JP Morgan and The London Whale

Case Overview

In 2012, 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 group's 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 company's 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 Chase's businesses are organised into six major segments - Investment Banking; Retail Financial Services; Card Services & Auto; Commercial Banking; Treasury & 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 bank's excess deposits and to hedge trading risk in other parts of the bank. Ina Drew served as the bank's 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 portfolio's size, risk and RWA, as well as eliminated the hedging protections.

Despite the fact that the SCP's 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 Chase's 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 CIO's large positions and trades became very visible. According to CIO's analyses, the SCP was generally "balanced", the market was dislocated, and mark-to-market losses were temporary and manageable. JP Morgan Chase's 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 portfolio's exposure was much greater than previously reported by the CIO and the market's knowledge of the CIO's 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 Morgan's 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 judgement 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 favourable picture by hiding some of the unrealised 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 CIO's 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 CIO's valuations for the SCP as the bank's 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 favourable 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 firm's 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.

CIO Risk Committee

Prior to the first quarter of 2012, the CIO risk committee was subjected to less scrutiny than other critical lines of business and this resulted in weak risk controls and pervasive infrastructures that performed ineffectively within CIO. In addition, the committee itself was understaffed. This was made worse when the risk function of the firm did not place any emphasis on hiring more risk personnel for CIO. Even if the risk personnel were hired, they were seemingly more accountable to the CIO management, instead of the firm's risk function. As such, some of the risk managers did not feel independent enough from the business operations of CIO to criticise the trading strategies used. In essence, no meaningful checks could be done on the activities of CIO.

Other than the fact that the Committee only met three times in 2011, the composition of the attendees was poor, as it mainly involved only key members of CIO. As such, along with its passiveness, the committee could not update the risk structure and risk limits for CIO in time. As the SCP increased in size and complexity, these inherent weaknesses in CIO's risk management became more critical. The threats posed by these weaknesses, such as permitting the pursuance of risky trading strategies, grew in significance with the size and complexity of the SCP.

Even though a new CRO, Mr Goldman, was hired for the CIO in January 2012 to build risk controls and to improve practices, it was all too late to develop structures that may curtail the losses in CIO. Furthermore, he lacked sufficient experience in risk management.

Risk Committee

Unlike the other largest U.S. lenders, the risk committee of JP Morgan lacked directors with the relevant banking and financial risk management experience. The only one with the requisite experience had not been employed in the industry for more than 25 years. Despite the severe lack of relevant financial risk management experience, the composition of the risk committee had not changed since 2008. The committee that was headed by James Crown, with members Ellen Futter and David Cote, was also relatively small.

The severe lack of Wall Street experience made it almost impossible for the committee to pose critical questions to the CIO CRO to eliminate any potential risks in the trading strategy. Having met for only seven times in 2011, coupled with the lack of relevant experience, the committee simply gave the bank's risk-appetite policy the green light.

Other Controls, Oversight Committees And BOD

As with the case of the CIO risk committee, the CIO VCG faced operational shortcomings in its reviews that were accentuated as the SCP grew in size and complexity. At the time, they were also under criticism from JP Morgan's internal audit group relating to issues of inadequate price and valuation testing. Within the firm, there was no practice of circulating daily trading activity reports, which would

have allowed for easier detection of issues. In particular, the CFO should have noted the significant financial risks that resulted from the firm's lack of control over traders.

Furthermore, the process of approving and implementing the new VaR model was haphazard. The CEO, Jamie Dimon, appeared to have provided an approval in writing without much thought, as he would later testify that he could barely recall giving the approval. Consumed by the idea that the operational and risk infrastructures were robust, reviews carried out by the Model Review Group that uncovered operational and mathematical problems with the new model were largely ignored, with no corrective actions taken before implementing the model in late January.

Office of The Comptroller of The Currency

A key regulator for JP Morgan Chase is the Office of the Comptroller of the Currency (OCC), whose primary mission is to charter, regulate, and supervise all national banks and federal savings associations. Prior to the media reports of the "London Whale" trades in April 2012, almost no information regarding the SCP was disclosed to OCC. The lack of disclosure provided by JP Morgan precluded effective OCC oversight and hence, no reviews were conducted on the SCP prior to 2012. However, there were red flags which signaled the increasing risk taken up by the CIO. In 2011, the bank had filed risk reports with OCC, which disclosed that the CIO had repeatedly breached its stress limits in the first half of 2011. This should have warranted attention and follow-up from the OCC. However, the OCC did not take further action. Furthermore in 2012, the CIO took up a US$1 billion high risk derivative bet, which resulted in a US$400 million gain to the CIO. The OCC was aware of the US$400 million gain, but had failed to enquire on the reason and the extent of the trade going on at the CIO.

