It is difficult to assess the J.P. Morgan $2-billion loss based on the information released so far.  That doesn't stop the knee-jerk anti-capitalists, though, from charging Jamie Dimon with reckless neglect or worse.

Many analysts -- notably among them Charlie Gasparino in the Huffington Post, of all places, took a more sensible approach and pointed out that risk-taking is part of any capitalist enterprise.  No doubt, as details emerge, it will be easy to second-guess everyone from the "whale" trader to Chairman Dimon himself.  Still, it is always fun to play detective and try to figure out the riddle from the available information.  Apparently the FBI is about to play cops and robbers with JPM's management.  Millions of taxpayer dollars will be wasted; the truth, whatever it is, should be quite simple.

What seems indisputable is that the whale made trades on behalf of the bank.  Most observers are suggesting that these trades were meant to "hedge" a portfolio of bonds.  The accused instruments are credit default swaps.  A parade of TV pundits, bloggers, and other geniuses assure us that these securities are complex, arcane beasts, way beyond the ken even of analysts who make their comfortable living in the media by explaining things to the rest of us dummies.  For at least 25 years now, the awesome derivatives are treated as secret weapons of mass destruction by people who are quite capable of understanding and explaining them.  It remains a mystery to me why the smarter guys like Neil Cavuto and his guests continue to hide the truth from their viewers.

Here is a short course in credit default swaps, or CDS.  They are insurance policies.  We are all familiar with insurance policies; they are hedges against something (usually) bad happening. There is life insurance hedging the threat of death, fire insurance for fire, health insurance for illness, etc.  But the best example for us is mortgage insurance.  If you've ever bought a house with a small down payment, it is likely that you were required to purchase insurance on behalf of the lender to hedge against the possibility that you might default.  Since the lender has a lien on the property, such insurance is really just an extra layer of protection, shifting the default risk to a third party, in return for a fee.

When individuals buy insurance, they usually ignore the risk that the insurer itself might default.  In the heady multi-billion-dollar environment inhabited by big banks, this possibility is ignored at their peril.  Suppose Bank X buys Greek bonds, believing that the eurozone won't let Greece default (bad bet!).  Fearing the worst, the risk management committee orders the Bank X traders to offset some or all of that risk.  The traders call banks Y, Z, and W and buy CDS from them.  These are insurance policies which trigger some kind of payoff if Greece defaults.

You may and should ask what constitutes a "default incident."  In the end, lawyers and judges (!) will decide that.  Bank X then hopes that Banks Y, Z, and W are capable of meeting their obligations.

One other difference between ordinary insurance policies and CDS is that insurance policies aren't normally traded between insurance companies.  But CDS trade in a rather opaque marketplace where only giant banks dare to tread.  Opaque though it is, the insiders know the prices at which they can buy or sell a particular CDS.  If the riskiness of the underlying bonds is perceived to go lower, the value of the CDS bought by Bank X may decline in value.  If the hedge was done properly, this paper loss should be offset by an increase in the value of the bonds themselves.  At least, that is, the theory.  Option traders will recognize that CDS are essentially just fancy put options.

Meanwhile, back at JPM, the story seems to be that the whale bought CDS to offset some risk in some (as yet) undisclosed securities.  Given the magnitude of the paper loss advertised to have occurred, the underlying security position must have been quite large.  Had that position collapsed to near zero, the loss might have been enough to threaten the health of the bank.  If so, it was actually prudent to offset some of that risk with CDS.  As far as can be inferred from known facts, the CDS never actually paid off, and (consistent with that) their market value declined.  Perhaps the whale over-hedged the position, or, more likely, he overpaid (in some sense) for the insurance provided by the CDS, and/or perhaps Bank Z was perceived to be shakier than originally thought.  We just don't know yet.

What we do seem to know is that under orders from very high up, probably the chairman's office, the whale was told to liquidate or offset some part of a very large position, even at a loss.  In this context, "offset" means selling a new CDS to still another counter-party, which creates risk of its own.  Welcome to the modern world of high finance.

Now that we all understand the use of CDS, it should be easy to see that the cause of JPM's problem was not the instruments themselves, but a miscalculation of their true worth to the firm.  In other words, the bank had to evaluate the credit risk inherent in the underlying bond position.  Well, they are only human.  The snipers are already asserting that big banks have no business trading in the bond market.  They should stick to writing mortgages, which they have proved to be really good at, or financing various businesses, large and small.  The problem is that buying bonds is the same as loaning out money.

Did that sink in?  Banks borrow money from depositors.  They lend that money to other customers at a higher rate of interest, if they can.  If they misjudge the credit-worthiness of the borrowers, of the value of some pledged collateral, they may lose money on a particular loan.  If this happens too often, or to very large loans, it may mean failure.  Too bad!  Capital requirements are designed to prevent this, but risk is still risk.

What I don't get is the rather odd Volcker rule, which seems to tell the banks which loans they should make.  You know, don't use deposits to lend money collateralized by swampland or unproven goldmines, or sovereign debt of certain nations.

If banks lose money, regulators are accused of being too lax.  If banks are too cautious, regulators are accused of being too tough.  The great conceit on the part of regulators is that they even have a clue.  JPM just lost more than two billion dollars in a bad trade.  The stock market genie punished the shareholders with a loss of five to ten times that.  Now that is a regulator who knows what's going on.