JP Morgan and The London Whale

Case Overview

In 2012, the media released the story of the London Whale. Two traders had used an atypical trading strategy which greatly increased the size and risk of the portfolio they were handling. This trading strategy was later described as flawed, complex, poorly reviewed, poorly executed, and poorly monitored, by the groups CEO. More than US$2 billion of mark-to-market losses in relation to these trades were reported. But who was to blame? The risk committee which was responsible for monitoring the entire companys transactions, the regulator the Office of the Comptroller of the Currency, or the management of JP Morgan? A Task Force was set up to investigate these losses. The objective of this case is to allow for a discussion of how JP Morgan handled this case and issues such as how the various stakeholders could have played a part in preventing the massive loss.

Company Profile

JP Morgan Chase & Co. (NYSE: JPM) is a leading global financial services firm and one of the largest banking institutions in the United States. It began as JP Morgan & Co., a commercial bank founded in New York in 1871. A series of mergers and acquisitions subsequently led to the formation of JP Morgan Chase today.

JP Morgan Chases businesses are organized into six major segments Investment Banking; Retail Financial Services; Card Services and auto; Commercial Banking; Treasury and securities Services and Asset Management; as well as a Corporate/ Private Equity segment which comprises Private Equity, Treasury, the Chief Investment Office (CIO), and corporate staff units and expense functions that is centrally managed.

The CIO was spun off as a separate unit within the bank in 2005. The primary responsibility of the CIO is to invest the banks excess deposits and to hedge trading risk in other parts of the bank. Ina Drew served as the banks Chief Investment Officer from 2005 to May 2012. In 2007, CIO launched the Synthetic Credit Portfolio (SCP), which sought to provide protection against credit risk and adverse credit default events in the market.

How the Scandal Unraveled

The head of credit trading of CIO, Javier Martin-Artajo, and the credit derivatives trader Bruno Iksil, generated billions in profits on a portfolio that featured bets on certain corporate credit indices from 2007 to 2014. They were instructed by executives to reduce Risk Weighted Assets (RWA) in late 2011. Rather than dispose of the high-risk assets in the SCP, which is the typical action taken by CIO, they purchased additional long credit derivatives to offset its short derivative positions in January 2012. This trading strategy eventually increased the portfolios size, risk and RWA, as well as eliminated the hedging protections.

Despite the fact that the SCPs derivative holdings were increased, the portfolio was losing value. Hedge fund insider, Boaz Weinstein of Saba Capital Management, found that the market in credit default swaps was probably being affected by aggressive activities in February 2012. Ina Drew suspended trading in the portfolio on 23 March 2012.

In early April, the media broke the story of the London Whale and unmasked JP Morgan Chases CIO as the entity behind the large positions in the market. The market for the credit derivatives in the SCP was small and had limited players; thus CIOs large positions and trades became very visible. According to CIOs analyses, the SCP was generally balanced, the market was dislocated, and mark-to-market losses were temporary and manageable. JP Morgan Chases Group Chief Executive Officer (CEO), Jamie Dimon, agreed that the publicity surrounding the SCP was a tempest in a teapot and the Chief Financial Officer (CFO), Douglas Braunstein, stated that the firm was very comfortable with its positions in a 13 April analyst call.

When losses continued to increase after the analyst call, non-CIO personnel were directed to review and take control of the SCP in late April. It was then revealed that the portfolios exposure was much greater than previously reported by the CIO and the markets knowledge of the CIOs positions would make it even more difficult to reduce losses and close out their positions. A review of the valuation of positions in the SCP concluded in consultation with PwC that the SCP complied with U.S. Generally Accepted Accounting Principles (GAAP).

On 10 May 2012, Dimon disclosed that the trading strategy for the SCP was flawed, complex, poorly reviewed, poorly executed, and poorly monitored. More than US$2 billion of mark-to-market losses in relation to these trades were reported. A Task Force was formed shortly after 10 May to investigate these losses.

JP Morgan Chase stated that it was no longer confident that the 31 March valuations reflected good-faith estimates of the fair value of all the instruments in the SCP after consulting with PwC for the second time. Cumulative losses of US$5.8 billion and a restatement of first quarter net income (a downward adjustment of US$459 million) were announced on 13 July 11.

Mismarking of Derivative Valuations (Internal Control)

Corporations that own derivatives, such as those held in JP Morgans SCP, are required to determine their fair values at the end of each day in accordance with U.S. GAAP. However, GAAP allows some subjective judgment in determining what prices are most representative of fair values. While most entities use the midpoint price of the daily range (bid-ask spread) as their valuations, or marks, CIO began to deviate from this policy in the later part of the first quarter of 2012 to hide fair value losses on the credit derivatives in its SCP.

