By Michael Crimmins, who has worked on risk management and Sarbanes Oxley compliance for major banks
The bad news just keeps on coming in the JP Morgan CIO scandal. We’re getting a lot of salacious detail, but the media manages to continue to miss the bigger picture. On Tuesday, David Henry at Reuters coined a wonderful catch-phrase that should prove difficult for JPMorgan to explain away to its depositors and to the rest of us - “JPMorgan dips into cookie jar to offset ‘London Whale’ losses”.
The main point of the article is that the ‘cookie jar’ contains $8 billion of unrealized gains from the profitable investment of excess deposits. The tricky bit for JPM, its depositors and inquisitive regulators, investors, external auditors, and disgusted citizens is explaining why $1 billion of that reserve was gifted to the CIO desk to cover its trading losses. Trickier still is Dimon’s pledge of the entire $8 billion to cover any further CIO trading losses. Henry reports:
‘JPMorgan Chase & Co has sold an estimated $25 billion of profitable securities in an effort to prop up earnings after suffering trading losses tied to the bank’s now-infamous “London Whale,” compounding the cost of those trades.’
The story estimates that JPM sold $25 billion of the Investment portfolio assets to generate the initial $1 billion gain used to offset the $2 billion losses Dimon disclosed in the May10 press conference. There is no word yet on the size of the losses JPM has incurred since the announcement.
The size of the investment portfolio was reported as $381 billion as of March 31, 2012. At that time the $381 billion portfolio contained underwater assets of $84 billion. Those underwater assets were worth $1.4 Billion less than JPM paid for them. JPM can’t sell them without realizing additional losses, so they will probably not be touched. That leaves investments of $297 billion that can be sold at a profit. The unrealized profit on these items was reported as $9.8 billion as of March 31, 2012. Since then JPM has liquidated assets in the portfolio to realize the $1 billion gain used to offset the CIO trading loss. Based on Reuters estimates the balance of the profitable trades remaining in the portfolio is $272 billion and the remaining unrealized gains available to cover additional losses are $7.4 billion.
As a result of the sale, at least 12% of the total investment account reserves that were, in theory, set aside to protect depositors in the event of a market shock, have been raided to prop up the second quarter bottom line. But that assumes you buy the Dimon’s “excess deposits” party line. As Amar Bhide pointed out, much of these funds are actually hot international money, not the cash reserves of retail investors and ordinary businesses. So no matter how you look at this, it isn’t pretty. Either you have JPM raiding deposit reserves to preserve trader and executive pay, or you have Dimon misleading investors and regulators in depicting a profit-driven, risk-seeking trading unit engaged in “hedging” on behalf of “depositors.”,
The Reuters article focuses on the stupidity of the decision to sell Investment account assets from a tax perspective but barely address the larger long term problems facing the bank.
The financial industry has gone through periods in the past when banks cashed out good assets to cushion losses, said former SEC Chief Accountant Turner. It happened during the U.S. savings and loan crisis in the 1980s, abated during a period of tougher regulatory scrutiny and fewer losses, and then came back during the latest financial crisis.
But the costs are significant. In statements about the latest losses, Dimon has been careful to emphasize the disadvantage of paying more taxes, said Chris Kotowski, an analyst at Oppenheimer & Co.
“I think he was trying to tell you, ‘Don’t expect us to offset all of these losses,’” Kotowski said.
Turner pointed to the elephant in the room, but didn’t address it directly, and Reuters’ David Henry didn’t follow his lead.
Turner is pointing out that one only raids the cookie jar in times of systemic stress. JPMs inclusion of the Investment account assets as part of the trading portfolio defies both accounting norms and historical precedents.
And Kotowski’s conclusion is wrong. ‘What he was trying to tell us’ is that these losses will continue to be buried in the investment account until such time as JPM determines that it is tax efficient to recognize offsetting gains. He has already hinted that these loss-generating CDS positions will take time to unwind, which signals that JPM will make every effort to reclassify the loss-producing hybrid trading-hedges as held to maturity positions against the investment portfolio.
