Wall Street And The Public Trust

Three weeks ago, JP Morgan announced that it lost $2 billion on a single hedging position. Then, one week later, the firm released information that suggested that the transaction might have been more of a reckless gamble than a conservative hedge.

And last week, the financial community was even more concerned about Facebook’s botched Initial Public Offering (IPO) than about JP Morgan. Bloomberg named it the worst IPO of the decade; others speculated that it might be the worst IPO ever.

Government officials are now investigating the JP Morgan and Facebook transactions. Indeed, they may discover that the public trust has been badly damaged, whether or not there were any legal transgressions.

We’re In The Money!

In the Depression era film Gold Diggers of 1933, Ginger Rogers zinged Wall Street with the sardonic anthem We’re In The Money! While that film played on screens across America, President Franklin Roosevelt busily signed laws to ensure that another Wall Street crash (like the debacle of 1929) would never occur again.

The Glass Steagall provisions of the Banking Act of 1933, for instance, banned commercial banks from engaging in many proprietary trading activities. And the Securities Act of 1933 prohibited publicly traded firms from “playing favorites” by requiring them to disclose relevant information to all parties simultaneously.

These regulations were designed to protect the interests of small investors. Thus, banks that accepted savings and checking deposits were prohibited from putting those funds at risk, and from selectively sharing insider information with wealthy investors.

Such regulations became bedrock principles that generated a level of trust in the American financial system that helped the United States maintain its pre-eminent position in global finance for decades. Last week, however, JP Morgan and Facebook did much to damage the public trust in the system.

Hedging Activities

JP Morgan’s black eye involved what CEO Jamie Dimon initially called a “terrible, egregious mistake.” He originally claimed that the recent $2 billion loss resulted from a poorly designed hedging contract that should have shielded the firm from incurring losses, but that inadvertently generated mammoth losses instead.

The Volcker Rule of the Dodd Frank Act is designed to reimpose certain Glass Steagall policies that prohibit banks from engaging in speculative profit-seeking proprietary trades. But the Volcker Rule doesn’t prohibit hedging transactions, which are defensive strategies that are designed to function as insurance policies by limiting trading losses.

Hedging positions are desirable activities, from the perspective of government regulators, because — when designed and executed properly — they minimize the risk of losses. But two weeks ago, we learned that the division that designs JP Morgan’s hedging contracts may have been striving to generate significant profits instead of (or in addition to) focusing on minimizing losses.

A hedging function that attempts to generate sizable profits? Under traditional banking guidelines, it shouldn’t be considered a hedging function at all. And yet JP Morgan decided to define it in this manner, which arguably allows it to continue to engage in proprietary trading activities.

Valuation Disclosures

Meanwhile, last week, the first day of public trading for Facebook got off to a bumpy start. The NASDAQ experienced technical problems and was forced to delay trading activities for approximately 30 minutes.

After that, Facebook’s embarrassment grew worse. The value of Facebook’s stock began the day at $38, an amount established by the firm and its IPO advisor Morgan Stanley, and ended the day at virtually the same level. But it reportedly only remained at that level because Morgan Stanley and its team of underwriters bought back the stock to prevent it from dropping below $38.

By the end of the week, Facebook’s stock was trading at $31.91, 16% below its initial $38 value. Clearly, the firms established an initial value that was too high. But did Facebook and Morgan Stanley simply make a mistake by asking investors to pay an inflated value? Or were they — in the words of former General Electric CEO Jack Welch, according to his Twitter posting on May 21st — “piggish”?

Furthermore, we recently learned that Morgan Stanley warned its major clients in advance that it had reduced its revenue estimates for Facebook. Thus, preferred clients were warned that the opening valuation might be too high, but the general public did not receive this information.

Although the Securities Act requires firms to disclose relevant information to the general public, Morgan Stanley decided to define its warning as “guidance” and not as “disclosure,” which arguably allows it to engage in selective communication activities.

An Issue of Trust

It is indeed possible that JP Morgan, Facebook, and Morgan Stanley may have complied with government regulations. If they have not broken any laws, they will certainly not be prosecuted for breaching the public trust.

Yet public trust in the American financial system may well be damaged if JP Morgan’s trading activities are permitted to be defined as hedging transactions, and if Facebook’s and Morgan Stanley’s selective disclosures are permitted to be defined as guidance. And without the public trust, the financial system cannot endure.