Chart created using Omega TradeStation 2000i. Chart data supplied by Dial Data.

It is nigh on impossible to overlook JP Morgan Chase (JPM-NYSE) as the stock to feature in SOTW. JPM and its high-profile chairman and CEO, Jamie Dimon, have been all over the news the past week because of its $2 billion loss on a hedge. When that admission was made JPM's stock plunged some 10% and is now down some 26% from its highs of only six weeks ago.

According to the company the loss was caused by a miscalculation on a hedge strategy involving synthetic credit products. These are derivatives tied to credit performance. They are called Credit Default Swaps (CDS) and are designed to protect the owner of a credit instrument, usually a bond, from a loss in the event of a credit default. A hedge therefore implies that one is the owner of the bond or credit and the CDS is purchased as protection. Think of the CDS as the purchase of a put option when one owns the underlying asset.

So if one owns the underlying instrument, how does one lose $2 billion on the hedge? That question has not been answered. The rumour mill has it that far from owning the CDSs, JPM was short the CDSs, having sold the derivatives.

According to reports, the position that caused the loss was a spread trade, being long an index of investment grade corporate bonds and short on high-yield securities using CDSs. The understanding is that the trade went awry when the basis or spread between investment grade bonds and government securities went offside, the bet not being offset by similar moves in the insurance on the high-yield bonds. Spread trades between different though similar instruments in an illiquid market can be dangerous.

As well it is being widely reported that JPM holds a portfolio of some $100 billion or more of asset backed securities. Recall that it was asset backed securties that were at the heart of the 2008 financial crash.

Selling CDSs is not new. If institutions are buying them to protect against a possible credit default then someone has to write them. This is what American International Group (AIG-NYSE) did prior to the 2008 financial crisis, only AIG did not hedge its positions and when the financial crash got underway AIG was met with calls on its CDSs that exceeded its capital. AIG was bankrupt and might have brought down the entire financial system if the US government hadn't intervened and bailed out AIG (and many others) by providing liquidity through loans and outright capital purchases, using taxpayer funds.

Some believe that the $2 billion loss admitted by JPM may only be the start. There have been indications that the loss may be higher. Overall a $2 billion loss on capital of about $132 billion doesn't seem like much. But in the world of derivatives, losses can multiply very fast, as AIG learned, and capital is wiped out. JPM says it was hedging and not trading and was within the so-called "Volcker rule" (see below).

On April 13, Mr. Dimon called concerns over the bank's trading risk "a complete tempest in a teapot". On May 10 he announced the $2 billion loss. JPM is now being sued by shareholders in a securities fraud lawsuit. This is not the first time that JPM has been involved in securities fraud lawsuits. In March 2003 JPM paid $2 billion in fines and settlements to investors and the SEC for their role in the Enron collapse of 2001. In March 2005 JPM paid another $2 billion for its involvement in the underwriting of WorldCom bonds. More: November 2009 a settlement of $733 million with the SEC over JPM's involvement in Jefferson County, Alabama that almost bankrupted the county; and, finally in January 2011 the bank was forced to apologize for overcharging active duty military families on their mortgages and foreclosing on a number of families.

All this has led to calls for more regulation. Following the 2008 financial crash there have been numerous calls for more regulation of banks. The problem is that the banks are so big, and so involved in operations well beyond just taking deposits and making loans, that if they fail they appear to assume that governments will just step in and bail them out. That is what happened in 2008.

Governments now want more regulation and the banks are fighting to prevent it. Jamie Dimon has been one of the most vociferous. And it is political as well, especially in an election year. President Obama and the Democrats want more regulation, while the Republicans and its possible Presidential nominee are on record as supporting the banks in opposing it.

Banks acting like hedge funds came about following the repeal of the Glass Steagall Act that had existed since the Great Depression. Following Glass Steagall, banks made loans and took deposits and managed their positions but continued to have large foreign exchange operations and were involved in the interest rate swaps market that was very similar to their loan books. Investment dealers did investment banking and took on positions within the context of their capital.

