Via e-mail, some updates from Michael Crimmins, a bank compliance expert and member of Occupy the SEC, on the continuing failure of the media to portray the real significance of the JP Morgan London Whale losses: that it revealed glaring deficiencies in internal controls that warrant prosecution of Jamie Dimon under Sarbanes Oxley (SOX). This section of a July post by Crimmins explains why the London Whale control failures are serious. JP Morgan’s kid gloves treatment by the press shows it pays to be a major advertiser:
JP Morgan’s jawdropping revelations in its Friday earnings call don’t seem to be attracting the attention they deserve. The market may have shrugged off the size of the losses and the corporate governance modifications plans, but the announcement opens the door wide for the next phase of this scandal. The biggest question is whether Jamie Dimon should keep his job.
The first stunner, that JP Morgan was restating the first quarter financials, should have caused a deafening ringing of alarm bells. For a company of JP Morgan’s stature to be compelled to restate prior period financials is a very clear signal of bigger problems with their overall financial reporting. In isolation we would normally expect to see a massive selloff with an event of that seriousness. Analysts and reporters may have missed the significance since it was dropped into a footnote and overshadowed by the other disclosures.
Add in the magnitude of the restatement which increased the CIO losses by a massive 90% over the previously reported losses and you’d expect to see further panic. The original 1Q12 results included a loss of $718 million. The restated results added another $660 million , bringing the total first quarter loss to $1.4 billion.
But the real cause for alarm is the reason for the restatement. JPM was forced to disclose that it relied on its traders to provide honest and accurate valuations for its financial statement disclosures. That’s like putting the foxes in charge of not just the henhouse, but the entire farm. Much to its chagrin that was a costly choice. Note that was not a mistake, but a conscious choice.
That Stone Age policy has been extinct for a generation at every financial institution that signs a SOX internal controls certification. Oops, I’m wrong there. AIG relied on their trader marks too, but their external auditors finally had had enough and forced them to disclose ‘material weaknesses’ in internal controls. The stock dropped like a stone with that revelation.
Every firm that I’ve worked at has an independent valuation unit that resides outside the business unit. In JP Morgan’s case it seems that unit reported to the business, which is a serious deviation from good practice. (There is a remarkable new story up at Bloomberg which has former JP Morgan executives acting as if there was nothing amiss about having traders mark their own positions or having the valuation unit for the CIO sit within the CIO. This is in fact a troubling sign about the acceptance at senior level in JP Morgan of deficient controls as “normal”). History has shown that staffers preparing the valuation will be subject to pressure from the unit leaders, particularly if the business has losses that the producers hope can be reversed. Additionally, most major trading operations have a valuation committee that includes the corporate CFO to challenge (and memorialize the analysis of) the valuations and the valuation process. The activity of this committee is generally reviewed by (and in many cases attended by) the external auditors, especially since the beginning of the crisis.
It appears that JPM is attempting to make the case that rogue traders, with criminal intent, mismarked the books. That may be so and relevant criminal charges against those traders should be pursued. But that strategy does not protect management. If there was mismarking, especially to the extent that occurred here, it is the responsibility of management to know or have procedures in place to alert them to the potential for fraud.
Yves here. Crimmins prediction, that JP Morgan would try to blame traders for the position marks, has proven to be correct. Tonight, the lead story in the New York Times business section is “At JPMorgan, an Inquiry Built on Tapes,” with this as the summary:
Investigators examining a multibillion-dollar trading loss at JPMorgan Chase are focusing on calls in which employees openly discussed how to value troubled bets in a favorable way.
So the press is taking the JP Morgan party line that that exculpates management, when it doesn’t, particularly when JP Morgan’s practice was so radically out of line with industry norms. As Crimmins writes:
Sorkin’s team is doing their job managing JP Morgan’s PR hoping to minimize the threat to Dimon as the bank’s third quarter earnings announcement approaches Friday.
I expect JP Morgan will have to disclose the progress of its own internal investigation, and summarize the civil and crimminal investigations underway. It will also be interesting to see what the external auditors have to say. The full court PR press beginning with the New York Times Ina Drew story last week, followed by the toss of chief risk officer Barry Zubrow under the bus is looking like a desperate media offensive. I’m expecting the Friday news will not fit that narrative. We’ll see.
JP Morgan hopes the fiasco will be blamed on those rouge mis-marking traders. Me too since it violates Control 101 and keeps Jamie on the hook. Sacrificing Zubrow shouldn’t be enough. The Times story follows the party line that the traders worked in isolation, hence senior management is off the hook:
The scope of the inquiry suggests that the problems were isolated to a handful of executives and traders in an overseas division, and did not reflect a fundamental weakness with the bank’s culture and leadership. The investigation does not appear to touch the upper echelons of the executive suite, notably Ina Drew who oversaw the chief investment office. The findings could insulate JPMorgan and its chief executive, Jamie Dimon, from further fallout.
But that’s not how it works. Management is responsible for the integrity of controls and they were inexcusably lax and were directly responsible for the losses. And so we also see:
JP Morgan is also under investigation by civil regulators, including the Securities and Exchange Commission, which is examining whether the bank misled investors about the severity of the losses. British authorities have also recently opened inquiries into the matter, according to the officials.
Jamie is getting increasingly cocky and unhinged, i.e., allying with Blankfein to lobby for a lame duck fiscal cliff solution, the day before Schumer cuts that effort off at the knees.
And in today’s appearance at the Council on Foreign Relations he reiterated that mistakes were made and that he is fully responsible. That blatant admission (again) shows he’s pretty confident that he’s immune from any SOX threat. But that’s an unnecessary, hubristic risk to take before this matter has been put to bed.
One of these days, Dimon’s lack of caution will catch up with him. He’s probably right that it won’t be the London Whale, but this was a closer call than he seems to realize, and there is also no sign that he’s correcting the underlying risk control deficiencies ex reinstating the older, more conservative Value at Risk model, when we suspect the higher risk levels allowed in the later version were no accident. Inability to learn from your mistakes is a serious flaw, particularly at Dimon’s level.