In the end, what have we learned from JPMorgan Chase & Co.’s $7.1 billion “London Whale” trading debacle? For those who have lost track, the derivatives trades resulted in losses of $6.2 billion plus an additional $920 million in fines -- so far.
First, we learned that Jamie Dimon, the onetime king of Wall Street, was wrong to describe it as a “tempest in a teapot.” Then we learned that inside the bank there was (still is?) a culture of paranoia and secrecy that encouraged traders to hide their mushrooming losses.
The list goes on. We learned that it’s possible to make a $237 million mistake in a spreadsheet. We learned that the bank’s managers failed to disclose, in a timely manner, material information about the extent of the growing losses to the board’s audit committee -- a panel that included Ellen Futter, my sister-in-law, who has since left the board. We learned that the Securities and Exchange Commission is showing a bit more backbone than usual by insisting -- shocking! -- on JPMorgan actually admitting to wrongdoing.
But mostly we have learned that the whole system of allowing traders to mark the value of complex transactions on their books is deeply flawed. It was also a recipe for the disaster that became the London Whale.
As I have documented in my two books about the financial crisis, discrepancies in the prices of hard-to-value securities led to the demise of two Bear Stearns Cos. hedge funds in mid-2007. That led to the March 2008 sale of Bear Stearns to JPMorgan for a pittance, thanks to a $30 billion assist from taxpayers.
Price discrepancies in the value of these same types of squirrelly securities led to massive collateral disputes between Goldman Sachs Group Inc. -- which proved to be spot-on in its valuations -- and American International Group Inc., whose London-based unit foolishly insured much of the risk in the global market for mortgage securities. The collateral disputes led, in part, to the $185 billion taxpayer bailout of AIG in September 2008.
It is clear from the 35-page cease-and-desist order the SEC got JPMorgan to sign that, once again, the problem of improperly marking the value of trades has caused a huge and quite well-hidden -- at least temporarily -- trading loss. Generally accepted accounting principles and the bank’s internal accounting policies, the SEC order says, required trades to be marked “within the bid-ask spread” at the point that is “most representative of fair value in the circumstances,” and at the price “where the traders could reasonably expect to transact.” The idea that a security should be priced “where the traders could reasonably expect to transact” is the mantra of the senior executives and risk managers at Goldman Sachs, which has repeatedly shown the world it knows a thing or two about how to value its trading books.
The same discipline didn’t exist at JPMorgan. As the order reveals, the bank’s traders had every incentive to mismark their books to hide their losses.
Beginning in March 2012, the most senior trader managing what the bank called its synthetic credit portfolio urged other traders in his London group “to stop reporting losses” to group management “unless there was a market-moving event that could easily explain the losses.” After that instruction, a junior trader “began to assign marks that often were at the most aggressive point in the bid-offer spread received that day (i.e., the point that resulted in higher valuations of the SCP positions),” according to the SEC order. “As a result of these marking practices, the SCP traders intentionally understated mark-to-market losses in the SCP.”
Boy, did they. By the third week of March 2012, the discrepancy had reached $432 million. The traders, however, revealed significantly smaller losses in daily reports to management. A one-day, $250 million loss on March 30 was reported as $138 million.
This practice continued until April 29, after counterparties to the SCP trades had made collateral calls to the bank totaling $520 million -- a serious red flag -- and the responsibility for determining the value of the trades was taken away from the London unit and given to the investment-banking group, which concluded that the London traders had covered up a loss of more than $1 billion.
The cease-and-desist order says the bank has revised its valuation policies. As Goldman Sachs has done for years, JPMorgan will now obtain its valuations from multiple third parties rather than rely solely on its own traders. There is also a new protocol for reporting disputes to top executives. Why it took a $6.2 billion trading loss to incorporate basic risk-control mechanisms remains a mystery.
The only good news is that because JPMorgan is so big and profitable -- it is, after all, a charter member of the post-2008 Wall Street cartel -- the bank was able to absorb these losses and move on with only its reputation sullied.
Which brings me to ask: Who takes it on the chin for the $6.2 billion in losses plus the $920 million in fines? Shareholders? Insurance companies? Depositors? It certainly won’t be the people responsible for making them -- the unnamed “Senior Management” of the bank, as the SEC order refers to them.
Until names are named and years of bonuses clawed back, there will be no genuine accountability for bad behavior on Wall Street.
(William D. Cohan, the author of “Money and Power: How Goldman Sachs Came to Rule the World,” is a Bloomberg View columnist. He was formerly an investment banker at Lazard Freres & Co., Merrill Lynch and JPMorgan Chase, against which he lost an arbitration case over his dismissal. He is now involved in litigation with JPMorgan.)
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