The Permanent Subcommittee on Investigations is making the JPMorgan Chase the poster child for what is wrong with derivatives trades generally. The subcommittee issued a 301 page report and also held a hearing, JPMorgan Chase Whale Trades: A Case History of Derivatives Risks and Abuses.
The JPMorgan Chase whale trades provide a startling and instructive case history of how synthetic credit derivatives have become a multi-billion dollar source of risk within the U.S. banking system.
Subcommittee Chair Senator Carl Levin's opening statement tells us how vulnerable the financial system still is, going on five years after the global banking meltdown.
Our investigation brought home one overarching fact: the U.S. financial system may have significant vulnerabilities attributable to major bank involvement with high risk derivatives trading. The four largest U.S. banks control 90 percent of U.S. derivatives markets, and their profitability is invested, in part, in their derivatives holdings, nowhere more so than at JPMorgan.
The Whale story broke last May where the mythical rogue trader lost over $2 billion on derivatives trades, which turned out to be $6.2 billion in losses. Most of the press focused on the trader, known as The Whale, who made the risky derivatives bets and doubled down on the losses. Earlier CEO Jamie Dimon was let off the hook with a softball Congressional response. This subcommittee didn't play softball and instead made it clear, blaming a few for systemic financial vulnerabilities isn't going to do anything to stop the next financial disaster from happening. Senator Levin:
The whale trades demonstrate how credit derivatives, when purchased in massive quantities with complex components, can become a runaway train barreling through every risk limit. The whale trades also demonstrate how derivative valuation practices are easily manipulated to hide losses, and how risk controls are easily manipulated to circumvent limits, enabling traders to load up on risk in their quest for profits. Firing a few traders and their bosses won’t be enough to staunch Wall Street’s insatiable appetite for risky derivative bets or stop the excesses. More control is needed.
The subcommittee report (pdf), describing the trades which ballooned up to massive losses. It's a horror story read, and in many ways implies JPMorgan Chase employees were just making up numbers as they went along. The trades were on synthetic credit derivatives out of JPMorgan Chase's Chief Investment Office. The Chief Investment Office, or CIO, manages $350 billion in excess bank deposits. Because derivatives are based on models, which we believe to be faulty in the first place, traders easily hid their losses by manipulating evaluation and risk models. From the executive summary in the report:
Inadequate 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.
Reading what happened is like a course in organized crime creative finance. JPMorgan Chase asked the CIO to reduce the size of the portfolio by shedding some of the more risker derivatives so JPMorgan Chase in turn could lower their capital requirements. To lower risk should have meant reducing those risky credit derivative bets. Instead, CIO doubled down by adding even longer term derivatives bets. The kicker is CIO added more derivatives to the portfolio in order to lower their risk weighted assets as an aggregate and thus comply with JPMorgan Chase directives to reduce risky assets. Sound familiar? The new trades added officially canceled out the portfolio risk on paper, very similar to CDO tranches, yet clearly made the entire portfolio a walking derivatives time bomb. Only with bad models can one reduce risky assets by buying up more of them, but that's what happened.
The story is much more than a portfolio supposedly designed for hedging that went bad. JPMorgan Chase had credit a high risk proprietary trading platform under the guise of a hedging portfolio. Some of what happened is just outright fraud and banks get away with it for derivatives are so complex and there are so few players. Take this report gem for example where because derivatives are so difficult to evaluate in the first place, CIO could do a slight of hand to hid losses.
CIO began to assign more favorable prices within the daily price range (bid-ask spread) to its credit derivatives. The more favorable prices enabled the CIO to report smaller losses in the daily profit/loss (P&L) reports that the SCP filed internally within the bank.
CIO literally kept two sets of books, one for the price reported and one with the real price. Below is an excerpt from the report describing what happened:
The data indicates that the CIO began using more favorable valuations in late January and accelerated that practice over the next two months. By March 15, 2012, two key participants, Julien Grout, a junior trader charged with marking the SCP’s positions on a daily basis, and his supervisor, Bruno Iksil, head trader in charge of the SCP, were explicit about what they were doing. As Mr. Grout told Mr. Iksil in a recorded telephone conversation: “I am not marking at mids as per a previous conversation.” The next day, Mr. Iksil expressed to Mr. Grout his concerns about the growing discrepancy between the marks they were reporting versus those called for by marking at the midpoint prices: “I can’t keep this going …. I think what he’s [their supervisor, Javier Martin-Artajo] expecting is a re-marking at the end of the month …. I don’t know where he wants to stop, but it’s getting idiotic.”
