Here is a point typically missed in the hours of breathless banter on bankers’ “hedging strategies”. Leverage magnifies risk: it increases profits on the way up and predictably vaporizes capital when asset prices reverse course. On the opposite end of the spectrum– a true hedge neutralizes risk. A hedge is designed to make the risk free rate-today nil–with no gains and no losses.
For several years now, Investment bankers have been trading with leverage for profit, and calling it hedging. This would be their own suicide mission if they were doing it on their own risk. But they have not. They have kept the gains, and given tax payers all the losses, because they are now improperly under the protection of Central Bankers and governments who are mandated to backstop the banking system. The solution is simple. Separate banks from risk traders. Let the “traders” live and die by their own sword. How much pain must the world endure before this simple rule is reinstated?
Neil Barofsky, former special inspector for the U.S. Treasury’s Troubled Asset Relief Program and a Bloomberg Television contributing editor, talks about JPMorgan Chase & Co.’s $2 billion trading loss. Here is the direct link.