JPMorgan: What’s a Derivative and Why Should You Care?

May 14, 2012 1:59pm

It’s worth remembering the synthetic derivatives that helped cause the 2007/2008 financial crisis and the massive loss at JPMorgan Chase are fairly new.  There was a time when the world worked just fine without them.

Ironically the derivatives in the spotlight right now were started by a group of young JP Morgan bankers gathered for a conference in Boca Raton, Fla. in 1994.  They were there in part to come up with better tools to manage their risk.  They created this market largely to benefit themselves.

Gillian Tett, a managing editor for the Financial Times described the conference in a Frontline interview.  She says, “They began to look for ways to enable financial institutions to pass risk between them.   One way to do that was to sell loans, another way was to separate out the risk of the loan going bad from the loan itself, and out of that came this drive to develop credit default swaps.”

Up until now those defending these synthetic derivatives have argued that JP Morgan bankers were smart enough to handle this product, and other less-diligent operators started the trouble.

It’s also worth remembering that the loss thus far is $2 billion but the total worth (position amassed) of the bet was $100 billion.  You only hear about these sorts of things when they go wrong.  In the past the JP Morgan trader known as the “London Whale” had his bets (hedges) pay off and he reportedly earned $100 million.

Remember all the hype about the Facebook IPO – its expected value – yup – $100 billion.  Though obviously different, this gives you a sense of the magnitude of the money in play.

Is the bank using your money to make risky trades?  Money is fungible.  The banks got a lot of cheap money not just through a direct taxpayer bailout, but continue to get money through the Federal Reserve. 

 

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