A Failed Whale, and How to Fix It
Jamie Dimon, chairman and CEO of JP Morgan Chase & Co. (AP Photo/Mark Lennihan)
In the spring of 2012, JP Morgan Chase CEO Jamie Dimon appeared before the Senate Banking Committee, where nearly all the senators present approached him as a supplicant would approach an altar. Last week, after a damning report from the Senate’s Permanent Subcommittee on Investigations and a hearing led tirelessly by Senator Carl Levin, it became clear what a false, deceptive and manipulative set of gods Washington has been worshipping.
Even in the wake of the financial crisis, the bailouts and ongoing bank malfeasance, Washington has remained deferential to the financial industry. Regulators parrot the industry’s talking points and use them as an excuse to water down important parts of the Dodd-Frank Wall Street Reform and Consumer Protection Act. And congressional representatives on both sides of the aisle continue to introduce bills to slowly gut Dodd-Frank.
What has JPMorgan Chase been doing while Washington is so dutifully doing its bidding? In the words of the stunningly comprehensive subcommittee report, JPMorgan Chase “manipulated models; dodged OCC oversight; and misinformed investors, regulators, and the public about the nature of its risky derivatives trading.” Lest you think this is all, rest assured that there is more: JPMorgan was also hiding losses and ignoring its own internal warnings that risk was increasing dramatically.
The deceptions and dodges detailed in the report occurred primarily in a group called the Chief Investment Office (CIO). The CIO, according to JPMorgan, is tasked with investing what are called “excess deposits.” This is customer money that has not been loaned out elsewhere. Typically, banks will invest excess deposits in very safe products that are easy to trade in and out of in the event that customers take their money out. JPMorgan had $350 billion in excess deposits managed by the CIO group by the end of 2012—an amount that, the subcommittee report points out, “would make the CIO alone the seventh-largest bank in the country.”
Rather than invest this massive amount of customer money in something benign like treasuries (debt issued by the government), the CIO group created a new portfolio (think of a portfolio as a collection of trades) called the Synthetic Credit Portfolio. And it began to gamble in complicated, rare and infrequently traded (a k a “illiquid”) derivatives. By the first quarter of 2012, this portfolio had amassed $157 billion worth of trading positions (a position is a trade you still own, and have not yet closed out). And the positions the group had accumulated were so large for the markets that it trades in that people began to speculate about who this “London Whale” trader could be.
On April 6, 2012, Bloomberg News and The Wall Street Journal revealed that it was JPMorgan’s CIO office that placed these massive bets. Jamie Dimon initially downplayed the news, calling the story “a tempest in a teapot.” But the losses escalated from $2 billion in May, to $4.4 billion in June, and by the end of 2012, the London Whale trades had cost JPMorgan at least $6.2 billion.
In its attempt to do damage control in the wake of the April 6 news and the media blitz that followed, the subcommittee report points out that the bank made “multiple statements that the purpose of the CIO’s Synthetic Credit Portfolio was to hedge the bank’s risks.” In an article for The Nation last year, I explained the concept of hedging, and pointed out that this trade was not a hedge, or an attempt to reduce the bank’s risk. In the hearing on Friday, former CFO Doug Braunstein admitted as much to Senator Levin, “In hindsight the positions and the portfolio did not act as a hedge.” This mischaracterization of the Whale trades as “hedges” is just one in a long list of misleading statements JPMorgan made that are detailed in the subcommittee report. The subcommittee is right to point out, as it does in detail beginning on page 262, that these misstatements likely violate securities laws.
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If we take a step back, one important question is, why was JPMorgan allowed to gamble in risky products with customer money in the first place? This is precisely the kind of activity a crucial piece of Dodd-Frank, called the Volcker Rule, aims to prevent. It prohibits deposit-taking, loan-making banks that enjoy FDIC insurance and the cushion of customer deposits from gambling (or, in technical terms, placing “proprietary trades”).
But the Volcker Rule has yet to have been finalized and concerns remain as to whether or not a London Whale–sized loophole will be present in the final version. During his testimony before the Senate last year, Jamie Dimon actually took the time to lobby Senator Mike Crapo on a Volcker Rule exemption called “portfolio hedging.” Dimon implied that what they did with the Whale trades was portfolio hedging, and it should be allowed in the final Volcker Rule.
