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More on the Supposedly Out of Control JP Morgan Chief Investment Office and the “Fortress Balance Sheet”

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Whocouddanode? As more and more tidbits leak out about the activities of the JP Morgan Chief Investment Office, it increasingly appears to be a unit that was inadequately supervised. While that revelation is a dent to the reputation of self-styled ubermensch and alleged control freak Jamie Dimon, if he takes a few lumps in the press and otherwise can carry on as before, what difference will it make to him and the industry? Lloyd Blankfein took at least as much heat over a longer period, and he’s still firmly in place.

The CEO “I’m in charge and I know nothing” defense is alive and well because it has proven to be so successful. Even though having an operation with very large risk limits and actual exposures that was left overmuch to its own devices would seem to be a clear Sarbanes Oxley violation, the Federal government has had absolutely no appetite for going after current bank CEOs (and their efforts with Angelo Mozilo weren’t anywhere near as creative as those with, say, John Edwards). Dimon’s speedy firing of the unit’s head, Ina Drew, and other members seems to be a successful loss mitigation strategy.

But some of the latest stories reveal that the CIO was really out of control, in the sense that direct orders, both from on high and by the CIO to its traders, were ignored. This is a breakdown of the normal chain of authority. It means insubordination was tolerated. And don’t try, “Oh, you know those traders, they are really hard to manage.” Bullshit. You need to enforce discipline, and in a trading operation, the usual first step is in their face, pronto, and giving them a very public dressing down. Follow up actions include cutting position limits, and better yet, seriously docking the bonuses of traders who violate the desk’s strategy. A few high profile disciplinary measures and others will fall into line.

But this raises a next level of questions: why was this behavior tolerated at such a large, important unit? A Wall Street Journal story recounts how a CIO trader had lost $300 million in a several days on foreign exchange options trade “without any offsetting gains to balance out the losses.” That means it was not a hedge. The CFO of the unit got authority from the chief risk officer and the CFO of the bank to reduce the position size, which did happen.

Now note this is already a little weird. The CFO of the unit does not go to the head of that business, Ina Drew, to order the position cut, he goes higher up the ladder. And notice that no one seemed bothered that a trader wasn’t hedging but taking a bet; the concern simply seemed to be that this was a really bad bet (this is presented in the piece as a New York versus London turf war). And then we have this:

Last year, several executives in the CIO’s New York office noticed that London again was taking large trading positions, this time in derivative indexes that were viewed as illiquid, or hard to trade in and out of. Peter Weiland, then the chief risk officer of the CIO, and some more junior executives became concerned that if J.P. Morgan chose to sell the positions, the bank might suffer deep losses, said people familiar with the matter.

During a CIO management meeting late last year that included Ms. Drew, Mr. Macris and Mr. Weiland, the group discussed the size of the credit positions. They agreed that the positions needed to be reduced over time.

Even though everyone in the meeting was in agreement on what to do, the London office put on new trades this year that appeared to be at odds with the strategy, said people close to the company. Mr. Weiland was among those who became aware this year that the plan hadn’t been followed, those people said.

Mr. Weiland had begun a review last summer of the CIO’s risk limits and participated in a discussion about whether restrictions needed to be tighter and more specific, according to people familiar with the situation. But new limits were never agreed to, those people said.

The later part (the agreement on a strategy that appears not to have been communicated) looks like a bureaucratic failure, but the first part is more troubling: that the traders in London defied (or decided to work around) a clear strategy. And with that in mind, the bureaucratic response (oh, we need tighter limits!) is all wrong. The traders in question need first to be told in no uncertain terms that this sort of crap is never never to happen again, and they are to be told of what their intransigence has cost them in hard terms. That isn’t saying that position limits aren’t also important. But is it management 101 that insubordination needs to be dealt with forcefully. And that’s even more true in a trading environment than in other settings, where the costs of bad decisions can mount up quickly.

Reading between the lines, it appears that the London traders were pretty confident as to what the real game was, and it wasn’t following a strategy, but making money. That would be fine if this were a prop trading unit, but remember Dimon’s consistent claim: that this unit was hedging. As Michael Crimmins has discussed, that argument is bunk, since the failed position did not get hedge accounting treatment, meaning it was not closely enough related to any underlying position to be characterized as a hedge.

