The exact details of the loss-making trades transacted by the London unit of J.P. Morgan’s chief investment office (CIO) are unclear, but the consequences for the bank’s senior management should be devastating.
Yet, it is curious that Jamie Dimon, the bank’s chief executive, has so far largely managed to escape the opprobrium that other bosses have received in recent years after their banks’ commercial failures. As a highly prominent advocate for the banking industry’s campaign against what it perceives as excessive regulation, perhaps there is too much at stake to allow the vultures to circle.
A vigorous acknowledgment of errors of judgment, strategy and scrutiny, with allusions to the vast profits the bank is also generating, may be enough to limit the damage. Repentant, but unbowed, Dimon must believe that he and his bank can put the blunder behind them and march confidently forward.
However, it is impossible to ignore just how vital effective risk management is to the Dimon regime at J.P. Morgan, and the credibility of his PR machine.
Last October, Richard Raiford, the bank’s Asia-Pacific head of credit risk management, told FinanceAsia that one of the most important developments since Dimon’s arrival in 2004 had been the inculcation of positive attitudes towards risk assessment, control and management throughout the firm, reinforced by training programmes.
“Experienced personnel exercising good judgment, guided by clear procedures, is perhaps the critical feature of effective risk management,” said Raiford. And the tone and behaviour are set at the top.
This message is hard to reconcile with the reported activities of the CIO in London.
The type of trades executed seem to have been speculative, directional punts — the type of proprietary trading activity that the Volcker rule within the Dodd-Frank Act is meant to prohibit — rather than a hedging strategy. It is also unlikely that they were an aberration. Bruno Iksil, nicknamed Voldemort, the villain in the Harry Potter novels, or the London Whale, and his colleagues in the division are highly-paid traders, not risk-mangers performing a middle office function.
Overnight, there were press reports that the FBI and the US Department of Justice are examining whether there was any criminal wrongdoing involved.
Ever since last Thursday, when Dimon came clean about the $2 billion (and climbing) mark-to-market loss, at least one contributor has been identified. It could not be hidden, because other market participants were very much aware of the bank’s exposure, and had been for several weeks. They had reacted by taking opposite bets, squeezing J.P. Morgan’s short position in a synthetic credit derivatives index that referenced the debt of 125 leading US investment grade companies.
The CIO’s position represented a positive view about US corporate credit risk. Selling credit default swap (CDS) protection, or insurance, would turn out profitable if the value of the contract fell as expectations of corporate bond defaults declined while earnings and hence interest cover improved along with general investor sentiment. Instead, the price of the contract rose as hedge funds and other traders moved against J.P. Morgan’s bullish stance.
It is hard to see, at this stage, how that position could be part of a hedging strategy. In its most basic sense, a hedge is meant to offset a bank’s underlying exposure to the markets. Instead, this trade looks more like a leveraging of J.P Morgan’s already vast exposure to corporate credit, through its loan book and its holdings of corporate bonds.
There have been suggestions too that the bank’s portfolio of excess deposits to invest had doubled from $150 billion to $300 billion after J.P. Morgan bought Washington Mutual during the financial crisis, forcing the CIO to buy securities outright. In addition, The Wall Street Journal reported that at the end of the first quarter the bank had total deposits of $1.12 trillion and net loans of around $700 billion, and most of the surplus would have been invested in debt securities.
If that’s the case, then the defence that its position in the CDS index was a hedge is even less plausible. Surely, it is quite the opposite: more exposure, increased leverage.
And why, if the bank was sanguine about the outlook for corporate credit, didn’t it simply use those excess deposits to provide loans to companies that are struggling to survive or to those with spending plans that could boost sluggish economies throughout the world and create jobs?
Perhaps that’s a naive and unsophisticated question. Clearly, there are greater potential profits to be made gambling in the derivatives markets and, of course, bigger bonuses for traders too.
Equally unconvincing is the reason the bank declines to provide details about its failed trading strategy. By now most serious rivals in the market will be pretty sure about the extent and location of its positions, and are likely to tighten the squeeze further.
So far, Dimon’s response, after initially dismissing reports last month of Iksil’s trades as “a complete tempest in a teapot”, has been a robust mea culpa, while refusing to be drawn on specifics. “The strategy was badly executed, badly monitored,” he said in an investor call last week.
“We made a terrible, egregious mistake. There is almost no excuse for it,” he told NBC’s Meet the Press at the weekend. “In hindsight we took far too much risk, the strategy was barely vetted, it was barely monitored. It should never have happened.”
This frank admission of failure and apparent refusal, so far, to offer up excuses has been praised, but any other response would have been widely ridiculed. Dimon, of course, has been in the vanguard of bankers lobbying for a dilution of the regulatory regimes put in place since the 2008 crisis and, in particular, the restrictions on proprietary trading. As a spectacular instance of schadenfreude, the revelation of the activities at the CIO is almost too obvious for the pundits that Dimon has derided in the past to dwell on.
Heads are set to roll. In addition to the departure of Ina Drew, head of the CIO and a member of the bank’s operating committee, the jobs of Iksil and his London boss Achilles Macris are reportedly under threat.
Yet Dimon’s position seems strangely secure. After all, he has taken the plaudits for his relatively successful stewardship of J.P. Morgan through the dark period following the collapse of Bear Stearns and Lehman Brothers, and for his foresight in reducing exposure to the type of credit derivatives that his bank had been so instrumental in inventing.
He could speak with authority to legislators and regulators, because he could show them a vast, universal bank that could operate successfully, yet prudently, without being burdened by intrusive rules and restrictions. That high ground has clearly been lost.
Transparency of activities, attention to detail, leadership and standards are set from the top, Raiford told FinanceAsia. There is a consistency of message, such that no one questions the primacy of risk control anymore. Whereas in the past risk management was perhaps a support function, now it sits at the top table, he said.
And at the head of the table is Dimon. Surely he must take full responsibility and act accordingly.