Just when you thought America’s megabanks were safe and sound, JPMorgan Chase disclosed that it had lost at least $2 billion in just six weeks. The loss was suffered on high-risk investments in a portfolio of complex financial instruments known as derivatives. Ironically , it was incurred by a trading group within the bank that was supposed to manage the risks the bank takes with its own money.

So goes life in the fast lane. We have been led to believe that speculating in credit derivatives was a thing of the past. Not to worry; it’s all under control.

This shocking loss at one of the better-managed financial institutions has revived the debate about whether megabanks can be trusted to handle risk in the era of “too big to fail.” It shows that megabanks like JPMorgan Chase with so many moving parts, too much leverage and too much risk taking may have become too big to be effectively managed. Put differently, megabanks may be too big to succeed.

The loss also shows the market for the complex financial instruments known as derivatives remains opaque. So much for the financial industry’s argument about the dangers of too much regulation.

This loss is a major embarrassment to a firm that came through the 2008 financial crisis in much better financial shape than its peers by steering clear of risky investments that hurt many other megabanks.

While the loss did not cause anything close to the panic that followed the September 2008 failure of Lehman Brothers, it did shake the financial industry’s confidence. Stock in the bank, which is the  nation’s largest, lost 8 percent of its value in minutes. Fitch Rating Agency downgraded the bank’s credit rating by one notch. Standard & Poor’s revised its outlook on the firm to “negative,” suggesting a credit rating downgrade could follow. Other American financial institutions have also suffered losses.

You all remember the fall of 2008, when the roof fell in because too many financial institutions discovered that their investment portfolios were stuffed full of monopoly money derivative securities that were impossible to value for balance-sheet purposes. The derivative boom spread to the nation’s housing markets, where the subsequent meltdown brought Wall Street’s troubles to Main Street – with a vengeance.

These derivative securities were designed by the bright young Ph.D.’s in math or physics who found that it was a lot harder to earn a decent living in academia than earning a fabulous living on Wall Street. Their technical backgrounds let them quickly master the intricacies of quantitative finance theory and engineer all kinds of wild new derivative securities that were too complicated for most people to understand but very profitable for their employers.

So are derivatives tools of the devil? Or as Warren Buffett says, “weapons of mass destruction”? Not inherently.

Rather, they are extremely useful tools for transferring risk between willing buyers and sellers at mutually agreeable prices. And since the world is full of people with very different risk tolerances, derivatives can serve a highly valuable economic purpose.

The catch is that buyers and sellers of derivatives must be more than merely willing. They must also understand what the risk is really all about and how transferring risk doesn’t make it go away, no matter how many times it’s transferred, or to whom.

It is astonishing how few so-called financial executives and regulators understand what risk is really all about. They get carried away by the excitement of trading, let themselves believe they are participating in a no-lose game of boosting profits with no downside.

Until they wake up one morning to find themselves drowning in huge losses, while the rest us are left holding the bag amid a shattered economy. Let’s hope that isn’t what happens again this time.

We need to implement the Volcker Rule immediately to eliminate proprietary trading at commercial banks, and federally backed banks should be forbidden to engage risky trading practices. Of course, it may not be a bad idea to consider making the financial system less dependent on regulators and make banks small enough to fail.

originally published: May 15, 2012