But why does that matter? It’s likely that a significant portion of the CIO’s activities were an accounting gimmick. Let’s remember why it was located in Treasury: it is the chief “investment” office, because it is managing the “investment” portfolio. Banks hold liquidity buffers so that they can meet a bank run. They get special accounting treatment on these positions. While they can sell them at any time, like trading inventories, they are NOT marked to market. Instead, they are kept in an “available for sale” portfolio, which is treated on a hold to maturity basis. That, in really crude terms, means you don’t need to recognize losses until they look pretty certain (usually, credit related).

So what does that mean, in practical terms? It means the CIO is the perfect prop trading/income smoothing vehicle. You can realize gains whenever you want to, by selling (provided the position is in a reasonably liquid market) or possibly even moving it over into your trading portfolio and you can defer most losses. If it makes a turkey trade, it can bury it until the bank has other trading gains or income in other businesses to offset it. And it can keep profitable positions around and realize them as needed to smooth earnings (while the unrealized losses are reported in footnotes, most investors don’t seem to pay much attention to that item). Investors really like smooth earnings, they mistake them for stability and strength of the business, as opposed to adept profit management. No wonder the people in the CIO were so well paid. They’d have to be Dimon’s favorite people.

And thus it makes perfect sense that the unit would not be that closely supervised by senior management. Dimon would need plausible deniability that he was abusing the investment portfolio (which he apparently did; there were questions raised about his use of the investment portfolio when he was CEO of Bank One). Even though it has been reported at $370 billion, which already seems a tad outsized, this is presumably the magnitude of the cash and securities positions. Who knows how much in derivatives trades are booked in addition to that.

So is the real secret of Dimon’s “fortress balance sheet” that he keeps overly large liquidity buffers so he can run a bigger, better prop trading business? It could well be, but I doubt any of the investigations underway will probe deeply enough to find out for sure.

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32 comments

  1. David Kaplan

    You hit the nail on the head. Plausible deniability. And yes, they were running a hedge fund with favorable accounting treatment.

    1. Richard Kline

      Yes, that was my conclusion from first report. But to highlight two additional facts Yves works in here: a) The balance sheet of the CIO at JippyMo is large for the stated function of that department. It doesn’t make sense that JPM would let money just sit there, but makes much sense that as much would be put there as possible if it was used for prop trading. b) Dimon had a prior history of using the same department in a suspicious fashion at another major bank. That reduces the likelihood that it was just a rogue department, if the Bank’s head officer to whom the unit in fact reported directly had a prior history of similar strange functions.

      The only thing I find odd is that the traders at CIO were taking such really weak positions. Complacency only explains so much here. It’s not as if the hazards with what positions the CIO traders were taking were tail-end or opaque; rather, those hazards blazed big red, and not just to others in house at JPM who had the figures on those positions but to the markets as a whole. I am coming to suspect that the CIO guys had already _lost substantial monies_ not long before, and cranked risk on in a neck-or-nothing bid to get back closer to black. That’s pretty typical of big bust out moves. It’s one thing for the dudes on desk to be insubordinate to orders to build down from superiors; that’s some combination of balls and stupidity, do your own calculations folks. But it’s another to go deaf because you’re already sitting on career-smashing loses.

      To me, this latter conjecture fits with the vague reports about just how much JPM has presently lost, and in what trades/positions/pseudo-hedges. The derivatives fail may be only $2-3B, but there may well be as much or much more from other in fact _earlier_ fat losses, unreported as such, which are now *cough* hard to explain and so kept out of view as much as possible. My larger point is that JippyMo’s CIO may have been making huge, bad bets well before this one got sniffed out by the FinPress, but JPM is still trying to keep as much of that activity out of view as possible. I don’t think we have anything like the whole story here. . . . Of course, if JippyMo was hiding large losses at CIO from well before this incident and NOT disclosing them, that’s ‘material,’ what?

      1. C

        Firstly, I agree with your analysis.

        Secondly, I love the name JippyMo, it perfectly captures just the right amount of flagrancy and their own flippant attitude towards internal controls and the public at large.

  2. TulsaTime

    WHOCOULDANODE,indeed! Just one more stray factoid illuminating the money club. We, the dirty rabble, will never understand, and certainly never participate, at the level of our financial demi-gods. It’s a long way down from that far up Jamie, and you enjoy that descent and sudden stop.

