to uncover an "absence of documentation” within the firm and its supervisors.

Indeed, JP Morgan chief executive Jamie Dimon has conceded the design of the hedges was "sloppy” and "stupid”. But would the Volcker rules have really brought them to the attention of federal regulators earlier?

Hours later, the Comptroller of the Currency Thomas Curry was sitting in the same spot as Tarullo expressing dismay that the regulator he leads only became aware of the losses weeks before the public, despite having 65 officials inside the investment bank’s offices.

When you combine that with the officials from Tarullo’s institution, that number rises to 110. It’s incredulous to believe that none of those officials had processes guiding them to pick up these losses.

The errant trades came out of JP Morgan’s chief investment office. As Business Spectator’s Stephen Bartholomeusz explains, the CIO is ostensibly there to hedge against JP Morgan’s risk from a global perspective, but critics claim that’s a charade – it’s actually thought to be a proprietary trading desk in disguise (Reeling from JP Morgan's exposure, May 11).

It must be some disguise. The desk manages $US400 billion.

University of Maryland business Professor Peter Morici came close to the real issue.

"More accurately, the debacle raises serious questions about incompetence and corruption among federal regulators and inside the Obama White House,” Morici wrote late last week.

Morici’s sentiment is strong and lacks proper context. But it’s closer to the point.

JP Morgan executives managed to convince federal regulators that the CIO office was simply hedging and so none of the 110 officials inside the bank had anything to do with the $US400 billion desk, which is based in London.

So the Volcker rule would have caught this, right?

As Morici explains: "It turns out the unit was also buying stakes in distressed firms, including the publisher of Ebony, which is headed by former Obama White House official and Democratic Party operative Desire Rogers. Investing in distressed firms is work for private equity and hedge funds, not FDIC-insured banks. It is analog to Grandma cashing in certificates of deposit to play slots in Las Vegas, and has nothing to do with the Volcker rule.”

These trades should have been flagged by existing regulations that the banks are subject to.

Speaking at the committee hearing, Curry, who to be fair only assumed his role in April, admitted to the lapse and said the OCC was conducting a "critical self-review”.

It’s a familiar pattern of Wall Street executives exerting pressure on certain aspects of the tangled web of private and government institutions to undermine regulations that don’t suit them at the time.

It almost happened again last year with the spectacular collapse of MF Global and the subsequent fall from grace of its chief executive Jon Corzine, former boss of Goldman Sachs.

MF Global toppled with a leverage ratio of 40:1, putting Lehman Brothers, and its 30:1 ratio at the time of collapse, to shame.

This time the sector’s self-regulator, the Financial Industry Regulatory Authority, made MF Global know that the leverage situation was excessive and told them to lower it.

Four months before the collapse, Corzine reportedly went over the heads of FINRA to the US Securities and Exchange Commission in an effort to increase the leverage further. Corzine didn’t succeed in this instance, but the fact that he thought he could undermine such a fundamental lesson from the subprime mortgage crisis really illustrates how brazen Wall Street can be.

Morici is right when he says that the US political and economic systems struggle with corruption, but it’s not the kind that names like Jack Abramoff, Leon Panetta or Rod Blagojevich evoke. It’s subtler than that.

In his book "Republic Lost", Harvard Law School Professor Lawrence Lessig explains how the potent combination of loose campaign finance regulations and intense lobbying by the private sector has resulted in a ‘corrupting’ of the political process.

It’s not that campaign money and lobbying buy votes and shape legislation by sheer force. The two together shape the entire process of campaigning, debate and legislation. When the regulation is unfavourable, the contributions to both political parties and close business associations bring access to senior government ranks to bring special exemptions.

At the committee hearing, Senator Robert Menendez, a Democrat from the state of New Jersey, claimed the OCC has a "well-deserved reputation for being too cozy with the banks it regulates”.

Indeed it does, so much so that his statement isn’t news. So why hasn’t anything been done about that relationship sooner? It’s not as if there wasn’t any political incentive given the grief that the subprime mortgage crisis still exerts on the core voters of both political parties.

The financial sector isn’t the only industry that bends Washington to its will, but it is the most significant.

Lessig cites research which shows the financial industry has contributed $US1.7 billion to campaigns since 1989 and spent $US3.4 billion on lobbying over that same period.

That’s more than the energy, healthcare, defence and telecoms industries combined – and it should be noted that the US has significant problems in the first three of those sectors.

Voters look to elected officials to hold these institutions to the regulations they’re supposedly bound by, but the cumulative effect on each representative of private money is overwhelming. The average cost of re-election for a member of the House of Congress back in 1974 was $US56,000. Today that figure is $US1.3 million.

The general rule of thumb is that the average legislator has to spend a third of their time raising money for either their own re-election or their party.

In the race for voters, both political parties have structured themselves in a way that makes policy even more vulnerable to this kind of influence – by linking fundraising to political promotions.

If you want to be head of the Financial Services Committee, you have to raise more money for the party. And where is that money most likely to come from?

Campaign finance reform has always been bubbling in the background of US politics. The Occupy Wall Street movement briefly brought it to the forefront, but too briefly.

Of course, Morici might be wrong. The Volcker rule might have raised the trades with regulators earlier. But the American political system has demonstrated a consistent inability to preserve itself from the tentacles of outside influence.

If Obama or Romney are serious about de-risking the US financial system, they need to address the problem that has re-injected risk back into the system every time legislators have tried to remove it for good.

Given the size of the donations that both parties are accepting from the financial sector, campaign finance reform proposals are likely to be tepid and we’ll have more instances of Wall Street firms slipping through regulators.

And remember, we’re only hearing about this failure in regulatory frameworks because the JP Morgan trade didn’t work out.