JPMorgan estimated that Basel III would require it to either increase the amount of capital it held or reduce its risk-weighted assets. In anticipation, JPMorgan set out to reduce risk, among other actions. The contracts for the trade were designed to generate gains as credit deteriorated in selected markets.
While the initial number of contracts appears small, the notional amounts grew large as more contracts were added. Frequently, instead of disposing of troubling positions, new over-the-counter derivative contracts were added to the balance sheet. Who was to blame for the scandal? The short answer is that the entire management team was responsible.
Yet there were aspects to the portfolio that should have sent warning signals, especially to management accountants. The contracts resulted in a net short position, meaning the hoped-for gain could only be generated from a market downturn. Regulators have viewed shorts as inherently risky, particularly when derivatives are used, and the accounting rules are biased toward that view. Accounting rules require extra disclosures for credit contracts.
But the positions in the London Whale trade were presented as an overall adjustment to the JPMorgan portfolio rather than specified transactions. Such special elections remain transaction based, not portfolio based—in contrast to the greater flexibility provided by International Financial Reporting Standards IFRS.
But JPMorgan was bound to abide by U. GAAP, even for its London activities. They were held in the required default accounting format for derivatives. As a trader might describe it, they were marked to market. In other words, the fair value of the contracts was placed on the balance sheet and then measured again for every subsequent date the balance sheet was issued, with the change in value the mark posted to current earnings.
This is the same accounting treatment for trading positions in most broker-dealer activities. It became something of a specialized case where the measurement rules were misapplied. There should have been some concerns raised at JPMorgan—perhaps by management accountants—when these positions became noticeable as a source of profits. The Chief Investment Office desk responsible for the position reported to a local, London-based manager. And the trade was the responsibility of a single trader, supported by an assistant trader.
The growth in the volume of contracts, among other things, suggests that the CIO trader acted with unusual autonomy. The timing for an autonomously minded trader was good because the trades were initiated at about the same time that the bank CEO, Jamie Dimon, stepped back from day-to-day risk management.
Initially, the trade was executed and managed without a set trading limit i. This changed when losses appeared and continued to mount. By then, however, the losses had become unavoidable. Faced with losses, the trader took the view that markets might rebound in his favor. It was more the action of a risky gambler than a risk manager or a rational, systematic proprietary trader.
It was the opposite of hedging his bet. When the losses continued, a liquidity problem emerged. The market was willing to sell the trader more of what he already held but was much less willing to buy back the product. The trader was stuck with his position. As the positions grew, the larger size was accompanied by larger losses and declining liquidity. The appropriate fair value for reporting would be the most representative point within the bid-ask spread in a hypothetical transaction for a comparable contract.
As markets became less liquid, the traders relied increasingly on the accounting method of setting the fair value to the mid-market price within a bid-ask spread, as permitted under ASC Topic Using aggressive marks seems to be an effort to falsely minimize reported losses.
The situation worsened. Weaknesses in internal controls masked these events. But VCG policies were rewritten during the course of the crisis. The actual price testing also was subjective and insufficiently independent from the traders, who influenced the process.
Eventually, when the extent of the failure was uncovered, JPMorgan moved the positions out of the CIO to its trading unit. Several individuals in the CIO lost their positions, were exposed to compensation clawback, and are subject to continued legal action.
JPMorgan Chase is the largest financial holding company in the United Sates and has more than 2 trillion dollars in assets. It is also a global financial services firm with more than , employees United States Senate pg. Previous to , Mr. With Mr. Dimon guiding the firm, JP Morgan held an excellent reputation with respect to risk management.
Emerging from the financial crisis unscathed, Mr. Dimon became more powerful and confident. He frequently railed against the need for government regulations with regard to proprietary trading in large financial firms. Imagine a scalper who purchased 50, tickets to a sporting event with a capacity of 75, seats. The event is not nearly as popular as was anticipated by the scalper, thus the going price on the tickets plummets rapidly as would be ticket buyers wait for prices to fall further from face value.
The scalper intended to hold tickets for the long term expecting high demand but with too many people on the sidelines betting that prices would fall, the scalper had to cut losses and sell at a drastic loss. Since JP Morgan has an excess of deposits after the firm makes loans available to business and consumers, this excess cash is invested by the CIO group to hedge against disparate investment actions undertaken by other areas of the bank.
Ultimately JP Morgan would end up being a victim of its own success as it continued to conduct proprietary trades in the CIO division. Bruno Iksil and the London CIO office were steadily racking up daily losses in the hundreds of millions of dollars by investing in synthetic derivatives i. Credit Default swaps or CDS.
The trading positions that the CIO office held were not hedging against other bank investments, as was the purported charge of this office. Credit default swaps are financial derivatives the provide investors insurance on bonds against potential default. Needless to say, the companies in the index did not improve. The initial million dollar position that the CIO office held in the CDX IG 9 index was essentially cornering the market and when there were no willing buyers, the firm had to sell at massive loss.
The massively large trades in credit default swaps the same complex financial instruments that doomed A. G during the financial crisis began to affect credit markets worldwide. Initially, by the end of the week on May 11, when the firm held a hastily convened conference call regarding transparency around the London Whale trades, JP Morgan suffered a loss of By the end of May the synthetic derivatives portfolio alone had lost 2 billion dollars.
By the end of June the losses doubled to 4. Amazingly, Mr. Recorded telephone calls, instant messages and a shadow spreadsheet containing actual projected losses, revealed how traders were pressured to minimize the expected losses of the SCP Synthetic Credit Portfolio United States Senate Report, pg.
Internal CIO management also disregarded their own risk metrics such as the VaR or value at risk, which estimates the maximum risk of loss over the course of a day. This warning sign metric was ignored and then actually raised. Senior bank management was told that potential losses were massive and no longer functioned as a hedge to the bank; management then proceeded to downplay those issues until the losses mounted into the billions of dollars United States Senate, pg.
By June , Mr. Management instituted a number of changes as a result of the CIO trading imbroglio. All CIO managers based in London with any responsibility for the Synthetic Credit Portfolio were separated from the firm with no severance and without incentive compensation.
Along with upgraded personnel skills in the CIO Risk organization, management rightfully instituted a common sense approach to structural issues. To the chagrin of Mr. Dimon, this episode strengthened the case for more government oversight of the financial industry. Bianco, J. Understanding J. The Big Picture. English, S.
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