Or until such time as the SEC and DOJ or any other regulator or the PCAOB or Congress finally have had enough and call JPMs bluff. That time is now!
Why is all This Accounting Detail Important?
Normally, investment account gains resulting from standard Treasury management operations are earmarked for protection of depositors’ accounts. This is ‘boring utility banking stuff‘.
One of the underreported elements of the JPM scandal is that the CIO considered the investment account as part of the CIOs trading portfolio. This is unprecedented in the historical financial statement interpretation of investment accounts and undermines the basic logic underlying the favorable accounting standards treatment for investment account, or Available for Sale assets.
In the pre-crisis era Available for Sale (AFS) portfolios were relatively small and benign and provided Treasurers with a pool of assets they could tap in a systemic emergency without violating either the spirit or the letter of the accounting rules. Most assets were designated either as trading account assets, which were marked to market, or as “held to maturity” assets, which were booked at historical cost. Treasurers were given some discretion to designate assets as neither, with the understanding that they were intended to be tapped only in emergencies (as Turner pointed out in the Reuters piece).
Post crisis, the reality set in that the banks were loaded to the gills with toxic assets in their trading accounts. A compromise was reached among the regulators, accounting rule-makers and policymakers that the AFS portfolios could be used to house those assets ( i.e super senior tranches of CDO, …etc) that the banks felt they could unwind profitably over time. The result was a massive transfer of assets from the MTM trading account into the Available for Sale accounts. One major condition was imposed. The changes in the value of the assets would need to be disclosed and recorded as an adjustment to the Equity account. However, the banks were given a great deal of leeway to determine how those assets should be valued while they were parked in the AFS portfolio.
Over time investors stopped paying much attention to the changes in the AFS portfolios. But the CIO offices knew that was where the game was being played and went to town.
So Jamie’s raid on these accounts to cover short term trading losses undermines and abuses the dubious underlying crisis management efforts of the regulators, policy-makers and accounting rule-makers in one fell swoop. Needless to say JPM betrayed the spirit of the US government attempts to salvage the US financial system.
It also violates the letter of the law re SOX: If Dimon knew he was violating GAAP by being so indiscreet as to admit that non-trading assets were available to cover trading losses then his certification was fraudulent. Full stop, He should be prosecuted.
As a result there should be very grave concerns on the part of the SEC and DOJ (and the PCAOB for that matter) that the financial statements covering the periods the CIO was in operation at JPMorgan have been misstated. At its most basic level, it begs the question, if investment account assets were sold to cover trading account losses in 2012, then why weren’t they reported as trading account assets in previous reports? Additionally, if the assets were managed as part of a trading strategy in prior periods then the prior period reports are also wrong.
Prior year gains on the CIO portfolio were included in income (and bonuses were paid to individuals on the performance of the assets in the ’trading account’ portion of the portfolio, in the hundreds of millions), yet corresponding losses on the ‘hedged’ portion of the portfolio booked as investments have been buried in the Investment account and deferred. These embedded losses had not been properly disclosed in prior periods.
On Wed Cardiff Garcia at FTAlphaville reported that this isn’t the first time Jamie Dimon managed the CIO and investment portfolio as one unified trading portfolio. It looks like he did the same thing at Bank One.
Bank One did not note whether the underlying hedged items increased in value or not to offset this decline, which may reveal one of the pitfalls of using credit derivatives for credit risk management. For instance, there can be an accounting mismatch if the credit derivative is marked-to-market downward, while the loan is kept at book value and can’t be marked up.
Financial statements matter. SOX exists to ensure that CEOs and CFOs understand and accept the consequences if they don’t. The SEC and DOJ and every regulator have the opportunity and incentive to throw Dimon under the SOX bus. What’s the delay?