Wednesday, July 15, 2009

Throwing off the TARP

J.P. Morgan Chase & Co. recently paid back $25 billion in federal bailout money that it had received via TARP, thus ending its brief stint of indentured servitude to the federal government.

The difference is quite striking. Now free of its vow to "honor and obey," J.P. Morgan Chase has stepped up its criticism of government proposals to impose new regulations on the derivatives market that many in the financial industry see as short-sighted.

A quick primer on derivatives may be helpful. In financial markets, the word "derivative" refers to any financial contract the derives its value from an underlying cash instrument (such as stocks, bonds, currencies, or commodities). There are three basic types of derivatives: 1) Futures and Forwards, 2) Options, and 3) Swaps.

Derivatives have received a bad rap recently because of the collapse of many derivatives constructed from mortgage-backed securities when the real estate bubble burst. The fact remains that derivatives are, for the most part, a good thing. They help reduce risk in financial markets, not increase it. Financial managers of corporations use derivatives to hedge against future uncertainty, which results in smoother earnings over time.

This is the crux of J.P. Morgan Chase's complaint. The Obama administration wants to force ALL derivatives to be traded via a central exchange, similar to a stock market. This would allow regulators to easily monitor the entire derivatives marketplace. The problem with this approach is that a significant portion of derivatives are one-of-a-kind contracts specifically designed to reduce a specific risk in a specific company.

The central exchange approach would be a logistical nightmare. Even if it were technologically possible, it would put a massive damper on the custom derivatives market. The seemingly honorable intent of the Obama administration is to reduce risk in the financial markets, but by damaging the attractiveness of derivatives in this manner, the perverse result could be an increase in risk, not a decrease.

J.P. Morgan Chase holds approximately $81 trillion (yes, trillion) in derivatives contracts. Clearly, they have a dog in this fight. They also have a great deal of expertise, which is demonstrated by the fact that they have paid back their TARP money and will be posting a profit this quarter. They know what they're talking about in this particular area. Maybe we should listen to them.

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