A Risk Manager’s Impossibility?
A reconsideration of the London Whale, JPMorgan’s risk management, Jamie Dimon’s oversight – and their implications for other financial institutions
If you are a risk manager at a U.S. bank, you will be faced with difficult decisions. You’ve probably already run into one or more of what I think of as the three major problems for risk managers. The first is the lip service paid to risk management by people in leadership positions who are unfit to lead; the second is ignoring or covering up oversized risky positions; and the third is not effectively managing short positions.
Jamie Dimon, Chairman and CEO of JPMorgan Chase, is still lauded as the best bank manager in America. That’s a leading indicator of how difficult your job will be if you actually try to perform your role in the way it should be done. Yet, if you go-along-to-get-along, you will probably be safe only temporarily.
Dimon was a busy man at the end of 2011 and the beginning of 2012. Apparently, he was so busy courting the media in his campaign against the Volcker Rule (which would prevent taxpayer insured banks from engaging in proprietary trading) that he didn’t do his job overseeing the proprietary trading in the Chief Investment Office (CIO) unit that reported directly to him.
Despite concrete evidence to the contrary – including a massive wrong-way coal short for JPMorgan’s own book—Dimon’s PR spin was that JPMorgan Chase didn’t engage in proprietary trading. Similar to Goldman Sachs’s ludicrous claim before Congress, Dimon claimed the bank only traded on behalf of customers.
Meanwhile, Dimon’s CIO unit was in serious trouble. In March 2012, the Wall Street Journal and Bloomberg News reported a huge position in credit-default swaps taken by JPMorgan’s London-based Bruno Iksil. His positions were so huge that other traders called him the “London whale.”
Dimon reportedly is a hands-on risk manager capable of handling the enormous responsibility of managing the largest and most systemically dangerous bank in the United States. If that were true, he knew or should have known about the oversized risky credit derivatives positions in the unit that actually reported directly to him.
The trade was so large and risky that before it was done bleeding, it would wipe out years of the unit’s earnings. Oswald Gruebel resigned as CEO of UBS in September 2011, after “rogue trader” Kweku Adoboli lost $2.3 billion. Dimon claimed he took responsibility, yet unlike Gruebel who felt it was his duty to assume responsibility for an unauthorized trading incident, Dimon didn’t step down. Even worse, Dimon reportedly exempted the CIO unit from rigorous scrutiny, and brushed off concerns about the unit’s lack of transparency.
The CIO unit was a poster child for rotten risk management and disclosure practices. By May 2012, losses were $2.2 billion and rising rapidly. The Wall Street Journal reported that losses could be as high as $5 billion, more than 25% of JPMorgan’s total profits in 2011. Losses ultimately rose to more than $6 billion — at least, that is the official “number.”
All of JPMorgan Chase’s problems came to a head on September 19, when, in an effort to resolve regulatory investigations into its $6.2 billion trading loss, the bank admitted to violating federal securities laws. As part of a settlement, it agreed to pay a $920 million fine to resolve claims by the Federal Reserve, the Securities and Exchange Commission (SEC), the U.S. Comptroller of the Currency (OCC) and the U.K. Financial Conduct Authority (FCA, which gets a $220 million payout). But the Justice Department and the Commodity Futures Trading Commission (CFTC) are still on the case. The CFTC informed JPMorgan that it recommends enforcement action.
In April 2012, senior management already knew the CIO unit used aggressive valuations that obscured $750 million in losses. The SEC, in its September 19 statement, said that JPMorgan admitted that those losses occurred “against a backdrop of woefully deficient accounting controls” (including spreadsheet miscalculations that caused large violation errors) in Dimon’s CIO unit. Moreover, the commission said that the bank was also guilty of “misstating” its financial results in its public filings for the first quarter of 2012.
“JPMorgan failed to keep watch over its traders as they overvalued a very complex portfolio to hide massive losses,” George S. Canellos, co-Director of the SEC’s Division of Enforcement, said in the statement. “While grappling with how to fix its internal control breakdowns, JPMorgan’s senior management broke a cardinal rule of corporate governance and deprived its board of critical information it needed to fully assess the company’s problems and determine whether accurate and reliable information was being disclosed to investors and regulators.”
Though the SEC did not name individuals in its release, it did state that “senior management” applies to the people who held the titles of CEO, CFO, CRO, Controller and General Auditor at JPMorgan as of May 10, 2012.
