Is Still a Conflict

JP Morgan sold credit default insurance and a mutual fund managed by JP Morgan’s Asset Management Group bought the insurance.   That’s a conflict of interest.  No way around it. See, As One JPMorgan Trader Sold Risky Contracts, And One Bought Them.

Surprisingly, however, the article by Azam Ahmed implicitly condones, and even praises the transaction.   Rather than finding any criticism of this transaction, Ahmed quotes a researcher at the Brookings Institute who states,  “the lesson is that the asset management firms really do act like different different bodies”.  Apparently this is a good thing.

I disagree.

Conflicts of interest undermine the trust upon which our financial system is built.  Simply put:  one party/individual cannot represent both sides of a transaction.  Or, to put it more colloquially, no one can serve two masters.

In the context of the JP Morgan trade, the credit default swap is a contract.  This contract imposes rights and obligations on each of the parties. These are obligations “with teeth”.  Remember when Goldman and AIG were fighting over collateral which needed to be segregated to support similar derivative-type contracts?.

Suppose similar conflicts arose with respect to the JP Morgan trade.   Would the Asset Management Group, on behalf of the mutual fund and its investors, sue the bank to enforce the credit default swap?   Imagine all of the judgments which would have to be made in this context.   Are the investors in the mutual fund confident that the Asset Management Group would have represented them (the Investors) aggressively against their (the Asset Management Group’s)  employer?

To further highlight this conflict, imagine if the trade had gone the other way.  Assume that JP Morgan Bank earned a huge profit and the mutual fund lost $2 billion on its investments.  In that scenario the Bank would have earned a huge profit at the expense of its clients.  I suspect very different articles and columns would be written.

The most disturbing aspect of the Article, however, is the absolute lack of sensitivity to the conflict issue.  Reflecting the approach of an adolescent kid beseeching her parent “but everyone does it!”, Ahmed explains “That one hand of the bank was selling while another was buying is not uncommon in the dog-eat-dog-world of Wall Street”.  I guess if “everyone does it”, its OK.

The fact of the matter is, it is not OK.  The very foundation of the financial system depends on trust.  One element of this trust is that advisors (or rather agents) will act for exclusively for the benefit of investors (principals), that they will avoid conflicts of interest. While transactions can be structured to meet various legal requirements (and I’ve done tons of “structuring” in my career) and possibly fall within various exemptions or special rules, the reality is that, a conflict is a conflict is a conflict.

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