The traders managing the SCP were themselves in charge of providing the daily accounting valuations, based on the marks they had chosen to use. Julien Grout, a junior trader on the SCP team, would then send out a daily communication to key CIO personnel on the profit-and-loss performance of the portfolio as per bank practice. In order to show a more favorable picture by hiding some of the unrealized losses, the traders began using marks that differed from the midpoint.

For five days in the middle of March, Grout began recording on an internal spreadsheet the difference between the values they were reporting to the bank and the midpoint valuations. On 16 March, this difference representing unreported losses reached US$300 million, and Grout later stated that it could grow to US$1 billion by the end of the month. These differences would only begin to significantly reverse toward the end of the first quarter, as the traders decided to report larger and larger losses by reporting valuations closer to the midpoint, gaining significant attention from senior management.

Under U.S. regulations, banks were required to have an internal process to verify the accuracy of asset values reported. In JP Morgan, the CIOs Valuation Control Group (VCG), which reported directly to the CFO of CIO, fulfilled this requirement by conducting a review at the end of each month, which included a check on the derivative valuations in the SCP by using data from independent pricing services, actual transactions and market quotes. In the month-end reviews during the first quarter of 2012, VCG approved CIOs valuations for the SCP as the banks policy allowed some degree of subjective judgement, and also because the marks used were still within the bid-ask spread and the range set by the oversight group. Thus, no requests were made for the SCP traders to cease using their own favorable estimates or to revert to the midpoint valuations from these reviews. The CIO would only do so when ordered to in May, arising from the discovery in March that the Investment Bank, a separate line of business in JP Morgan, was assigning different values for the very same credit derivatives also held by CIO.

Breaches of Risk Limits (Risk Management)

In relation to its trades, the CIO used five different risk metrics to monitor its risk exposure the Value-at-Risk (VaR) limit, Credit Spread Widening 01 (CS01) limit, Credit Spread Widening 10% (CSW10%) limit, stress loss limits, and stop loss advisories. From January to April 2012, all of these limits were breached more than 330 times in total.

Under the firms policy, breaches of these limits had to be reported to their respective signatories, as well as the CIO Risk Committee, and the Market Risk Committee or Business Control Committee. When a breach occurs, the business unit must take immediate steps to reduce its exposure so as to be within the limit, unless a one-off approval is granted. The one-off approval represents a temporary allowable increase of the relevant limit. The Value-at-Risk (VaR) of the SCP was an estimate of the maximum daily mark-to-market loss. As early as January 2012, the VaR had already begun to exceed its limits. In response, Jamie Dimon and John Hogan, the CEO and Chief Risk Officer (CRO) of JP Morgan respectively, approved exactly such a one-off increase from US$125 million to US$140 million until the end of January.

At that time, CIO then implemented a new VaR model which instantly reduced the VaR by close to half the previous amount, thus allowing it to end the limit breach via new calculation methodology. Subsequently on 10 May, the bank reverted back to the old model, with CEO Jamie Dimon announcing that the new model it had adopted was inadequate in portraying risk.

The Company later admitted during the Senate inquiry that the new model was rushed through internal approval the Model Review Group (MRG) of the bank had found problems with the new model and requested action plans to resolve the issues. However, these were never completed.

The continuing increase in the size of the portfolio also led to breaches in the other metrics, as the large position taken by CIO meant that small variations could translate to larger losses in the SCP. These breaches were apparently ignored by management or handled by having their limits raised.

Discussion Questions

1. What are the key corporate governance issues with JP Morgan? What can be done to improve the risk management and internal control in JP Morgan?

2. Evaluate how JP Morgan communicated with stakeholders following the trading scandal.

3. What should be the role of government in regulating financial institutions?

4. Should the non-executive and independent directors be held accountable for the trading losses in JP Morgans CIO? On hindsight, if you were one of the directors on the Board, what would you have done before the scandal was made public in May 2012?

5. The tone at the top significantly influences a companys corporate governance. To what extent is this related to the trading losses suffered by JP Morgan? Explain. 6. The breach in the regulations could have potentially been avoided. If you were the trader, what would you have done? How do you think a whistleblowing policy may help prevent this?

6. The breach in the regulations could have potentially been avoided. If you were the trader, what would you have done? How do you think a whistleblowing policy may help prevent this?