Close your eyes and go back in time. Remember Nick Leeson’s trading bets (1995) & Lehman Brothers Holdings Inc. (PINK:LEHMQ)’s sub-prime mortgage positions (2008). Of course, if you are a financial “collapse historian” of some measure or even a victim, you will definitely come up with a few flashes of painful memories, where an individual or collective “escalation of commitment” to loosing positions or propositions cost the world’s economy, investors & traders dearly.
Fast forward to early 2012, it was JPMorgan Chase & Co. (NYSE:JPM) and the London Whale Trade story. The Chief Investment office (CIO) of the company at London was responsible for billions of dollars of losses in relation to CDS derivatives related positions. Mind you, the primary responsibility of CIO working with JPMorgan’s Treasury is to manage JP Morgan’s excess cash. Thus, a few hundred traders manage billions of dollars of cash.
After 10.1% Return In 2020, Mohnish Pabrai Changes Strategy [2020 Letter]
Mohnish Pabrai's flagship hedge fund, the Pabrai Investment Fund II, returned 29.6% in the second half of 2020. Following this performance, the fund returned 10.1% net for the year, underperforming the S&P 500 but outperforming the Dow Jones Industrial Average, which returned just 9.7%. According to a copy of the investment manager's year-end letter to Read More
In the whale story also, it was the case of unbridled enthusiasm, subsequent sinking, prolonged defense of lost cases & ultimately, concealment & deceit..defeat. The whale trader (Bruno Iksil), obviously with accomplices like Achilles Macris, was able to take huge “Whale” positions in JPM’s Synthetic Credit Portfolio, “balance” the portfolio when things got bad, and continued to hold the loosing positions (in IG-9 etc.). The “Synthetic Credit Portfolio” consisted of standardized indices based on baskets of credit default swaps (“CDS”), tied to corporate debt issuers. These positions continued till the realization dawned on the Senior Management that it was impossible to remain a flat ostrich anymore. The behavior of these “professional” traders was similar to that of ordinary amateur trader/investor who on the average loses, adds loses, avoid stop losses and invites disasters in hoping for a “mean revert”.
JPMorgan Chase & Co. (NYSE:JPM), with nearly $100B in revenue in 2012, however, survived the ~ $6.2B loss because of its success in other investments based on an upturn in the financial markets & mortgage portfolio. Had these losing CDS derivative positions continued for longer and the world economy deteriorated, things could have been terribly different for the company having more than $2.3 trillon in assets. Of course, the liquidity position of European banks, the availability of easy money and a backup commitment from central banks (albeit for the sovereign default scenario) helped support sentiment. The stock, which crashed dramatically in April – June 2012 after the news regarding the severity of its losses became public, has since recovered mainly on back of overall financial performance of the company. JPM managed to absorb the Whale loss inflicted by gambling sharks. Of course, there are possibilities of law suits from investors, which will only add to the problems.
However, the world will not always remain so lucky. There are lessons to be learnt by all, especially in corporate governance for risk management & oversight. JPMorgan Chase & Co. (NYSE:JPM) conducted an internal inquiry and the regulators also pulled out their scanners.
Based on the initial findings mentioned in the recently released report of JP Morgan Management Task Force regarding 2012, what is frightening is how quickly and easily things got out of hand. In April 2012, what appeared as a “tempest in a teapot” to CEO, Jamie Dimon, suddenly became a “flawed, complex, poorly reviewed, poorly executed, and poorly monitored” position in May 2012. Even the CFO, Douglas Braunstein, was “very comfortable” about the mess in the same earnings call in April. The losses were “allowed” to grow from $100M to $5.8B in six months from January to June 2012. In fact, results of the first quarter 2012 had to be recast to reflect $459M of understated losses indicating concealment. Obviously, there were no meaningful controls in existence there. The report points out that there were issues related to organization structure, reporting confusion of CIO’s Chief Risk Officer, interpersonal issues, lack of detailed oversight etc. The CIO level risk officers were unable to voice their concerns and solve the matter at firm level. Even the finance function was criticized for poor implementation of price testing procedures. The risk testing models were novice & under-tested. An interesting policy lapse is that the risk limits were applied to the CIO office as a whole rather than based on asset class, trade size etc. Wow!!
At JPM, the corporate governance risk control mechanism is the responsibility of the Risk Policy Committee (RPC). This is in line with the Dodd-Frank Enhanced Prudential Charter. The Risk Policy Committee is responsible for oversight of the CEO’s and senior management’s responsibilities in relation to risk management. Committee is required to meet at least annually to recommend any proposed changes to the Board for approval.
Now that the report is out, it is the duty of the major shareholders (not only of JP Morgan) to scrutinize & suggest changes in the system in their companies. The competence & the activism of the board level RPC has to increase substantially. The Chief Risk Officer (CRO) or anyone heading the firm level risk should be selected very carefully. This important committee should be staffed & expanded to become independently competent to obtain and actively analyze risk related information. It may meet more often, initially every month maybe, to evaluate the micro level risk management policies and granular controls based on asset class, individual securities, VaR etc. Mechanisms to implement these policies may be in place and the information systems may give micro level reports. Any changes in risk management practices may be highlighted by the system and the board committee should be able to get near “real time” information. In turn, this Committee may submit its reports to the board of directors, especially flagging the exceptions. The quarterly financial statements may mention significant deviations in risk management practices and their expected effect. Trading / hedging positions above a specified size may be reported to the CRO. This will help monitor any ensuing counter positions etc. Practices of hedging the hedge, may be carefully examined to take real time action in case of aberrations. MTM losses beyond a certain limit should draw red flags and may be brought in public domain.
CIO losses draws the attention of all to the vulnerability of huge corporations &, consequently, the world financial markets to individual errors in judgment by traders / risk managers. It appears, that in absence of, or even despite risk controls, sometimes, hedges become trades and traders get into gambling with investors money. Such hedging or trading desks surely have a right to operational freedom to perform, but those in command are supposed to be thorough professionals. Fiduciary duties are of prime importance when such experienced organizations are trusted by ordinary investors / customers with their hard earned money. The inter-linkages between global financial markets and the expected cascading effects of financial disasters obviates the urgent need for strengthening the corporate governance control mechanisms to ensure continuous and meticulous oversight to risk management.
Micro level trading errors apart, ultimately the losses in JPMorgan Chase & Co. (NYSE:JPM) were a result of systemic failure. Unlike the Nick Leeson case where his trading jacket was later sold for an insane sum, the trading attire of Bruno Iksil is hopefully still with him. However, if risk management controls are not put in place, you never know what comes up for bidding!!