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Sunday, March 17, 2013

JPMorgan: Beyond Regulation and Corporate Governance?

JPMorgan Chase, the largest U.S. bank by assets of $2.4 billion as of 2013, was a the time the largest single participant in world credit derivatives markets. According to a report issued by a U.S. Senate committee on March 14, 2013, the bank’s Chief Investment Office (CIO), charged with managing $350 billion in excess deposits, placed a “massive bet on a complex set of synthetic credit derivatives in early 2012. Those securities lost over $6.2 billion. According to the Huffington Post, the London trading desk that executed the trades “is intended to hedge the giant bank's credit risk, not increase it.” In fact, JPMorgan employees mischaracterized the trades as hedges to regulators. Risk measures, such as the VaR model, were ignored and a revised VaR model was constructed so as to permit the risk being taken on, and even increase. Repeated breaches of credit spread risk limits were also ignored, as were the stress loss limit breaches, stop loss advisories, and concentration limits. The U.S. Senate report summarizes the improprieties.
“(I)nadequate derivative valuation practices enabled traders to hide substantial losses for months at a time; lax hedging practices obscured whether derivatives were being used to offset risk or take risk; risk limit breaches were routinely disregarded; risk evaluation models were manipulated to downplay risk; inadequate regulatory oversight was too easily dodged or stonewalled; and derivative trading and financial results were misrepresented to investors, regulators, policymakers, and the taxpaying public who, when banks lose big, may be required to finance multi-billion-dollar bailouts.”

In short, all of the warning lights were ignored even as the bankers claimed to outsiders to have a “fortress” balance sheet.

                                                                         Jamie Dimon of JP Morgan. An egregious $2 billion mistake, but don't regulate the securites.  AP

The bankers at Morgan minimized the oversight of the Office of the Comptroller of the Currency (OCC) and resisted the results of its examination. The bank failed to provide the OCC with data from the bank’s Chief Investment Office (CIO) for several months—the CEO being reportedly angered when subordinates resumed sending the data. The bank misinformed the OCC in claiming that the SPC Book would be reduced and long acquisitions were mischaracterized as reducing rather than increasing risk. In short, JPMorgan provided the OCC with limited or incorrect information and updated the regulatory agency only when losses were about to become public. The bank’s claims notwithstanding, the extent of involvement of bankwide risk managers, the SCP as fully transparent to regulators, the long-term basis of SCP decisions, the “Whale trades” as hedges, and the compatibility of SCP trades with the Volcker Rule were all misleading asseverations made to hid the true risk (and losses) from external stakeholders including regulators and stockholders.

According to the bank, its chief investment office “had significant mark-to-market losses in its synthetic credit portfolio, and this portfolio [proved] to be riskier, more volatile and less effective as an economic hedge than the firm [had] previously believed." In other words, the bankers at JP Morgan had failed to put a lid on the extent of risk taken on proprietary trades. "We made a terrible, egregious mistake," Jamie Dimon, the bank’s CEO, said in an interview. “There's almost no excuse for it." Trading in so-called credit derivatives was designed to hedge against financial risk, he added, not to make a profit for the bank.

In essence, the bankers had forgotten that they were in banking. They then used subterfuges to rationale and hide their failures. In a way, it was a rolling Ponzi scheme wherein bigger subterfuges were needed as the losses mounted. “Ultimately, this is about banks being dissatisfied with the single-digit returns on equity that are associated with their conventional lending businesses, and trying to find other ways to make money," said Daniel Alpert, founding managing partner at investment bank Westwood Capital, "with risk, once again, taking a backseat to potential reward.” It was not merely a case of an inaccurate risk model; rather, excess risk was known at least to some of the bankers, who then covered it up both within the bank and externally. It was not exactly a “free market” of “perfect information.” Rather, a huge concentration of private wealth (over $2 trillion in assets) had been able to dodge even strengthened regulatory constraints in order to trade with such risk that it was systemic in nature.

According to the Huffington Post, the extraordinary loss “provided ammunition to those calling for new regulations, particularly the part of the Dodd-Frank financial reform act known as the Volcker Rule, or a ban on proprietary trading by federally insured banks.” However, the rule itself could have been sufficient, were it not watered down due to pressure from the industry. According to the Huffington Post, there had been “a barrage of pressure from lobbyists, who . . . helped to complicate and water down the rule.”  The resulting rule was akin to Swiss cheese in that there were enough holes for Wall Street bankers to game the new limits. In a sense, regulators can be blamed for succumbing to political or related industry pressure. “If the regulators do what [the Volcker rule] says ... this activity would not be permitted,” Sen. Carl Levin (D-Mich.), one of the authors of the Volcker rule, told CNBC in 2012.  “The purpose of Dodd-Frank was essentially to bring back a cop on the beat on Wall Street,” he added. What if the cop is on the take? Had Congress even considered the possibility?  Might it be that we overstate the value of regulation?

It is ironic that Jamie Dimon was consistently speaking out against the added regulation in Dodd-Frank because email evidence would come to light showing that he had knowledge of the risky “Whale” trades. Although he had “supported giving the government the authority to dismantle a failing big bank and wipe out shareholder equity,” he had been opposed the Volcker Rule—even as he knew that a bank too big to fail was undertaking excessively risky proprietary trades. Although he admitted that the bank had “badly monitored” the credit derivatives and taken on “far too much risk,” he saw no problem with the fact that the Volcker Rule being implemented by regulators would not cover such activity. Accordingly, Rep. Barney Frank said in 2012 that he hoped that the final version of the rule would prevent the type of trading that led to the huge loss. But is this hope too naïve, given the games being played at JPMorgan to evade the regulatory limits so to trade for greater returns? It is not as if top executives were held accountable by their board. One executive, for instance, saw his compensation cut from $10 million to $5 million. Is the latter figure any sort of punishment? Clearly, corporate governance is not sufficiently strong to hold even such a management accountable. Put another way, $2.6 trillion in private wealth were beyond corporate and regulatory compliance.


Mark Gongloff, “JP Morgan Chase Admits Big Losses on ‘Egregious’ Credit Trades,” The Huffington Post, May 10, 2012. http://www.huffingtonpost.com/2012/05/10/jpmorgan-chase-london-whale_n_1507662.html

D. M. Levine, “JP Morgan Trading Loss Suggests Little Has Changed Since the Financial Crisis,” The Huffington Post, May 11, 2012. http://www.huffingtonpost.com/2012/05/11/jpmorgan-trading-loss-2-billion-financial-crisis_n_1510217.html

Huffington Post, “Jamie Dimon on Meet the Press: We Were ‘Dead Wrong’ to Dismiss Trading Concerns,” May 13, 2012. http://www.huffingtonpost.com/2012/05/13/jamie-dimon-meet-the-press_n_1512671.html

JPMorgan Chase Whale Trades: A Case History of Derivatives Risks and Abuses,” Report of the U.S. Senate Committee on Investigations, March 14, 2013.