It was Jamie Dimon's steady hand on the tiller of JPMorgan Chase, as he navigated the nation's largest bank through a financial crisis that destroyed several of his peers and won him near legendary status. But now that reputation is taking a hit, as he struggles to bring JPMorgan through the rough seas of a massive derivatives trading loss.

In May, the bank announced that it had incurred at least $2 billion in losses in attempts to hedge against credit risk, a sum that soon ballooned to $3 billion and could go higher still. Now many are asking how this could have happened so soon after several banks were slain by similar transactions.

The bank's trading losses are already having far-reaching ramifications—to the bank and the entire financial services industry. True, while the loss is significant, unless the process of unwinding the still open trades causes it to skyrocket it won't turn JPMorgan Chase's quarterly black ink to red.

But the adverse effects are real and widespread. Perhaps the greatest impact is to Dimon's reputation as the adept, hands-on manager of the huge institution, including its once-lauded risk-management function.  But maybe he didn't learn from the mistakes of others. Clearly the bank did a lousy job of identifying, analyzing, and managing risks that resulted in this new and outsized trading loss.

So what went wrong? To be sure, no one other than those directly involved with the trades knows exactly what occurred, and we might not know until the trades are completely unwound, if ever. But the losses speak for themselves.

What began as a proper hedging strategy appears to have somehow “morphed” into a profit-seeking activity. And for awhile, such strategies worked well for JPMorgan. In the three years ending in 2011, the chief investment office reportedly turned out $5.4 billion in gains. In the background, while JPMorgan Chase came through the financial crises better than most, it still felt the pain of its 2008 acquisition of Washington Mutual. And with the acquisition, in addition to what turned out to be a badly flawed loan portfolio, JP Morgan added riskier securities to its investment portfolio with a sense they needed to be hedged against. The chief investment office stepped up its activities, getting heavily into credit default swaps, ostensibly to insure against declines in the bond portfolio. But with economic conditions improving, the investment office went the other way with more hedges to offset the risk. Of course it's difficult if not impossible to have the perfect hedge, but in this case the hedges were way out of balance. And then hedge funds got into the act, sensing JPMorgan Chase was getting into an untenable position, and they took advantage of it.

The Far-Reaching Implications

The impact on JPMorgan Chase is significant:

JPMorgan Chase's stock price dropped 20 percent, resulting in tens of billions of dollars in market value losses.

The Federal Reserve, Justice Department, and British regulators have started investigations. The FBI is looking into the bank's accounting policies and public disclosures about the trades that prompted the trading loss, and the Securities and Exchange Commission and Commodity Futures Trading Commission have opened similar inquiries. We already hear the questions, “What did Jamie Dimon know, and when did he know it”?

At the bank's recent annual shareholders' meeting Dimon received strong support, but 40 percent voted to oust him as board chairman, with a number pointing to the trading loss as evidence of the dangers of one person being both CEO and board chair.

There have been calls for Dimon to give up his seat on the board of the Federal Reserve Bank of New York, citing his undue influence.

A major institutional shareholder called on the bank to “claw back every single dollar possible” from the compensation of all bank executives involved in the trades.

After announcing a plan to increase dividends, Dimon later said dividends will remain unchanged, but subsequently said he “hoped” the bank wouldn't need to cut its dividend. And the bank is stopping a $15 billion share repurchase program.

There's significant impact on the broader industry as well. Dimon has been a leader in the effort to get regulators to draft industry-accommodating regulations under Dodd-Frank's so-called Volcker Rule, but now this trading loss is causing the regulators to rethink just how accommodating they should be. And there have been calls to reinstate Glass-Steagall, though that effort seems unlikely to gain traction.

Where Was the Risk Management?

Many observers, including Treasury Secretary Timothy Geithner, have called the JPMorgan Chase trading fiasco a clear failure of risk management. And no doubt it is, extending to the possibility of any or all of the above mentioned events transpiring. That is, in addition to the risk of a large trading loss, the related implications to the bank and the wider industry should have been on the bank's risk radar screen.

In terms of the trading itself, we know risk management in the financial markets is complex. Hedging activities risks are manifold, including challenges in matching movements of different securities or indexes, specific terms of derivative contracts, timing of the expiration of different instruments, short-  verses long-term positions, and yield curves coming together, or not, and in different time frames. With that said, these are smart, knowledgeable people, who for the most part understand the markets and risks.  

There's no doubt the JPMorgan Chase trading fiasco is further sharpening the focus on the structure of the banking system.

What seems to have gone wrong is that JPMorgan's chief investment office was looking for profits, or what insiders call the “icing” on hedges. And when markets began to move in the “wrong” direction, the bank's London unit doubled down on its bet, thinking things would eventually reverse. It seemed to overlook or purposefully ignore the fact that some of these market positions were highly illiquid—or the unit thought the bank was so powerful that it could rule the markets, holding out long enough if others bet against it.

One widely used risk-management technique encompasses the value-at-risk model, designed to estimate, within a specified confidence level, the greatest loss in a specified time frame, based on certain assumptions. Well, the model seemed to be working well until the bank revised it in the first quarter of this year, and then too late found that it understated potential losses on the derivatives trades. With the old model reinstated, the estimated losses were almost double.

Where Were the Regulators?

About 110 examiners from the New York Fed and Office of the Controller of the Currency reportedly have been embedded in JPMorgan Chase. But for some reason, none were in the bank's chief investment office in New York or London. This despite the office having an investment portfolio in the neighborhood of $400 billion and having become a profit center gaining more than $5 billion over the last three years. Well, one reason, according to a Fed official who was an examiner at the bank, is because the JPMorgan Chase executives pushed back hard at any need for examiners to be at the unit, saying its activities were no cause for concern—and Jamie Dimon was “trusted because he had done so well through the turmoil.”

A former New York Fed examiner adds that he believes it's because Dimon “is too close to his regulators.” In that regard, a number of industry observers point to Dimon's seat on the New York Fed's board as posing a conflict, though he counters that his role is to provide economic advice, not bank supervision or rule writing. As for the OCC, well there have been many critics who have deride the regulator as too close to and lax with the banks it's supposed to be regulating.

Going Forward

From a bank's perspective, lessons to be learned are many. Lines need to drawn between true hedging and profit-seeking trades, value-at-risk models need to be properly applied, derivatives and markets and related risks need to be understood, and effective management and sound judgment needs to be brought to bear. And the potential impact of an outsized trading failure on a bank's reputation and beyond must be considered as part of risk management.

From an industry perspective, JPMorgan Chase's trading loss has prompted economists to refocus on the too-big-to-fail issue, and to consider the extent to which the large institutions benefit or harm the economy as a whole. JPMorgan's debacle is just another chapter in a long-running debate by legislators, regulators, and others on what constraints should be put on government-insured deposit-taking institutions. To be callous, present conditions can be seen as “heads the bankers win, and tails the taxpayers lose.” That's somewhat of an overstatement, as bank executives do pay a price when things go bad, as a number of former senior JPMorgan executives can attest.

And, we need strong and successful financial institutions to drive financial and credit systems for a sound and growing economy. There's no doubt the JPMorgan Chase trading fiasco is further sharpening the focus on the structure of the banking system. We can hope the rulemakers, banks, and regulators get it right, balancing risk and reward to drive effective financial performance long into the future.