Glass Steagall was enacted during the Great Depression, following the collapse of numerous banks and investment dealers, and was repealed in 1999 under President Bill Clinton. Since then banks have been acting more like investment dealers, using their balance sheets to leverage their positions in a manner quite similar to hedge funds. The banks are major global players in the securities and derivatives markets.

Trouble is, depositors in banks are covered by insurance through the Federal Deposit Insurance Corp. (FDIC). The banks are in effect leveraging depositors' funds, and if the trade goes wrong the taxpayer is there to bail them out. The world's largest investment dealer, Goldman Sachs (GS-NYSE), became a bank following the 2008 financial crash just so they too could be protected under FDIC.

The FDIC has itself gone to the brink of bankruptcy because of the huge payouts that were required following the financial crash of 2008. Over 700 US banks went under, although none of them were the large money center banks such as JP Morgan.

The Volcker Rule is a section of the Dodd Frank Wall Street Reform & Consumer Protection Act (think of it as Son of Glass Steagall) that proposes to restrict US banks from making certain kinds of speculative investments that do not benefit their customers. That could return banks to their traditional business of loans and deposits and managing (hedging) their loan mismatches in a more traditional manner, as they did prior to the repeal of Glass Steagall. Banks of course are resisting that.

The situation is not much different here in Canada, where the "walls" came down back in the 1980s. Today the Canadian banks run huge trading operations that meld investment banking and investment dealer operations with traditional banking. Tougher rules and oversight from the Office of the Superintendent of Financial Institutions (OSFI) does prevent some of the excesses that occur in the US banking system.

Global banks, especially the large US money center banks, are major players in the global derivatives market. The Bank for International Settlements (BIS) estimates the size of this market at $708 trillion. Some believe it is actually over one quadrillion dollars. To put that in perspective, the world's GDP is estimated at only $70 trillion and US government debt is $15 trillion. The global derivatives market is 10 times the size of world GDP.

The top five US trading institutions in the derivatives market are JP Morgan Chase, Citigroup (C-NYSE), Bank of America (BAC-NYSE), Goldman Sachs and Morgan Stanley (MS-NYSE). Together they account for 96% of all derivatives outstanding in the US market, estimated at $231 trillion by the US Comptroller of the Currency. The largest is JPM, with over $70 trillion of derivatives. It has assets of $1.8 trillion.

Derivatives are notional amounts so in that respect they are not comparable to assets. But they do have considerable risk. There are four main types: futures and forwards, swaps, options, and credit derivatives. The latter category includes the aforementioned CDSs. Of the total US banking position, interest rate swaps is the largest, making up some 63% of all derivative contracts. There are netting agreements between the major players in the industry such that some 92% of contracts are covered by the netting benefit.

Derivatives trading and other trading operations make up a considerable percentage of the banks' revenues. That is why trading operations are so lucrative and why the players in the industry get paid huge bonuses as a result. Goldman Sachs is the biggest trader on the street and there have been years where the trading operations made up over 70% of its revenue. In a bad year trading revenue can result in losses, as Hong Kong Shanghai Bank USA (HSBC) found out last year in the third quarter.

Derivatives do pose potential huge risks to the banks' capital. According to the US Comptroller of the Currency the total percentage credit exposure to capital of JPM as of December 31, 2011 was 256%. Total credit exposure for all contracts was $348 billion although half of that is covered by netting agreements. The odds of all of them collapsing at once are supposedly low, but if everything went wrong at once JPM's capital would be wiped out twice over. Goldman Sachs' total percentage credit exposure is even larger, at 794%.

So far the loss is not large but it could become larger. There are many who would like to see the banks go back to their roles of making loans and taking deposits and then managing the risk in a more traditional manner, rather than acting like huge hedge funds and then assuming the government is always there to bail them out when they lose.

JPM's chart is not pretty. The high was back in 2007 and JPM stock lost 72% from the highs of 2007 to the lows of 2009. Today JPM remains 36% under the 2007 highs. The rather large bearish looking symmetrical triangle appears to suggest that if it is broken to the downside JPM could go bankrupt. Warren Buffett has called derivatives "financial weapons of mass destruction". Derivatives were behind the financial crash of 2008. They may well be behind the next crash as well.