The reports in mid-September from UK and US regulators did not add much in the way of detail about the actual trades that went wrong. The reports did, however, highlight the mutual fear and loathing between JPMorgan’s chief investment office and its investment bank.
And the investment bank staff brought in to clear up the mess created by the CIO did not seem to have much confidence in senior management at the very top of the firm either. The SEC report released on September 19 revealed that two of the investment bank executives working to reconcile the many valuation problems in May 2012 were worried about signing certification documents that would be used to file JPMorgan’s quarterly accounts, and that one of them consulted an outside lawyer about the scope of his obligations before eventually falling into line.
The CIO staff running the structured-credit portfolio trades that eventually blew up had many positions in which their own investment bank was the counterparty and thought that if they were forced to unwind those trades in March 2012 there could be a permanent loss of $350 million because each side of the deals would have to agree a price.
The FCA said that an unnamed individual at the investment bank quickly identified the implications of this argument. This is believed to have been Daniel Pinto, who was co-head of fixed income at the time and is now co-CEO of the entire investment bank. He said: "What I see is an accusation that the investment bank, with someone leaking the position of CIO, is acting against CIO and mismarking the books to damage CIO." He noted that if this were true he would "need to fire a lot of people".
As the FCA noted, the logical inference was that if the investment bank’s position marks were correct, there was a mismarking problem with the CIO. The CIO management in London instead assumed that the problem was with the investment bank and took no further action.
The most recent reports by regulators sided decisively with the investment bank staff over the valuations. They also found no evidence that investment bank staff actively undermined the positions of their CIO colleagues. There is no question that the internal rivalry was keenly felt, however.
It spilled into conversations outside the bank that led to awareness in the industry of the mutual dislike. For example, Achilles Macris, the boastful former international head of the CIO, was in the habit of telling external counterparties that he was responsible for greater value at risk than his peers at the investment bank, according to people who know him.
Attempts to control the value at risk reported by both the CIO and the bank overall led to some of the corner-cutting for which JPMorgan was recently sanctioned by regulators.
An increase of $15 million for the overall VaR was agreed in early 2012, but it is telling that one of the main initiatives by the CIO when it was hitting risk limits and struggling to cope with demands for a group-wide reduction in risk-weighted assets was to try to adjust the way in which it measured its VaR so that it could report a lower number.
Corporate infighting and valuation arbitrage had become second nature, possibly because CIO staff had drawn correct short-term tactical conclusions from previous bouts of internal conflict.
The FCA report noted that the structured-credit portfolio within the CIO lost substantial amounts of money in the first half of 2009 – around $400 million – but stuck with its positions and generated strong revenue for the year. In 2011, the year before the London Whale disaster, the strategy was particularly profitable and appeared to show the merits of running big positions, as the pay-off from a hedge against the bankruptcy of American Airlines alone generated $400 million.
By the end of 2011 the structured-credit portfolio had generated roughly $2 billion of gross revenue since inception.
The sheer size of the positions in the CIO seems to have contributed to a form of number-blindness among experienced staff at JPMorgan.
The bank recorded an odd exchange in a footnote to its own investigation, for example.
It disclosed an email sent to chief financial officer Doug Braunstein in April 2012 in which CS Venkatakrishnan, head of model risk and development, said he had noticed that notional exposures at the CIO were very large, totalling $10 trillion in either direction. Venkatakrishnan said that he was concerned about counterparty credit risk, as $6.5 trillion of this exposure came from just four trades. Venkatakrishnan later concluded that he was mistaken, as many of the trades were internal and thus netted out, meaning the notionals involved were lower.
But it is difficult to escape the conclusion that the zeroes on the JPMorgan derivatives books were starting to blur, even for quant veterans like Venkatakrishnan, who has a PhD from MIT, never mind for staff like CFO Braunstein who did not have a sales and trading background.
This helps to explain how CIO staff could stall for time as they faced internal pressure to reduce the size of positions. JPMorgan’s own report condemned CIO staff for misleading firm-wide risk controllers as the crisis unfolded.
The UK regulators in turn took umbrage at the way JPMorgan as a firm adopted a similarly disingenuous approach to questions about its exposure in an apparent example of bad practices driving out good at the bank.
The FCA’s predecessor regulator, the Financial Services Authority, had told JPMorgan in 2010 that it wished to be informed of any significant changes in the CIO’s assets and risk appetite, including structured credit.
At the end of March 2012, JPMorgan attended a quarterly supervisory meeting when it failed to mention that the CIO’s structured credit managers had been instructed to stop trading two days before, that the notional size of its exposure had ballooned and that structured credit had lost $298 million year to date, rather than the $128 million disclosed to the regulator.
In a follow-up call in April, JPMorgan failed to disclose that losses were already at $705 million and were expected to exceed $1 billion and that the trading strategy had resulted in an "almost total loss of hedging effectiveness".
The regulator said: "The tone of the call was deliberately reassuring... as a result the Authority has concluded [that it] was deliberately misled by the firm."
This in turn pushed up the eventual fine for JPMorgan, in yet another example of how internal dissent and dissembling has cost the bank and its shareholders.