Why JPMorgan gets away with bad bets

Editor's note: William K. Black is an associate professor of economics and law at the University of Missouri-Kansas City. A former senior financial regulator and a white-collar criminologist, he is the author of "The Best Way to Rob a Bank is to Own One."

(CNN) -- JPMorgan Chase can be considered a systemically dangerous institution, which means that it is "too big to fail" because the government fears that its collapse would cause a global financial crisis.

It is simply irrational to allow such an institution to exist, especially when it can easily incur a $2 billion trading loss.

Banks are more efficient when shrunk to the point that they can no longer endanger the world economy. But because JPMorgan and similar banks are the leading contributors to Democrats and Republicans, neither political party has the courage to order them to reform.

The Volcker Rule, which aims to prevent insured banks from engaging in speculative bets, was passed as part of the Dodd-Frank Act over the objections of Treasury Secretary Timothy Geithner and almost the entire Republican congressional delegation.

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William K. Black

Back in 2008 when the financial crisis hit us hard, a host of large institutions were destroyed. AIG, Merrill Lynch, Bear Stearns, Lehman Brothers, Fannie Mae, Freddie Mac, Washington Mutual and Wachovia all suffered massive losses on their toxic derivatives, particularly collateralized debt obligations (CDO) and credit default swaps (CDS), better known as "green slime." One would think everyone has learned a lesson. Jamie Dimon, JPMorgan's CEO, now agrees that banks should not invest in derivatives. But government subsidies have a way of encouraging fraud and speculation.

JPMorgan, the nation's largest bank, receives an explicit federal subsidy (deposit insurance) and a much larger implicit federal subsidy. It's improper for the megabank to use these subsidies to speculate in derivatives. And yet it can do so with hardly any serious regulatory consequences.

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Financial institutions such as JPMorgan love to buy derivatives because they are opaque, create fictional income that leads to real bonuses and when (not if) they suffer losses so large that they would cause the bank to fail, they will be bailed out.

The Dodd-Frank Act's Volcker Rule was designed to solve the problem.

However, JPMorgan led the effort to gut the Volcker Rule and the provision that requires transparency. JPMorgan is the world's largest proprietary purchaser of financial derivatives -- precisely what the Volcker Rule sought to end. The bank claims that it does not engage in proprietary trading and that it purchases derivatives solely to hedge. That claim is an example of what Stephen Colbert meant when he invented the term: "truthiness."

A hedge is an investment that offsets losses in another investment. JPMorgan's supposed hedges aren't hedges under accounting rules because they haven't been shown to perform as hedges.

JPMorgan bought tens of billions of dollars of derivatives that increased its losses rather than reduced them. It calls these anti-hedges "hedges" -- in other words, it practiced "hedginess." The bank's approach to hedging is that it would like to purchase a derivative if it deems that derivative to be a hedge to something else and voila, it's a hedge.

The draft regulations of the Volcker Rule allow such faux hedges because JPMorgan lobbied to render the rule useless. JPMorgan asserts that these inherently unsafe and unsound anti-hedges are "hedges" as that term is defined in the draft regulations implementing the Volcker Rule. But if hedginess is permissible, the Volcker rule is unenforceable.

It is a travesty for JPMorgan to be able to create an additional $2 billion in losses through investments that are supposed to be allowed only if they reduce losses. The government must revise the regulations and reject JPMorgan's absurd treatment of anti-hedges as hedges.

Faux hedges are a common, dangerous abuse and a lethal form of speculation. From 2003 to 2006, the Securities and Exchange Commission caught mortgage giants Fannie Mae and Freddie Mac violating hedge accounting to maximize their executives' compensation. Fannie's faux hedges, like JPMorgan's faux hedges, increased losses. The Justice Department failed to prosecute, and the senior executives walked away wealthy. Their successors blew up Fannie and cost taxpayers hundreds of billions of dollars.

When a bank CEO is honest but incompetent, faux hedges simultaneously increase risk and create a false complacency that the hedge has offset the risk. This can cause catastrophic losses.

Dishonest bank CEOs use faux hedges to loot the bank by creating fictional income and hiding real losses. The fake income makes the CEO wealthy by maximizing his compensation.

The current JPMorgan speculation in derivatives weakens but will not kill the bank. If it and other systemically dangerous institutions continue to engage in hedginess, it is only a matter of time before we'll get a replay of the financial crisis. And who'll lose out? Taxpayers like you and me, of course.

The opinions expressed in this commentary are solely those of William K. Black.