As you know by now JP Morgan Chase lost $2 billion last week by taking big bets on European bonds. Interesting to note (and telling) I found no article that explained what caused the loss. I scanned the internet and there are plenty of articles talking about whose heads would fly, articles supporting more regulation of the banks, articles about the political ramifications of the presidential race but no article that tried to explain what actually happened.  

Why not? I believe it’s because it’s too complicated for the lay person to understand. The investment that caused the loss is called a “synthetic credit portfolio.” Wow! What does that mean? I would guess that the average investment banker doesn’t fully understand the complexity of the investment vehicle either!  

Should we be concerned about this loss? Absolutely! As long as the American taxpayer has to bail out the banks when things go wrong we have every reason to be concerned. This $2 billion loss last week, although significant, is manageable. In comparison, last year JP Morgan Chase made a profit of $18 billion so a $2 billion loss is not the issue.  

The importance of last week’s loss shows us that we are just as vulnerable to a catastrophic event as we were four years ago when Lehman Brothers started the ball rolling. That’s the lesson we learned from this latest blunder by JP Morgan Chase. No legislation has been enacted, no common sense has been gained, that will prevent us from doing it all over again. How ominous is that.  

So if I were suddenly in charge how would I fix the problem? I would do the following:

1. As I stated in January in this blog I am in favor of the Dodd-Frank bill. Now I’m no expert on the bill but it has a number of common sense ideas that should be fully implemented. I know this is unpopular with many of my readers who believe in free markets but I believe that some regulation is necessary to save us from ourselves.

2. The deeper more penetrating question is, “Should banks in general be doing these types of trades?” I strongly believe the answer is a resounding “no” and agree with the Volker Rule (a section in the Dodd-Frank bill) which bans speculative trading on a bank’s own accounts.

3. I believe there needs to be a change in how investment bankers are compensated. Greed drives risky behavior. If they are on the right side of the bet they’re handsomely compensated. But what happens if they make poor choices? Do they give back some of their previous commissions and bonuses? Hardly! Instead reward employees for making sound investment decisions over time (perhaps over 2 or 3 years) and not on any one particular transaction.

4. The ultimate goal should be that banks should be allowed to fail if and when they make egregious errors in judgment. The federal government should not be in the business of bailing out the banks when things go wrong (though I do believe it was the right thing to do in 2008 to avoid a more catastrophic upheaval). This may mean that banks should be forced to downsize into several smaller financial institutions so that we can avoid the problem we had last time around when many of our bank were “too big to fail.”

Make me king for a day and I’ll solve all the world’s problems. But seriously, what occurred last week should be viewed as a wake-up call to everyone who is in charge of our financial institutions. How vulnerable are the American banks to the European debt crisis? What happens if a sovereign default does occur? Therein lies the great unknown.