Dimon has created his own Catch-22: he wants to be in charge, without doing the work that it takes to actually be in charge. If he’d like to now claim that he did do the work required of him, then he has to admit that he lied to the public.
Given the choice between admitting negligence and lying, Dimon chose negligence. He now suggests that it shouldn’t matter, anyway, because JPMorgan has made up for the $6.2 billion in losses through revenues generated elsewhere—in units that, unlike the CIO, don’t report directly to him.
Dimon Compounded His Credibility Problem
JPMorgan didn’t merely ignore news reports, Dimon refuted them. On April 13, 2012, Dimon had knowledge that losses were already as high as $1 billion. That was not publicly disclosed. Instead, Dimon told shareholders it was “a complete tempest in a teapot.” He said it was the bank’s job to invest “wisely and intelligently.”
It was Dimon’s job to understand the risks that unit was taking, and by now the time to do his job has long passed. When Dimon materially misled the public and his shareholders about the magnitude of the problem, he knew – or should have known – otherwise.
As rumors of the actual position circulated, losses soared, and loss reports were estimated at $100 million or more per day by outsiders. Dimon delayed the 10-Q’s scheduled April 27th release.
“Sources” at JPMorgan sounded suspiciously like PR flacks. They told the Wall Street Journal that Dimon didn’t ask to see the positions until April 30. Even though the 10-Q was delayed, first quarter earnings had to be restated later.
Shareholders got some of the bad news on Thursday, May 10 – only five days before the shareholders’ annual meeting. Since there was a weekend wedged between, they barely had three days’ notice. Dimon admitted: “In hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed and poorly monitored.”
I’ll add that, with foresight, it was fully knowable, too.
Forty percent of JPMorgan’s shareholders voted for Dimon to lose his position as Chairman. If shareholders had more advance notice, the vote might have gone against Dimon.
You could almost smell Dimon’s flop sweat during his May appearance on Meet the Press. When David Gregory asked him how these losses unfolded, here (via Michael Hiltzik’s May 14, 2012 transcription in the LA Times) was his response:
“First of all, there was one warning signal — if you look back from today, there were other red flags. That particular red flag — you know, we made a mistake, we got very defensive and people started justifying everything we did. You know, the benefit in life is to say, ‘Maybe you made a mistake, let’s dig deep.’ And the mistake had been brewing for a while, so it wasn’t just any one thing.”
Dimon insists no lies were told about losses that ultimately climbed to $6.2 billion. I’d love to hear his response to this question: “How do you define lie?” To any reasonable financial professional, it sounds as if Jamie Dimon—intentionally or otherwise—lied.
Even if he didn’t intentionally lie, it was his job to know better. Dimon has also publicly stated that he defies you to find a shareholder that lost money. Only his PR flacks should run with that spin. Six billion is not exactly chump change and, what’s more, the CIO unit that reported to Dimon was mismanaged.
The Sarbanes-Oxley Problem
It was Dimon’s responsibility to know the facts before making a public statement, particularly in the wake of press reports and accurate rumors about the oversized and risky credit derivatives positions. He wants to claim he was less informed than the press and other finance professionals outside his bank. However, he not only made public statements that were very far from reality but also refuted and dismissed accurate statements about JPMorgan’s internal problems.
According to Section 302 of the Sarbanes-Oxley Act (SOX) of 2002, the CEO and CFO of publicly traded companies must certify the appropriateness of their financial statements and disclosures and fairly present, in all material respects, the operations and financial condition of the company.
JPMorgan’s representations about the adequacy of its risk management are questionable. Moreover, JPMorgan Chase changed its accounting methods for the CIO unit’s credit derivatives trades near the time it faced huge losses. It’s questionable whether the impact of the accounting change was adequately disclosed. JPMorgan changed its risk measurement model, even though the bank had issues with it. In May 2012, Dimon said the model was later deemed “inadequate.”
Still, despite the mounting evidence against the firm, Dimon was not held accountable for the bank’s SOX violations until the Sept. 19 settlement. The SEC release from that date states that the bank’s management did not uphold it SOX responsibilities regarding corporate governance and disclosure. “Public companies such as JPMorgan are required to create and maintain internal controls that provide investors with reasonable assurances that their financial statements are reliable, and ensure that senior management shares important information with key internal decision makers such as the board of directors. JPMorgan failed to adhere to these requirements,” the statement reads.