  3. Shutterbuggery

    ” if he takes a few lumps in the press and otherwise can carry on as before, what difference will it make to him”

    This is the essence of the problem isn’t it? In the absolute unlikeliest scenario — getting caught — If I break into a bank vault and rob it of $50 million dollars, get caught, get probation and a fine of $100,000 with no obligation to return the $49,900,000 I’ve got salted away, WHO CARES IF I GET CAUGHT. Its part of the cost of ‘doing business’.

    Its the scale of this racket people aren’t getting their heads around. Punishment must be swift and absolute — complete impoverishment for them and thier familes AND decades of jail time in Sing Sing — or these guys will continue to break the law and profit by it, whether or not they get caught.

    As for getting bad press, who is stupid enough to believe they give a crap about that?

  4. freedomny

    “Reading between the lines, it appears that the London traders were pretty confident as to what the real game was.”

    The real game is “ask for forgiveness…not for permission.” It’s an inherent part of JMP’s culture. Everyone knows it, and the powers that be close their eyes, after they “wink wink”.

  5. kxmoore

    Over the years limits on the big U.S. banks have been lifted under the guise of allowing them to compete with big foreign banks (mostly European). Well, we see how mega banks are working out in Europe. Break-up the big banks. All of this piddling regulation does is cement the status quo.

  6. Young Chang

    The hearing would be more entertaining if MSM ( CNBC/Bloomberg/CNN) displays the amount of take (pardon, contribution) the honorable panel member received from JPM (better yet, from TBTFs) while he is questioning Jamie. It will help us to put the question in context.

    1. bhikshuni

      That would make a great piece for Geithner’s Jon Stewart or a MoveOn cartoon:

      Show the DC farce actors with tally signs above their heads.

      Photo editing software will do the job nicely.

  7. Conscience of a Conservative

    As Francine Mckenna said, this was the last place one would expect this to occur. But the background is important.
    First, the Fed caps rates at zero. Second the tax payer bears a great deal of the credit risk at JP Morgan. So why should we be surprised?

    1. Yves Smith Post author

      I’m seeing if I can get Das to post on this, but this is a crock.

      First, no mention of derivatives, which are effectively senior to senior bonds. Second, it cheerily says the FDIC can void all cross default clauses. Um, only if they are governed by US law.

      Those two issues are kinda big problems.

      And did you notice the effort to make a $200 billion loss seem inconceivably big? Erm, the losses on Lehman, a smaller bank, without a monster derivatives clearing operation, were bigger than that, Nice try, though.

      1. vlade

        Even more ingenously, it compares the 200m loss while the scenario actually starts with 50m loss then triggering a bank run. Which makes it well within any of the numbers mentioned.

        They also claim “systemicaly important operations continue” – it’s far from clear that anyone would continue to use tri-party repo and clearing facilities unless they were immediately ringfenced and spun into separate, well capitalised company. Loss of these would, I speculate w/o looking at the balance sheet, have significant impact on profitability of the bank as whole, making the rest of the bank considerably less attractive to investors.

  8. stripes

    Fox news reporting…Senator Grassley says DOJ is in contempt for withholding documents about Op Fast and Furious. Hmmm….. Sen Cornyn insists AG Holder should resign. Obviously the whole Dept is corrupt and useless. No criminal prosecutions for any of the Wall Street crooks is criminal. Obama told the banksters he was the only thing standing between them and the pitchforks. He should have added himself and his buddies at the DOJ. They really believe people are this stupid…? There are also no lawyers in Obamas home state fighting the mortgage fraud. Where is the Congress and Senate on this massive cover up…? America is only a free country if you are rich. That is not right.

  9. Daniel de Paris

    Hi Yves,

    I’D REALLY LIKE YOU TO ADDRESS THE KEY ISSUE HERE. Not how those TBTB banks trade, but what is the use of trading in current times? Wha the hell this trading is bring to our countries.

    Anyone with a clue – including those who have “traded” – financial markets knows that trading activities are currently a negative impact on business and our countries.

    And not only from a moral standpoint. From an economic one, it is even clearer.

    What the hell are the currrent financial markets bringing to our countries? Price discovery? Advanced and solid funding for business when this one, the solid funding is missing? I fail to see the point.

    By the way, when litteraly tenths of millions of relatively smart people try to save their bucks til very late at night, trading from home instead of working hard and creatively on their real job, that activity becomes pathetic from a pure macro-economical POV…

    Trading financial instruments to-day holds more of the “assignat” trading during the late 90s in France (1790s by the way) than a noble advanced funding of the industrial and/or colonial operations of Britain during the nineteenth century.