The subcommittee report makes it clear that the Synthetic Credit Portfolio (SCP) was not a hedging operation; it was a proprietary trading desk. The subcommittee found that “despite more than five years of operation, the CIO never detailed the purpose or workings of the SCP in any formal document nor issued any specific policy or mandate setting out its parameters or hedging strategies.” The traders who were hired into the group worked as proprietary traders before. Worse still, the Synthetic Credit Portfolio was a shadowy entity, one “generally not named in internal bank presentations.”
What this means is that Dimon’s lobbying act last year before the Senate was an act of brazenness only appropriate for his self-aggrandizing personality. The company he leads created a massive proprietary trading desk, attempts to hide the sins of that desk when it is exposed and then has the audacity to go before the Senate, misconstrue the nature of the trades this group makes and ask for an exemption to a future rule based on a lie the company is telling.
As I pointed out last May, in JPMorgan’s Comment letter about the Volcker Rule, it complained, “The proposed rule appears to presume that banking entities will camouflage prohibited proprietary trading to evade the rule, and that extraordinary efforts are necessary to prevent this behavior.” It seems this complaint was well-thought out, as camouflaging proprietary trading in a unit meant to invest customer money is precisely what JPMorgan Chase was doing in the CIO office.
While Dimon was misrepresenting the actions of the bank before the Senate, a team of his mathematicians was working behind the scenes to game the bank’s regulators. Perhaps the most egregious part of the subcommittee report comes in a section that includes the quote, by a quantitative analyst named Patrick Hagan, “Um, you know that email that I should not have sent?”
First, a brief explainer. Under a set of international banking requirements known as Basel, banks have certain regulations on capital. As explained in Anat Admati and Martin Hellwig’s important new book, The Banker’s New Clothes, capital regulations require that “a sufficient fraction of a bank’s investments or assets [must] be funded with unborrowed money.” How much capital a bank is required to have is in part determined by its overall Risk Weighted Assets or complicated formulas that seek to measure the riskiness of each investment owned by the bank.
The subcommittee report details in a series of transcribed phone calls how Patrick Hagan figured out a way to juice their numbers to produce “the lowest [Risk Weighted Assets] and the lowest capital charge for the bank.” Hagan then worked with others in the quantitative research group to make this gaming of the numbers a reality. The subcommittee presents a damning phone conversation between the most senior-ranking risk officer, Peter Weiland, and Hagan. Weiland, who should have been watching to make sure such manipulations didn’t happen, does not stop Hagan, but instead lightly chastises him for talking about such “regulatory arbitrage” by e-mail.
JPMorgan’s duplicitous practices could never have succeeded had there been a strong regulator overseeing its activities. Fortunately for JPMorgan, but unfortunately for the American public, the Office of the Controller for the Currency (OCC) was the principal regulator in charge of ensuring this sort of deception did not occur—and they missed myriad red flags that this case presented. The OCC had sixty-three regulators on-site at JPMorgan, yet none of them looked at these positions. The subcommittee report details how the OCC failed to notice when JPMorgan stopped providing copies of key reports, did not analyze reports that showed JPMorgan had breached risk limits, and did not ask follow-up questions when a change to a risk model led, overnight, to a 50 percent reduction in the CIO’s risk. This is hardly the OCC’s first egregious failure of oversight (the Independent Foreclosure Review fiasco is a recent example), but it may well be one of its most spectacular.
This is hardly the first time a megabank has cheated, manipulated and deceived regulators, Congress and the public. I suspect that if a team of expert investigators dug around any megabank for nine months, they’d likely dig up something similar to the findings presented by the subcommittee. This is what the OCC is supposed to be doing, but they’re not. The question is, are our elected officials finally going to hear the message this time? Can this display of incompetence at managing risk by the bank long heralded as the pinnacle of prudence and good risk management enough to force movement on crucial, long-stalled issues?
JPMorgan fiercely debated whether or not to even re-state their earnings once they became aware of additional losses in the Synthetic Credit Portfolio. The reason? JPMorgan told the subcommittee that “$660 million was not clearly a ‘material’ amount for the bank.” The most powerful megabanks are now so large, that even deceptions on this scale may not count as important enough to report. I can think of no better piece of evidence to follow the lead of Senator Sherrod Brown and pursue ways to break up the banks. Cleaning up Wall Street is going to take a multi-pronged approach. Finalizing outstanding Dodd-Frank rules, completing a loophole-free Volcker Rule and lending support to Senator Brown’s Safe Banking Act are crucial first steps.
Sherrod Brown has big ideas for the big banks. Read William Greider’s take in the April 1 print edition of The Nation.