What JPMorgan's Recently Released Internal Reports Unintentionally Say
After apologizing at Davos - but only to his shareholders - according to William Cohan on the Bloomberg View, the JPMorgan Chairman and CEO hastened to add about 2012, “We did have record profits. Life goes on.”
It is true; JPMorgan reported a strong financial performance in 2012, “London Whale” trading fiasco notwithstanding. I must admit that despite my 18 years inside the firm (when it had a meager $300 billion balance sheet), I struggle to comprehend $100 billion of revenues, and a $2.3 trillion balance sheet, with an “off-balance sheet” managed by a few handfuls of mostly male, mostly thirty something traders that is many orders of magnitude larger. Maybe I’m a dinosaur. Life goes on.
Not so fast.
Two recently released JPMorgan internal reports on the causes of the $6 billion (and apparently still counting) trading losses in the Chief Investment Office (“CIO”) are quite revealing in two ways: first, for what they intend to say, and second, for what they unintentionally say to anyone paying attention.
Of course what is left unsaid has tremendous bearing on how our “life will go on” as well. The context of this trading fiasco – post Long-Term Capital Management (LTCM), post taxpayer bailout, post Dodd Frank, post Volcker Rule, post robo-signing, post foreclosure settlement, post Libor scandal, mid-money laundering scandal, mid-global “depression” - reveals the irreverent audacity of JPMorgan, in case there was any doubt. Also left unsaid is the self-evident conclusion that even the most “well managed” mega-bank is too big and complex to manage, govern, or regulate as bankers privately acknowledge to me all the time, and some, like Sandy Weill and John Reed, say publicly.
What the detailed reports intend to say is that 1) the Board acted properly, and in fact was given false and inadequate information, but nevertheless, can improve its (impossible) oversight function, 2) the CIO screwed up – conflicted mandate, fundamental incompetence, and capable of gross dishonesty when under pressure – perhaps even fraud, and 3) the firm’s risk controls were inadequate – people, limits, models, and communication. Over a hundred pages of details when juxtaposed against lessons learned from the 2008 financial crisis, as well as the 1998 LTCM crisis, makes sober reading for proponents of self-regulatory discipline and strong regulatory advocates alike.
The report also says a few things that, remarkably, didn’t even raise the pen of internal censure – that is how lost JPMorgan is in its own rationalization of its business practices. Most blatant, the Report of the Review Committee of the Board, in an apparent attempt to justify the activity by illuminating the pre-“London Whale” track record of the now defunct CIO (which thoughtful observers saw as an earnings smoothing prop desk speculating with tax payer insured deposits on an unprecedented scale in violation of at least the spirit of the Volcker Rule), states that:
The CIO’s “[t]actical credit strategies, which included both cash and derivative positions, had contributed approximately $2.8 billion in “economic value” from inception, with an average annualized return on equity of 100%.”
“Tactical credit strategies” that produced $2.8 billion in “economic value”, with no mention of the underlying positions it was designed to hedge, certainly can’t be confused with “hedging” – recall Dimon referred to the “London Whale” trade as a “hedge that morphed into a trade”. This revealing (fraudulent?) statement is an attempt to imply that Dimon’s (unique to the industry) CIO operation under his direct supervision created tremendous value as a profit center. Until it didn’t.
More telling, the report that undoubtedly received tremendous internal scrutiny before its release, says that this $2.8 billion in trading gains earned an average annualized return on equity of 100% since inception! No joke. Anyone think Warren Buffett would find it credible that Ina Drew and the crew that couldn’t shoot straight compounded returns on equity at an annualized 100%? Frightening really.
If you’re not afraid yet, footnote 74 of the Report casually mentions that a junior risk manager “had noticed that the notional exposures (of credit default insurance contracts) at CIO were very large, totaling about $10 trillion in each direction.” Think about that statement: The “Chief Investment Office”, set up by Dimon to manage excess deposits of a couple hundred billion dollars that should be prudently invested in low risk, liquid securities, and, to ostensibly hedge the “tail risk” of the firm’s $700 billion loan portfolio, had built up trading positions in credit default swaps amounting to $10 trillion…in each direction.
Any director qualified to genuinely govern JPMorgan (no easy feat) should have immediately demanded an independent review of the firm’s risk metrics – more on this below - and of its capital allocation methodology that generated the patently false 100% return on equity calculation when it was first presented to the Board back in 2010. Without a satisfactory explanation (like perhaps, “it sounds crazy, but we monetize in part our too big to fail subsidy in this book”), such an implausible claim should have been seen as a flashing red warning signal for the $6 billion disaster it would become – "if it sounds too good to be true" – and grounds for an immediate termination of duties.
The second revealing message the report conveys without intending to is that despite the lessons learned from the LTCM failure, the three industry led comprehensive “post mortem” reports on that crisis, and from the subsequent financial meltdown of 2008 – all of which point to an over-reliance on Value at Risk (VAR) metrics as a root cause of the systemic crises - JPMorgan was apparently using and no doubt continues to use VAR models as its primary risk metric across the entire firm, including the non-linear risk of credit default swaps that VAR can't measure. The report also makes it clear that traders game the models to generate the outcomes they want, but that is not news to anyone familiar with modern Wall Street’s culture.
The unspoken reason firms like JPMorgan continue to use VAR metrics despite fully understanding their shortcomings is because to use robust stress-test based capital at risk models (like any sophisticated hedge fund that operates in the real free market uses) leads to the conclusion that many trading businesses do not generate adequate returns on properly accounted for risk capital (much less the patently absurd 100% returns on equity claimed by JPMorgan’s CIO). And that means no casino finance underwritten by taxpayers, and of course no obscene bonuses for clever fools.
The transparent discussion of VAR models in the Report seems oblivious to the reality that their very use as the primary risk metric for managing firm-wide risk, when combined with the banker lobbies doing their work to undermine tougher capital and liquidity requirements for “systemically important financial institutions,” virtually ensures more crises to come that will require tax payer bailouts. This revelation should send “we the people,” saddled with the crushing debt overhang from the prior recession, into the streets. That regulators condone the continued use of these models and get pushed around on tougher capital and liquidity limits can only mean one thing: they have concluded that it’s simply too dangerous to the system to reveal that the emperor has no clothes.
But all is not lost. In an unlikely alliance in our dysfunctional Congress, Senator Sherrod Brown, Democrat from Ohio and Senator David Vitter, Republican from Louisiana are on the case behind the scenes in what could emerge as financial reform 2.0, including perhaps even a move to break up the big banks.
And life goes on.