Chase Loss Shows Hidden Risk In Banks

The very low interest rates are forcing banks and insurance companies to gamble with their investments to make up for the lower returns they get from traditional investments. These companies are allowed to use hypothetical loss estimates which can be changed. They are allowed to “mark to book value” (the purchase price) or they can recognize a gain when they sell. So these companies are skating on thin ice by taking increasing greater risks to earn money through short term trading like the fiasco at Chase where Chase lost $2 Billion to $3 Billion in bonds CDS contracts.

The risk to society is that one day a bank may be forced to admit that it legally hid its losses by using “mark to model” accounting and lowballing the estimate of future losses for its loan portfolio. A bank could get around the Volcker rule by loaning money in a profit sharing agreement to a tiny speculative hedge fund and essentially the hedge fund would pretend to take all the risk and the bank would pretend it was just a loan which had a profit sharing contract with the borrower. However, if the hedge fund lost money and thus the loan became worth very little the bank could pretend the loan to the hedge fund was still worth face value. Eventually the truth will come out that the Fed’s easing has merely warped and camouflaged financial problems and made them worse.

An interesting quirk with Chase’s loss is that this may make their bonds go down in value, so the bonds can be bought back by the bank at discount, thus creating a profit. So bad news is good news. Maybe the employees who lost money should be given a bonus for enabling the bank to profit from a drop in the value of its bonds.

Unfortunately for Chase their London subsidiary that lost $2Billion in derivatives may not be able to make the tax deduction for the loss flow through to the parent corporation as offshore subsidiaries don’t pass through either losses or gains until they mail out a dividend check.

About the author

Don Martin, CFP®

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