As I noted earlier, the $2 billion “Fail Whale” trade has morphed into a $3 billion loss – and counting. The trade is still being unwound, so we aren’t yet sure about the final losses. What we do know more today is about the massive size of the trade:

“They were caught short,” said one experienced credit trader who spoke on the condition of anonymity because the situation is still fluid. The market player, who does not stand to gain from JPMorgan’s losses and is not involved in the trade, added, “this is a very hard trade to get out of because it’s so big.”

He estimated that the initial loss of just over $2 billion was caused by a move of a quarter percentage point, or 25 basis points, on a portfolio with a notional value of $150 billion to $200 billion — in other words, the total value of the contracts traded, not JPMorgan’s exposure. In the four trading days since Mr. Dimon’s disclosure, the market has moved at least 15 to 20 basis points more against JPMorgan, he said [...]

“JPMorgan Chase has a big hedge fund inside a commercial bank,” said Mark Williams, a professor of finance at Boston University, who also served as a Federal Reserve bank examiner. “They should be taking in deposits and making loans, not taking large speculative bets.”

“Large” is an understatement.

The Obama Administration has finally decided to react to this by working on toughening the Volcker rule. Obama’s regulators put together the draft proposal on implementing the Volcker rule that weakened it in the first place, of course. Notice that it’s the White House officials talking to the Treasury on this one. We can glean from that how the Volcker rule was gutted, and why.

But this is a very placid way of reacting to this issue. The Volcker rule by its very nature may be too complex to ensure a firewall between investment and commercial banking. Indeed, even the legislative interpretation allowing position-based hedges would let through a surprising number of speculative trades. This is true even if you tighten up the language on “portfolio hedge,” which is what the Fail Whale trades were. Incidentally, the WSJ article notes that Gary Gensler, head of the Commodity Futures Trading Commission, believes that portfolio hedging should not be allowed under the rule, which represents some movement as he’s one of the major rule-writers on this.

This could be a time for thinking differently. Not just about the Volcker rule, but about a modern-day Glass-Steagall, or even a beefing up of capital requirements, which I’ve seen more than one conservative tout in recent days. There’s even this idea from the Cato Institute on using the FDIC deposit insurance guarantee to indirectly constrain bank size. I don’t agree with all of it, but at least there’s some thinking across the political spectrum on how to make banking boring and constrain the runaway financial sector that continues to lowball its risk.

Moreover, you could let loose the law enforcement folks:

This fiasco is beginning to look a lot like accounting control fraud. The Justice Department and the FBI have begun criminal probes. The SEC is also investigating. So far, the objectives of these investigations are under wraps, but if I were an SEC or DOJ enforcement official I’d be laser-focused on bringing a Sarbanes-Oxley case against Jamie Dimon.

Sarbanes-Oxley emerged out of the Enron frauds. This law requires the CEO to certify that internal controls are operating effectively to give comfort to readers of the financial statements that the disclosures contained in the reporting are reliable. There are civil penalties for filing a false certification and criminal penalties, including jail time, for false filings found to be fraudulent. So far none of the obvious candidates like Dick Fuld at Lehman or Jon Corzine at MF Global have been prosecuted under the law.

Jamie Dimon looks like a very attractive candidate to investigate for SOX violations.

Read the whole thing. Based on prior history, I have no confidence that the SEC or the FBI have any interest in Sarbanes-Oxley violations in their investigations. We’ll certainly find out in the coming weeks.