    I understand that US liberal still cherish the activity of their financial marketplace, mostly requesting the partakers to be more heavily regulated.

    It is about time that this site starts to discriminate between markets and markets. Between the need for a decent financing of the economic activity and a casino setup.

    These current generation of financial markets are an absolute crap per se.

    They fails even the most basic of their initial motivations and should be rebuilt from scratch with a view to be a trading place for those who buy the stuff (the real one) and sell the stuff (the real one as well).

    One of your many right-wing listeners

    1. James

      Some good points, but those are hardly typical right wing points of view, at least not as currently conceived.

  10. timotheus

    Corker (R-TN) was previewing the softball treatment Dimon will get later today in the Senate by whining about how vewy, vewy hard it is for regulators to determine if a trade is a hedge or a bet. It’s all just SOOO complicated, we should leave the messy details to really smart guys in the banks. Don’t you agree, Mr Dimon, sir?

  11. stripes

    The Corporate Government show is on CNBC. Jamie Dimon discussing what he doodoos over at CHASE…..his words……with the corrupt politicians….his goombas…..All along the watchtower…the joker said to the thief…

    1. James

      When corruption becomes the new norm; hard work, honesty and integrity are seen as truly radical concepts. Maybe we’ll rediscover them one day, but the so-called “smart money” seems to be saying otherwise these days.

      1. stripes

        Sen. Sanders was awesome. He told Maria Bartoromo of CNBC that Wall Street are not the job creators and they are running a gambling casino on Wall Street…….may I add with the wealth of all of US.. Bernie said the rich need to pay more tax …Maria said what about all of US who pay no income tax….Bernie said the American people can’t afford to pay income tax…and besides that we pay tax everytime we buy gas..and may I add in Illinois…they tax our food and tax our tax on utility bills..etc..You tell em Bernie…!

  12. Gentlemutt

    Hi Yves. Nice piece. As a former trader, trading manager, and risk manager, etc, I can suggest one simple litmus test for whether the JPM crew were “hedging”: look at the memos they wrote their bosses each year just before bonuses were decided.

    Their brag sheets for performance reviews will tell us exactly what the traders were telling their bosses as they jockeyed for their share of the bonus pool.

    On a separate note, the dribble now coming out about the inadequacy of the failed-trader-brother-in-law cum senior Risk Mgr makes the mighty Dimon’s inherited fortress look all squishy inside, in a nepotistic sort of way.

    Cheers!

    1. monday1929

      Or, maybe just look at the amount of the bonuses. Why would “hedgers” get trader-like bonuses. Speaking of nepotism was fired years ago from a metals trading desk (for a totally fabricated reason, after years of an error-free operation) to allow for the hiring of someones cousin. Within three months some major losses ensued…….
      It marked the end of my romance with Wall Street and explains some of my bitterness towards these bastards.

      Now, I just buy Puts, and wait. And wait. And wait.
      The shame is that some of these people are pretty smart and could do something useful for society. But most at the Top are sociopaths.

  13. Guy Fawkes

    Just finished watching C-Span and quite a bit of public fellatio. Anyone else need a cigarette?

  14. Enraged

    Does it really matter when Japan and China (countries 2 and 3 in terms or economic power) will start trading directly in yen/yuan, starting July first and completely bypass the dollar?

    We are done. The mighty dollar is done. And the leaked treaty obama is concocting is allowing countries willing to risk setting shop here to play by their own rules and disregard our environmental, patent, labor, etc. laws?

    The dollar is done. The country is for sale. No, let me rephrase: the country is for grab. Dimon is almost insignificant in the big scheme of things. Whatever he does is just the tail of the comet. The whole thing has passed by us. We didn’t act, we didn’t seize the opportunity to right wrongs and… here is the result. better have more than one passport in thiese days and ages. Can come pretty handy…

    1. enouf

      Why would any amount of passports help when the Rule of Law has been ‘drowned in the Bathtub’?

      call me cynical ;-)

      Love

  15. stripes

    Too funny CNBC’ s Kudlow Report tonight showed a clip from Geithners CFR speech earlier today..There was a strange shadow cast on his face which made him look like he had a Hitler mustache. Proof enough for me that there are mysterious forces at work.

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