JPMorgan’s Risk Management Potemkin Village
Jamie Dimon doesn’t have a succession plan for his big bank, and seems to have ousted anyone who could challenge him. But it seems he also didn’t have succession plans in place for lower- level employees.
In 2010, Joseph Bonocore, then chief financial officer of the CIO unit, raised concerns to top executives after London-based traders lost approximately $300 million within days on a foreign exchange-options trade. There were no offsetting gains. Barry Zubrow was JPMorgan’s chief risk officer at the time, and Michael Cavanagh was the CFO. Both reported directly to Dimon.
Dimon reportedly recalls that he was told of the trade, and Bonocore was given the authority to order that the FX position be reduced. In late 2010, Bonocore took over as JPMorgan’s treasurer, but he was gone by October 2011. After he suddenly had to leave the bank for “personal reasons,” the largest systemically dangerous bank in the United States had no treasurer for five months. Bonocore now works for Citigroup Inc. Before leaving JPMorgan, he reported to Doug Braunstein, then the bank’s CFO. Braunstein is now a vice chairman. In March 2013, Braunstein admitted to Congress that he didn’t level with shareholders in April 2012, when he participated in Dimon’s “teapot” conference call.
Regulators did not receive granular information about JPMorgan’s trades on a “regular and recurring,” basis. Moreover, Congress pointed out that there was more than one serious issue with the firm’s regulatory reporting.
JPMorgan stopped filing required profit-and-loss statements for the CIO unit in 2011, citing security concerns. Senator John McCain pointed out that such concerns should not have prevented the firm from fulfilling its requirements.
JPMorgan claimed its risk management practices were sound. Yet the CIO unit had ditched a model it used for years, replacing it with a new model in 2012 while ramping up its complex trading positions. A new model, combined with a huge derivatives position, is a red flag to reasonable managers. That’s the time to question reports submitted by people whose pay depends on the results.
The CIO unit’s risk management seemed to be a revolving door, with no one in place for long periods of time. When the CIO’s troubles became apparent, Irvin Goldman was the risk manager. He is the brother-in-law of Barry Zubrow, JPMorgan’s former chief risk officer and then head of corporate regulatory affairs.
That wouldn’t necessarily raise suspicions of nepotism. But Goldman had little experience in risk management. He also had a serious question mark about his abilities on his record, having been fired by Cantor Fitzgerald after he allegedly traded stocks for a proprietary trading account and bought and sold the same stocks in his personal accounts. Yet he was given a job in JPMorgan’s CIO unit and was made risk manager on February 13, 2012. By May 2012, he was replaced.
Bruno Iksil, known in the media as the “London Whale,” traded credit-default swaps for the CIO unit, and he has an “agreement” with the New York Attorney General and the FBI. Two traders, Javier Martin-Artajo and Julien Grout, have been criminally indicted by Eric Holder, the Attorney General, and Preet Bharara, the U.S. Attorney for the Southern District of New York for allegedly covering up losses. Jamie Dimon and Ina Drew, the head of the CIO unit who reported directly to Dimon and who resigned in May 2012, have not been indicted.
One of the scape whales could just as easily have been a risk manager, particularly if he or she was not an in-law of a senior officer.
Worst Case Scenario: Covering-up a Large Risky Position
Ideally, a risk manager has the authority to review trading positions and adjust them. A large position can be vetoed or cut by the risk manager. Likewise, a hedge, such as a short position, can be imposed on traders. But risk managers often have responsibility without genuine authority.
When things go well, no one seems to question why an oversized position is on the books. If you object and the trade doesn’t blow up, then it seems as if you face the worst case scenario. You may lose your bonus or job, while everyone who stays silent earns a fat bonus.
As galling as that seems, it isn’t the worst case scenario. You could stay silent, collect a fat bonus and be criminally indicted. You can’t go along with traders that are putting on “unauthorized” huge risks. Covering up losses will make it even worse.
Control fraud is a term coined by William K. Black, an Associate Professor of Economics and Law at the University of Kansas City-Missouri, who witnessed rampant risk taking and outright theft when he was a top regulator in the savings and loan debacle. Parasites earned huge bonuses while their hosts, the financial institutions they managed, were drained.
In 2012, Dimon got an $11 million pay package (down from $23 million in 2011), and remains Chairman and CEO of JPMorgan Chase. The CIO unit’s chief investment officer, Ina Drew, took home $14.5 million in 2011 and was allowed to retire.
