One of the best metaphors for understanding how hedge funds and other elaborate trading strategies work is that they are "picking up nickels in front of a bulldozer." This contrasts nicely with the view within economics that there can never be $100 bills just lying on the street. There is free money, but it is both dangerous and difficult to go after. And while it is profitable to go after the nickels, when the bulldozer crushes you the losses can be spectacular. Like getting run over by a steamroller (another vehicle used for this metaphor), the losses are huge, painful, and immediate, yet they manage to continue coming.

The metaphoric bulldozer continues to crush JP Morgan's balance sheet in light of its disastrous credit derivatives trading (remember that?). The losses were originally supposed to be around $2 billion dollars. The losses have now tripled to $5.8 billion dollar, as reported last week in their quarterly losses. According to the New York Times a few weeks ago, some estimate that it will be more like $8 or $9 billion. $9 billion is a lot more than the original $2 billion. And it is a significantly more than the handful of nickles they were looking to pick up if the strategy had worked.

It's worth looking at this in light of the Volcker Rule. There's an argument that this kind of propritary trading is entirely fine and good for the economy, but it does not need to be done by institutions that have taxpayer money on the line or function as a systemically important part of the financial infrastructure of the economy. It will be both well provided and well compensated on its own through hedge funds and smaller players in the financial markets. If anything, taxpayer subsidizes could crowd out smaller players, distorting the way that the financial market works.

But there's also the question of what to do if a large, systemically risky firm fails. Here the Dodd-Frank policy regime involves prompt corrective action to begin prepping a firm that looks like it will fail for failure, much like how the FDIC currently does with commercial banks. This system works better if there is adequate time and if there are no gigantic surprises.

Contrast that with Bear Sterns and its hedge funds. Bear Sterns put up $40 million of its own money into two internal hedge funds between 2004 and 2006, and in June 2007, Bear had to bail out these two funds with a line of credit worth $3.2 billion dollars. $40 million dollars upfront got crushed under the steamroller to the tune of $3 billion. Such a large loss absorbed so quickly put significant pressures on the firm; it later collapsed.

Given this asymmetric payout, prop trading makes a certain type of failure more likely - one that is quick, out of nowhere, and large. This type of collapse strains our system for resolving large, systematically risky financial firms. This system is what we need in order for financial firms to collapse in a fair way, one that allocates losses to those who gained the most while also preventing huge spillovers to third parties. The Volcker Rule is an essential part of this.