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.