For five days, from March 12 to 16, 2012, Mr. Grout prepared a spreadsheet tracking the differences between the daily SCP values he was reporting and the values that would have been reported using midpoint prices. According to the spreadsheet, by March 16, 2012, the Synthetic Credit Portfolio had reported year-to-date losses of $161 million, but if midpoint prices had been used, those losses would have swelled by another $432 million to a total of $593 million.
That's amazing they were even be able to manipulate the prices to such a huge degree in the first place! The evaluation of derivatives is such murky waters, unrealizes losses like the $6.2 billion in this case can happen without triggering the fire alarms as a warning. That is the Senate report conclusion. Synthetic credit derivatives are too difficult to properly evaluate and they can blow up to incredible losses even though there is not any associated underlying asset that actually tanked in value in the real world.
The report also slammed JPMorgan Chase corporate culture and we'll assume the subcommittee is extrapolating that blast to all banks and their insistence on keeping their risky derivatives betting game. It is fairly evident the few players in the derivatives market will manipulate models, evaluations, pricing and act as if it's all good to just play with the numbers until something pops up that makes them look solid and profitable.
JPMorgan Chase also lied to the Office of the Comptroller of the Currency, the main regulator, but the OCC also fell down on the job. It was so bad, the Office of the Comptroller of the Currency was pretty much oblivious to what was going on until they read the Wall Street Journal.
From the OCC hearing testimony it appears little has changed. Regulation of derivatives doesn't seem to come up. The testimony discusses monitoring risk weighted asset models, seemingly oblivious to the risk baked into the models themselves. One pretty incredible recommendation from the OCC pops out. Wall Street traders are not being compensated enough to constrain themselves and be realistic with risk according to OCC. We have impossible to evaluate time bomb derivatives, shaky models with bad math and the problem is Wall Street isn't making enough money? We think Wall Street is making way too much money already. They do not need to make even more money simply for doing their job correctly in evaluating risk in the first place. From the OCC testimony:
We expect large banks to have a well-defined personnel management process that ensures appropriate, quality staffing levels, provides for orderly succession, and maintains appropriate compensation tools to motivate and retain talent. Of particular importance is the need to ensure that incentive compensation structures balance risk and financial rewards and are compatible with effective controls and risk management.
The Whale trader received $6.74 million in 2011. His junior partner, who warned on the trades, received $1 million. Clearly compensation is not the problem in risky derivatives trading for Wall Street gets their bonuses no matter how badly they screw up, guaranteed. From Senator Levin:
Rather than ratchet back the risk, JPMorgan personnel challenged and re-engineered the risk controls to silence the alarms. It is difficult to imagine how the American people can trust major Wall Street banks to prudently manage derivatives risk when bank personnel can readily game or ignore the risk controls meant to prevent financial disaster and taxpayer bailouts.
The subcommittee did a great job in investigating JPMorgan Chase's synthetic credit derivatives portfolio and bringing how bad this really was by ethical standards to light. The report makes it clear how derivatives are still the biggest threat to the next financial crisis. They had a host of recommendations (p. 16 of the report) with one to simply implement the Volcker rule which was already passed in the Dodd-Frank legislation. The Volcker rule has been fought tooth and nail. The banking industry has been out to gut it ever since it's watered down version became law.
Federal financial regulators should immediately issue a final rule implementing the Merkley-Levin provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, also known as the Volcker Rule, to stop high risk proprietary trading activities and the build-up of high risk assets at federally insured banks and their affiliates.
Unfortunately the report does not recommend simply banning some of these derivatives and reinstating Glass-Steagall. When one has bad math in the first place on some of these financial instruments, no amount of regulation will change that and from the mathematics themselves, some derivatives simply have contagion baked right in.