As incredible as it seems to bankers in Switzerland—where they still have a semblance of banking decency—regulators did not remove Dimon. While Dimon did step down from the board of the New York Fed in January 13, 2013, it was only because his term was up.
The unfortunate reality for risk managers is that since management pays lip service to Sarbanes-Oxley and internal controls, control fraud will very likely occur. No one at the top will take the fall for it. If it occurs on your watch, you may become a scapegoat.
Could You Have Hedged with the Big Short and Survived?
The bad news is that you might not be able to protect yourself. If people work hard enough to set you up to take the blame, they may succeed. But you can make it very difficult for them.
Document your recommendations and set up protocols in advance. When protocols are violated over your objections, record that, too. Keep your own records, especially when it comes to big trades or to trades that are difficult to manage. Short selling, even as a prudent hedge, can be one of those trades.
One of the best shorts of the decade was “the big short.” But if you worked at a bank, at AIG, or for a monoline insurer (including ACA, FGIC, MBIA and Ambac), you might have been crucified if you insisted on this hedge.
In the summer of 2006, hedge funds shorted the price-based ABX-HE 06-2 BBB- index with a pay-as-you-go credit default swap. When you short a credit derivative, you buy protection, meaning you are short the underlying credit – i.e., short the index. This particular index references BBB–rated tranches that were originally priced at par or 100. The rating is just above a junk rating, and the index references 20 home equity loan asset-backed deals. As the level of this index declined, it reflected a decline in the price of the underlying BBB– tranches, and the value of the short position increased.
Unlike stocks, fixed-income securities only trade above par when general market interest rates decline without an offsetting widening in general credit spreads; when general credit spreads narrow without an offsetting rise in general market interest rates; when something really wonderful happens to improve the prospects of a particular fixed-income security; or when a favorable combination of the previous three events occurs. Even then, fixed coupon payments are a self-limiting damper on the upside potential of the price. The index’s all-time high was only 100.94.
On the other hand, fixed income securities can fall below par if interest rates rise, if credit spreads widen, if ordinary defaults occur or if fraud is discovered. The best time to short a flawed fixed income security is when it trades at par and has nowhere much to go except down. The index’s all-time low was just over 2.
During the financial crisis, tranches of residential mortgage-backed securities (RMBS) and tranches of collateralized debt obligations (CDOs) created a short opportunity that is the stuff of dreams. The short sale was helped by a huge heaping of fraud in the construction of these securities.
If you haven’t had the opportunity to examine the publicly available evidence revealed in Congressional investigations, you should do it. Due diligence reports were suppressed. The suppression wasn’t disclosed, and phony data was reported in prospectuses. The investigation revealed even more multi-faceted fraud.
You cannot write a disclaimer that absolves you from securities fraud. The absence of criminal indictments is due the absence of meaningful investigations and law enforcement, not to the absence of fraud.
Even when sophisticated investors are involved, that doesn’t mean you are innocent of securities fraud. In fact, if material information is doctored and/or withheld from a sophisticated investor – and if he or she performed adequate due diligence and couldn’t have reasonably uncovered the fraud – then the investor can recover damages. Either way, the SEC can and should come after you for fraud.
It’s a Sure Thing, But When?
You would think that an index backed by fraud-riddled securities (like the ABX.HE 06-2) would start falling in value right away, but it actually took months. It took capital, strength of conviction, and patience to stick with the trade.
If you were a risk manager hedging a bank’s position in CDOs in 2006 (I assume that this passage is referencing 2006. Again, if my assumption is incorrect, please clarify), what would you have said to your boss if he asked you to even partially remove the hedge? It’s just a matter of time, because even though we’re pumping out fraudulent product like crazy, we’re still stuck with a lot of it, and we need to hedge.
If you knew enough to find this hedge, you were smart enough to know that you’d be ostracized and fired. It’s rare to find an honest richly-rewarded manager who will say: We’re creating phony securities that will implode almost immediately? Thanks for bringing this to my attention. I’ll put a stop to it right away!
Fixed-income fraud was so widespread and pervasive that everyone was lying about the marks of these securities. A ring of complicit trading groups propped up prices by buying trash from each other and stuffing it into new deals at inflated prices.
Meanwhile, hedge funds waited. Time was on their side, but they had paid money to put on the big short. The carry costs were small, because the trade started out at par, but they were shelling out cash, and so far, there was no return. The bottom would fall out and they’d have a windfall if they waited, but how long would they have to wait?
