The JP Morgan ‘hedging’ fiasco


Ina Drew - Senate Hearing (Source: CNNMoney)

“The strategy was flawed, complex, poorly executed, and poorly monitored.” – Jamie Dimon on the scheme that cost the firm over $6.2 billion last year.

Right before a series of hearings related to the failed hedging portfolio, the Senate released a 300-page report two days ago that revisited significant missteps in the risk-management process at JP Morgan that led to catastrophic losses in the first half of last year, as well as casting a dark shadow over former Chief Investment Officer Ina Drew. The heavy losses sustained by JP Morgan where from a complex derivatives portfolio that was build to hedge against credit risk in the Firm’s Chief Investment Office (CIO) and “in its capacity as a lender.”[1] The Senate report claims that JP Morgan failed miserably in heeding repeated warnings from its internal risk controls (more than 330 of them throughout the first four months of 2012), misled investors in a conference call in April 13 of that year, and withheld information from regulators. It also criticized authorities at the Comptroller of the Currency, which were tasked with guarding against such excessive risk-taking, for not pursuing the incoming red flags.[2] In January of this year, JP Morgan also released a document that highlighted some of the mistakes that were mentioned in the Senate report and widely acknowledged that senior management should have done better at handling the complexity, size, and riskiness of the portfolio.[3]The firm’s report directly placed the blame for the debacle on the traders that executed the flawed strategy, the “London whale” among them, while harshly admonishing their superiors for allowing the trades to ever materialize.

However, it remains unclear whether management actively sought to mislead investors, or was simply unaware of the true nature of the losses. Democratic Senator Carl Levin, who led the Senate probe into the trades, is convinced that the former is in fact the case. After the report was released, he stated that the bank’s communications and securities filings “misinformed investors, regulators, and the public.” Yet by the time Jamie Dimon characterized the losses as a “tempest in a teapot”, the portfolio had reportedly lost $719 million[4], a fraction of the final amount. Given the difficulty of estimating losses in such a complex derivatives portfolio, it seems exaggerated to assume that both Douglas Braunstein, the CFO at the time, and Dimon were knowingly issuing false statements and thus breaking the law. Furthermore, on May 10, 2012, the bank’s Controller completed a special assessment that concluded that the CIO had “accurately reported the value of its derivative holdings” in line with best industry practices, while conceding that the firm had aggressively priced the derivatives in the portfolio to minimize their regulatory capital.[5]

It is also surprising that the Senate subcommittee decided to try and galvanize public opinion by characterizing the losses as a clear violation of the Volcker Rule, contradicting a previous statement by the CIO[6], and by dismissing the scheme as a “make believe voodoo magic ‘composite hedge’”[7], even when such a rule has not been finalized and does not represent law under which the Securities and Exchange Commission currently operates.

Though the media will focus on the obvious errors that occurred throughout this episode, and the particularly egregious decision to tweak the firm’s value-at-risk (VaR) metric to allow for the trades[8], it is only responsible to properly take into account the specific circumstances surrounding the bank’s errors and disclosures. It must also be said that JP Morgan, despite the trades and tarnished image, reported record profits and higher revenues for the year.[9] Still, the Senate findings will ensure that the pressure remains on Dimon to never let similar mistakes happen again. Expect the authorities to speed up the implementation of the Volcker rule, and to continue to paint the financial sector as a ‘runaway train’ that needs stiff regulations to function, let alone thrive – regardless of the validity of such claims.

-- Andrés Muñoz


[1] JP Morgan Chase & Co. Management Task Force, Regarding 2012 CIO Losses, CIO Reports, http://files.shareholder.com/downloads/ONE/2369390770x0x628656/4cb574a0-0bf5-4728-9582-625e4519b5ab/Task_Force_Report.pdf, p. 2
[2] Permanent Subcommittee on Investigations, JP Morgan Whale Trades: A Case History of Derivatives Risk and Abuses, United States Senate, March 15, 2013, p. 3
[3] Regarding 2012 CIO Losses, p. 8-9
[4] JP Morgan Whale Trades, p. 4
[5] JP Morgan Whale Trades, p. 6
[6] JP Morgan Whale Trades, p. 236
[7] JP Morgan Whale Trades, p. 36
[8] Jessica Silver Greenberg, JP Morgan Faulted on Controls and Disclosure in Trading Loss, Dealbook, http://dealbook.nytimes.com/2013/03/14/jpmorgan-faulted-on-controls-and-disclosure-in-trading-loss/
[9] JP Morgan, Form 8-K, CIO Reports, http://files.shareholder.com/downloads/ONE/2369390770x0x628654/23d47648-fb16-4f84-b9f2-47c60d158be0/4Q12_CIO_Report_-_Form_8K.pdf

Comments

Post a Comment

Popular posts from this blog

Ireland's Economic Comeback

Image
On Wednesday, the International Monetary Fund (IMF) released a billion dollars of financial help to Ireland, as the country complied with the requirements set up in its 2010 bailout plan. The plan, which saved Ireland from bankruptcy after it suffered a massive banking crisis starting 2008, is reaching its end, as Ireland is getting ready to start issuing sovereign debt again in December. However, the country has to reach a minimum annual growth of 2% for its debt to become sustainable. Ireland is now out of its second recession in five years with a 0.4% second quarter expansion. This positive data, however, falls short of the optimistic 1.3% growth over the entire year predicted by the Irish government. Irish exports have grown by 4.3% over the same period, while household consumption grew by 0.7%. The IMF decision came almost one week after other good news for Ireland: on Friday, September 20, Moody's announced positive forecasts on Ireland's sovereign debt, which it now judg
Read more

Ongoing Contact

Students today commonly use Twitter and Facebook and, therefore, they receive lots of information on a regular basis. Information comes to them in small bits many times each day. Therefore, the 48 to 72 hours between class meetings can seem like an eternity. It is little wonder that students often seem incapable of remembering what took place in the previous class meeting. The amount of correspondence they have received in the interim is probably massive. I don’t use Twitter because I can’t write anything in 140 characters but I use email A LOT. I want to keep the students engaged in the period between my classes. I want them to think about Financial Accounting every day not just when they are walking into class. The emails that I send to my students vary enormously from motivational to practice questions to simply informational. I often ask the students about these emails in class so they know they need to read them. Yesterday was our first class where we discussed ow
Read more

Obama pushes for diplomacy on Iran's nuclear program

Image
President Obama and Iranian President Hassan Rouhani both openly stated their support for a new diplomatic effort regarding Iran's nuclear program. Obama, addressing the UN General Assembly on Tuesday, stated that there was "basis for a meaningful agreement." In recent weeks, Rouhani, who was elected in June, has suggested that he is open to developing a program in which Iran is allowed to further their nuclear energy program but prevents them from building a weapon, claiming that a nuclear weapon program would "contradict our fundamental religious and ethical convictions." Obama said that Secretary of State John Kerry was working with the Iranian government to resolve the negotiations about Iran's nuclear program. In his statement to the UN General Assembly, he stated that success in the negotiations would be a "major step in a long road to a difficult relationship, one based on mutual interests and mutual respect," adding that "the roadblock
Read more