Market speculation is that the losses stem from a London based trading unit that supposedly was selling protection on a portfolio of corporate credits.  The seller of credit protection is taking on credit risk, which is a natural position for a commercial bank. So, maybe the bank believed it was underexposed to corporate credit and assigned the London unit the task of increasing the bank’s exposure to the desired level. 

Like other banks, JPM produces each day an estimate of the maximum loss that it would expect to incur on trading positions 95% of the time.  This number is called the 95% value at risk (VAR).  It is also the minimum loss that one would expect 5% of the time.  That is, we should expect a daily loss greater than the VAR five percent of the days.  One weakness of the VAR is that it does not tell you anything about how large the loss is likely to be on the one in one hundred days that the VAR is exceeded.  JPM’s VAR during the first quarter was reported to be in the neighborhood of $60-70 million.  Thus, the actual loss has turned out to be more than 30 times the VAR.  While this loss did not transpire all within one day, the huge size of the loss relative to the VAR supports the argument that capital requirements set at a modest multiple of daily VAR is too low, probably much too low (I made the same argument back in October – http://www.clucerf.org/blog/2011/10/24/value-at-risk-and-extreme-scenarios/).

On Friday, the JPM stock price fell ten percent, shaving $15 billion off the value of the company.  This is seven times the reported loss.  On the face of it, it appears that the equity market reaction is overblown.  Or maybe stock market investors have downgraded their formerly high assessment of JPM risk controls. 

In a former life I was responsible for the interest rate hedging operation at a fortune 100 financial services company.  I used to say, only partly in jest, that my personal performance metric was to never show up on the front page of the Wall Street Journal in an article on hedge debacles.  There have been many such debacles over the past two decades.  Each time there is some lesson to be learned, for example separating trading and controls (Barings), recognizing that loss distributions tend to have fat tails (LTCM), the need to alter compensation schemes for senior executives and traders (Bear Stearns and Lehman Brothers).  The good news is that with all these lessons, management teams are no doubt getting smarter and more cognizant of the various things that can go wrong.  Even so, boards and management teams are probably still not smart enough to avoid future debacles.  The overriding lesson is that we should insist on more transparency and greater capital cushions for the giant banks.  If this makes them less competitive, and thereby encourages reductions in size, so be it.

Who is right?  Well, in a sense, they both are.  The President is surely correct that there has been net growth in jobs over each of the past 26 months.  But Governor Romney is also correct in noting that in a typical economic recovery job gains have historically been much stronger than the tepid 150,000 pace of the past year or two.  We are now almost three years past the end of the recession, and the number of jobs is still four million below the pre-recession level.  The current recovery has been subpar, at best.

The unemployment rate in April ticked down from 8.2 percent to 8.1 percent.  To the Democrats, this represents improvement.  To the Republicans, this level of unemployment is way too high and even then is under-estimated due to the effects of people leaving the labor force (when people who are unemployed quit looking for jobs and leave the labor force, the reported unemployment rate declines).  Democrats acknowledge that there have been many people leaving the labor force, but they attribute this largely to normal retirement for baby boomers.  The oldest boomers (baby boomers are those born between 1947 and 1964) reached the age of 60 five years ago and 65 this year.  Thus, it is reasonable to expect that the numbers of retirements should have been increasing in recent years, and will remain elevated for the next ten to twenty years.

Republicans argue that boomer retirements can’t be the whole story.  Today, the labor force is smaller than it was before the recession began.  Given normal population growth of approximately 1% per year, we might expect that, absent an increase in discouraged workers, the labor would have grown by six million over this period.  But this argument does not really address the boomer retirements.   The average birth rate between 1947 and 1964 was 4.1 million per year.  These are the folks who are now leaving the work force.  Sure, many boomers will attempt to prolong their working lives due to low savings and recent lackluster returns on investment.  This may slow but will not prevent work force departures.  A high rate of exit will persist for the next fifteen years.  Meanwhile, the average birthrate for the years 1992 to 2009 (roughly, the birth years for native born new entrants to the labor force to replace the departing boomers) was just 4.0 million.  Thus, absent positive net immigration, the labor force will be shrinking over the next decade or two!

What about immigration?  This has been a substantial net positive over the past few decades but has slowed to a trickle in recent years.  The bottom line is that the arguments of both parties have a ring of truth:  some of the weakness in labor force growth has been due to discouraged workers leaving the labor force, and the effect of boomer retirements is substantial and will become greater in coming years.  This demographic argument supports the case for improving the process for legal immigration.  Many talented, well-trained and entrepreneurial people want to enter the U.S. but are constrained from doing so.  Does either party have a solution for this?