JPMorgan Chase & Co. Whale Trades: A Case History of Derivatives

JPMorgan Chase & Co. (NYSE:JPM) was heavily criticized in a 300 page report released this afternoon by the Senate. The Senate stated that JPMorgan ‘gambled’, and compared the bank to a casino. The senate probed JPMorgan Chase & Co. (NYSE:JPM)’s famous London Whale trade. We have some exclusive coverage on the London Whale trade from hedge funds which took the opposite side of the trade (see How Hutchin Hill Took Down JPMorgan for one example). In (somewhat) related news, a second round of stress tests results have been released. We provide a summary for JPMorgan Chase & Co. (NYSE:JPM) specifically, followed by the London Whale report.

JPMorgan stress test comments via RBC Capital analyst Gerard Cassidy:

Stress test

JPM Capital plan

  • JPM announced that its capital plan was approved as part of the 2013 CCAR process, but with the condition that the company submit an additional capital plan by the end of 3Q13 addressing the weaknesses identified in the firm’s capital planning process.
  • JPM will be allowed to increase its dividend per share to $0.38 per quarter (28% payout) from $0.30 per quarter (21% payout) in the prior cycle.
  • JPM will be allowed to repurchase up to $600 billion of common stock (31% payout) versus $15 billion (70% payout) in the prior cycle. Note that the $15 billion buyback was suspended subsequent to the CIO trading debacle and only $3 billion was allowed to be repurchased in 1Q13.
  • Total payout came to ~59%, which is below the 91% payout in the prior year.

From Carl Levin:

Following a nine-month probe, the U.S. Senate Permanent Subcommittee on Investigations will hold a hearing tomorrow entitled, “JPMorgan Chase Whale Trades: A Case History of Derivatives Risks and Abuses,” and release a 300-page, bipartisan report with new information on the credit derivative trades that lost at least $6.2 billion last year.

The whale trades were conducted by traders in the London office of the Chief Investment Office (CIO) of JPMorgan Chase & Co. (NYSE:JPM), America’s biggest bank and largest derivatives dealer.  The Subcommittee’s investigation has determined that, over the course of the first quarter of 2012, the CIO used its Synthetic Credit Portfolio (SCP) to engage in high risk derivatives trading; mismarked the trading book to hide losses; disregarded multiple indicators of increasing risk; manipulated risk models; dodged regulatory oversight; and misinformed investors, regulators, and the public about the nature of its risky derivatives trading.  The Subcommittee’s investigation has exposed not only high risk activities and abuses at JPMorgan Chase & Co., but also broader, systemic problems related to the valuation, risk analysis, disclosure, and oversight of synthetic credit derivatives.

“Our investigation opens a window into the hidden world of high stakes derivatives trading by a major bank,” said Sen. Carl Levin, D-Mich., Subcommittee Chairman.  “The whale trades show how synthetic credit derivatives, when purchased in massive quantities through complex trading strategies, can become a runaway train of unstoppable losses.  The whale trades demonstrate how derivative valuation practices can be manipulated to hide losses, and how derivative risk controls can be bypassed or manipulated to conceal risk.  The American people have already suffered one devastating economic assault rooted in Wall Street excess, and they can’t afford another caused by unchecked derivative abuses.  When Wall Street plays with fire, American families get burned.  It’s time to put away the matches.”

Senator John McCain, R-Az., the Ranking Member on the Subcommittee, added the following: “The Subcommittee investigation sheds new light on this shameful example of an American financial institution operating with a ‘too big to fail’ mentality.  JPMorgan’s actions reveal how even a bank boasting a ‘fortress balance sheet’ can be easily seduced by the promise of huge profits through high-risk trading.  JPMorgan Chase & Co. gambled away billions of dollars through risky and exotic trades, then intentionally hid its losses from investors and the public, showing complete disregard for risk management procedures and regulatory oversight.  While JPMorgan Chase & Co. misled federal regulators, those same regulators failed to use the tools at their disposal to uncover the bank’s deceptions.  JPMorgan Chase & Co.’s ‘Whale Trades’ echo the reckless and irresponsible behavior that led to the financial collapse that struck our nation’s economy four years ago.  While I will need to closely examine any future legislation aimed at addressing some of the misconduct identified in this report, Wall Street must be reminded that it cannot gamble with our nation’s financial security, and that American taxpayer dollars should never be used as poker chips in JPMorgan Chase & Co.’s casino.”

In its investigation, the Subcommittee reviewed over 90,000 documents and conducted over 50 interviews and briefings.  The hearing, which begins at 9:30 a.m., on March 15, 2013, will take testimony from current and former JPMorgan Chase executives and representatives of its primary regulator, the Office of the Comptroller of the Currency (OCC).  At the hearing, the Subcommittee will also release nearly 100 hearing exhibits, including internal bank and OCC records, emails, and telephone call transcripts.

The Levin-McCain report makes the following findings of fact.

(1)   Increased Risk Without Notice to Regulators.  In the first quarter of 2012, without alerting its regulators, JPMorgan Chase’s Chief Investment Office used bank deposits, including some that were federally insured, to construct a $157 billion portfolio of synthetic credit derivatives, engaged in high risk, complex, short term trading strategies, and disclosed the extent and high risk nature of the portfolio to its regulators only after it attracted media attention.

(2)   Mischaracterized High Risk Trading as Hedging. JPMorgan Chase & Co. claimed at times that its Synthetic Credit Portfolio functioned as a hedge against bank credit risks, but failed to identify the assets or portfolios being hedged, test the size and effectiveness of the alleged hedging activity, or show how the SCP lowered rather than increased bank risk.

(3)   Hid Massive Losses.  JPMorgan Chase, through its Chief Investment Office, hid over $660 million in losses in the Synthetic Credit Portfolio for several months in 2012, by allowing the CIO to overstate the value of its credit derivatives; ignoring red flags that the values were inaccurate, including conflicting Investment Bank values and counterparty collateral disputes; and supporting reviews which exposed the SCP’s questionable pricing practices but upheld the suspect values.

(4)   Disregarded Risk.  In the first three months of 2012, when the CIO breached all five of the major risk limits on the Synthetic Credit Portfolio, rather than divest itself of risky positions, JPMorgan Chase & Co. disregarded the warning signals and downplayed the SCP’s risk by allowing the CIO to raise the limits, change its risk evaluation models, and continue trading despite the red flags.

(5)   Dodged OCC Oversight.  JPMorgan Chase dodged OCC oversight of its Synthetic Credit Portfolio by not alerting the OCC to the nature and extent of the portfolio; failing to inform the OCC when the SCP grew tenfold in 2011 and tripled in 2012; omitting SCP specific data from routine reports sent to the OCC; omitting mention of the SCP’s growing size, complexity, risk profile, and losses; responding to OCC information requests

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