The financial press wasn’t ringing alarm bells, even though subprime mortgage fraud was rampant. Prices of CDOs defied gravity, as investment banks bought trash from each other in a set-up that should have brought fraud conspiracy charges.
The summer of 2006 came and went with no drop in price. September and October came and went without incident. By Thanksgiving Day 2006, people weren’t thankful, they were complaining. Hedge funds talked about pulling the plug before year-end. They were starting to believe that lying about the value of these securities could go on for another year or more before the lack of value became obvious.
It’s hard to believe today, but at the time, banks’ CEOs and CFOs were painting a rosy picture of their prospects. They handsomely rewarded themselves and the securitization “professionals” that reported to them. Structured finance revenue had grown out of thin air from almost nothing to around one third of revenues in a very short time. Everyone was sucking cash out of financial institutions, while they were setting some of them up to fail.
Obvious Stress and Vigorous Denial
Then the stress started to show. At the end of November, the ABX.HE 06-2 index went down slightly. New hedge funds started to believe things would finally break and joined the existing shorts.
In early December, the index drifted down, and everyone was asking why. There were lots of good reasons that the index should have already collapsed. Now that it was showing weakness, no one could identify the exact trigger. Dozens of subprime mortgage lenders were in serious trouble, but nothing much showed up in mainstream media.
Ownit, a large subprime lender with ties to both Merrill Lynch and JPMorgan Chase, filed for Chapter 11 bankruptcy in December 2006. In November 2006, JPMorgan Chase had pulled Ownit’s credit line, but that wasn’t public news until December. The index began dropping like a stone as mortgage lenders began blowing up.
Banks were desperate to unload, so they accelerated issuance of corrupt CDOs and bought credit default protection on the corrupt product. They issued more deals in the first half of 2007 than in all of 2006.
There was no public outcry. Congress was silent. Financial market regulators were absent. No one in authority raised a ruckus. I was very vocal, but I am not a regulator.
By February 27, 2007, the index was priced around 69.97. It zigzagged up and down, but kept its downward trend. The zigzagging created mark-to-market issues, so speculators had to explain to themselves and to investors why they held the position. Since it was hard to get the actual loan documents, no one could tell the extent of the fraud. It was massive, but no one knew for sure how massive.
Around this time, the Wall Street Journal reported that CSFB said BBB–tranches backed by subprime collateral were trading at LIBOR + 625 basis points. No savvy investor would buy BBB– tranches backed by subprime loans at that level. Some BBB–tranches were trading like equity, since the view was that unrecognized losses had already eaten through the first-loss protection and through most of the tranche. In other words, they were almost worthless.
A savvy risk manager would have still had time to hedge in the first quarter of 2007. But could you have made that case and survived?
By the way, this is why senior management calls in consultants. No one on in the inside can be blamed for the bad news. That’s particularly beneficial when a necessary—but at first unpopular—hedge must be proposed.
The index kept falling throughout 2007, and then the rate of plummeting slowed and flattened out. As of August 26, 2013, the price was a little over 6.
An Impossible Task?
There has been no real reform in the financial system, and that means that risk managers have as much career risk as before the financial crisis in many financial institutions.
When senior officers can claim their institutions have great risk management controls and suffer no consequences when that is proved an outrageous lie, how can you advance a risk management truth?
As I’ve said before, maybe you can’t, but you can at least do your job on paper, and that may protect you, if you face the worst-case scenario.
This commentary was published on September 24 at Risk News and Resources, the online news source for the Global Association of Risk Professionals (GARP), with permission from Tavakoli Structured Finance. Subscribers to my mailing list received this article on September 19, 2013.
In this commentary, I gave a general outline of the trades as described in the SEC report. I did not dissect them, since the notional amounts and details of the 312 trading positions are not public information. It was interesting to me that the SEC discussed the trades in general, but it didn’t specifically talk about basis risk due to the use of both investment grade and high yield linked credit derivatives, and it didn’t discuss maturity differences.
In other words, the SEC doesn’t explain why even without a model, one could see that JPMorgan put on a very risky trade with a net notional exposure of $157 billion. Notional size alone doesn’t tell one much about risk when discussing derivatives (a longer discussion outside the scope of this commentary). But in this case, due to the apparent and reported basis risk, size is indicative of enormous risk.
See also: “Why POTUS Allowed Bailouts Without Indictments.”