The role of SCP was further downplayed in January 2012. The CIO misinformed the OCC claiming that it will decrease the notional size of the SCP. However, the notional size of the SCP was tripled over the course of the quarter instead. Furthermore, in the following months, JP Morgan began to omit key CIO performance data from its reports to the OCC. The OCC did not notice the missing reports and did not request for a new CIO management report from JP Morgan. In addition, various VaR breaches were disclosed in JP Morgan's risk reports to the OCC. However, the OCC did not review the reports or question the trading activities which resulted in the breaches to occur. Following the media reports on the "London Whale" trades, the OCC subsequently conducted a review on its own missteps. In October 2012, the OCC released an internal report that concluded that they had failed to monitor and investigate multiple risk limit breaches by the CIO and improperly allowed JP Morgan to submit aggregated portfolio performance data that concealed the CIO's involvement in high-risk trading activities.

Implications on The Volcker Rule

The Volcker Rule, introduced as part of Dodd-Frank Wall Street Reform and Consumer Protection Act, "is intended to reduce bank risk by prohibiting high risk proprietary trading activities by federally insured banks, their affiliates, and subsidiaries". However, the Volcker Rule allows hedging activities to continue.

On 13 April 2012, CEO Jamie Dimon dismissed the media reports about the SCP as "a tempest in a teapot". In addition, JP Morgan Chase Chief Financial Officer Douglas Braunstein reassured investors, analysts, and the public that the SCP's trading activities were made on a long-term basis, transparent to regulators, had been approved by the bank's risk managers, and served a hedging function that lowered risk and would ultimately be permitted under the Volcker Rule whose regulations were still being developed.

However, on the day prior to the earnings call, Ina Drew wrote to Mr Braunstein, stating that "the language in Volcker is unclear," a statement that presumably refers to the fact that the implementing regulation was then and still is under development. In addition, the bank had earlier written to regulators expressing concern that the SCP's derivatives trading would be "prohibited" by the Volcker Rule.

Misstatements and omissions about the SCP's transparency to regulators, the long-term nature of its decision-making, its VaR totals, its role as a risk-mitigating hedge, and its supposed consistency with the Volcker Rule, misinformed investors, regulators and the public about the nature, activities, and riskiness of the CIO's credit derivatives during the first quarter of 2012.

Impact on JP Morgan Stock Price

The announcement of the trading losses on 11 May 2012 sent the stock price down by more than 9% (US$40.74 to US$36.96). It also prompted a law firm, Finkelstein Thompson LLP, to investigate claims on behalf of the shareholders of JP Morgan's with regards to the losses. By 4 June 2012, JP Morgan's share price had dropped by 33% from its high of US$46.27 set on March 28 2012 to US$31.0037. On the following day, 5 June 2012, it was reported that the U.S. regulators would be reviewing the possibility of clawbacks from the staff involved in the trading losses. Investors were largely supportive of this as they took the view that it would help cover a portion of the losses, sending the stock up slightly over 3%. On 13 July 2012, at the same time second quarter earnings were reported, JP Morgan restated its 2012 first quarter earnings and announced to the public that the problems reported in the media had been fixed. Investors, upon receiving the information, were happy that measures had been taken to avoid further losses and this brought about a 6% increase in its share price during its day trade. Following the announcement of the results for the second quarter, the stock price of JP Morgan had been back on the rise again, rising back to the pre-11 May level by mid-September and back to its 28 March-high in early January of 2013.

In the Wake Of The Whale: Aftermath And Post-Developments

Since the trading scandal was exposed, changes have been seen in the management at CIO. Ina Drew, Chief Investment Officer, stepped down and retired from her position and also voluntarily returned two years of her compensation to the company. Several other CIO personnel, including Martin-Artajo, Iksil and Grout, saw their employment terminated as well.

Following the announcement of the trading losses in May 2012, several official inquiries have been set in motion to examine the factors that led to such events. JP Morgan set up a task force to examine the errors and proposed measures to prevent a repeat of the events. The U.S. Senate also publicly investigated the issue, subpoenaing internal evidence and key personnel from the bank, and subsequently issued a comprehensive report on the matter.

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? Contrast this with another financial institution in the United States.

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

3. What should be the role of government in regulating financial institutions? Compare this in the context of United States and Singapore.

4. Should the non-executive and independent directors be held accountable for the trading losses in JP Morgan's 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 company's 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?