information to consistently and accurately know who their counterparties are. Officials estimate that banks are up to three years away from having the necessary systems in place.
Dark Pools And High-Speed Trading
Another area of concern to regulators is dark pools, private trading venues that don’t disclose their activities publicly and account for 14% of all stock trading. Another 23% occurs in other off-exchange locales. The purpose of dark pools is to facilitate large institutional trading without exposure to high-frequency traders. Barclays bank runs Barclays LX, the country’s second largest dark pool, which is marketed with the motto, “Protecting clients in the dark.” But the New York Attorney General has charged that Barclays offered access to Barclays LX to high-speed traders. The bank is also accused of using other trading venues that benefit Barclays rather than its customers.
Under pressure from their institutional investor clients, many large brokers are routing trades away from Barclays LX and other dark pools. The SEC is investigating dark pools to determine whether they accurately disclose how they operate and whether they treat all investors fairly. Chairwoman White said in June that the size of off-exchange trading “risks seriously undermining” the quality of the U.S. stock market. Goldman Sachs recently agreed to pay an $800,000 fine for mispricing 400,000 trades in dark pool Sigma X in 2011. The firm already reimbursed clients with $1.67 million.
One big bank that remains squarely in regulators’ gun sights is Citigroup, and for good reason. The present firm resulted from the merger of Citicorp and Travellers in 1998. Vikram Pandit left Morgan Stanley in 2005 after being passed over for CEO and, with two colleagues, started a hedge fund, Old Line. It was sold to Citigroup in 2007, right at the top of the financial bubble, for $800 million. Even though that hedge fund was not very successful and eventually closed, Pandit rose to be CEO of the firm in December 2007.
On his watch, the company’s stock continued its collapse from what would have been $564 perâ€¨share in December 2006, except for theâ€¨10-to-1 reverse split in May 2011 to avoid the embarrassment of its selling at penny stock prices (Chart 10). The swoon to the trough in March 2009 was 98.2%.
Pandit’s relations with regulators were poor and he didn’t help matters by letting the bank consider completing the purchase of a private jet after receiving $45 billion in TARP bailout money. Despite his announcement to the Citigroup directors that all was well with regulators, the bank failed the Fed’s stress test in 2012. So it was not allowed to increase its quarterly dividend from one-cent per share to five cents and it requested but could not buy back up to $6.4 billion in stock. Shareholders were not amused and Pandit was shown the door in October.
Pandit told Congress in February 2009 that “my salary should be $1 per year with no bonus until we return to profitability.” After some improvement in the bank’s finances, he was awarded a $23.2 million retention package in 2011, close to the top of CEO compensation. Nevertheless, in April 2012, 55% of shareholders voted against increasing his pay to $15 million, the first nonbinding rejection of a compensation plan by a major bank.
In a repeat of history, last March the Fed again said Citigroup flunked its stress test, only the second bank along with Ally Financial to fail twice. So it can’t raise its quarterly dividend from one-cent to five cents per share.
It wasn’t the quantitative part of the test that tripped up Citigroup. Its Tier 1 capital ratio would only fall to 7% under very adverse conditions, still well above the fed’s 5% minimum. That adverse scenario, specified by the Fed, includes a deep recession with leaping unemployment, a steep decline in house prices and a 50% plummet in equity prices. Also, in the third annual stress test, the Fed made its own projection of the bank’s balance sheet, assuming the assets rise during tough times rather than fall as banks had assumed, so more bank capital would be necessary. In addition, the Fed forced eight big banks to assume the default of their largest counterparty.
The Fed this year flunked Citigroup on the quantitative side of the stress test. It cited deficiencies in Citi’s capital-planning process and risk assessments. The Fed had earlier warned the bank about these problems, but received an inadequate response. In effect, the Fed is questioning whether Citigroup is too big and too complex to manage without posing systemic risk.
The London Whale
In failing Citigroup in its stress test, the Fed has yet to bring up the bank’s risks controls in Mexico and the Banamex loss. But the Fed and other regulators have been clear over JP Morgan Chase’s lack of controls that led to the London Whale disaster in 2012.
Banks normally invest funds they’re not using for loans in Treasurys, but with low interest rates, JP Morgan became aggressive. As an example, at the end of 2006, it held $600 million in riskier corporate debt, or about 1% of total investments, but jumped those holdings to $10 billion, or 5% of all security holdings, two years later, and $62 billion, or 17% of the total, at the end of 2008 after the Fed initiated its zero interest rate policy. Similarly, non-U.S. residential mortgage security holdings jumped from $2 billion at the end of 2008 to $75 billion in early 2012. At the time, CEO Jamie Dimon disputed the idea that the bank was taking on more risk. “I wouldn’t call it more aggressive. I would call it better,” he said.
Meanwhile, the bank’s culture of risk-taking – and we believe the tone in any organization is set at the top – was rampant in London. A JP Morgan bank trader, Bruno Iksil, was making huge bets totaling $82 billion, with insurance-like derivatives called credit default swaps so big that he became known as the London Whale. That attracted hedge funds to take the other side of his trades, figuring he’d have to unwind them sooner or later. Meanwhile, his boss was urging him to put even higher values on his positions. When asked about this trading on April 13, 2012, Dimon said concerns were “a complete tempest in a teapot.”
Then came revelations of losses of at least $2 billion and Dimon began to realize the extent of the problem. “There’s blood in the water – hedge funds are going to come after us and make it worse,” he was told by a colleague. And they did, with the loss leaping to $6.2 billion by July. Dimon tried to get ahead of the bad public relations by stating that the trades were “flawed, poorly executed, poorly reviewed and badly monitored.”
The Chief Investment Office in which these trades took place was supposed to manage and hedge the firm’s fixed- income assets. But it has become clear that the CIO was taking directional bets and speculating in contradiction of the impending Volcker Rule. In 2011, risk-control caps that had required traders to exit positions when their losses exceeded $20 million were dropped. Subsequently, Dimon admitted as much, saying, “What this hedge morphed into violates our own principles.” Also, he was slow to fire Ina Drew, who was responsible for the CIO, and he dithered about clawing back the $14.7 million in stock awards she received.
Bones And Joints
Furthermore, Dimon, the bank and Wall Street faced huge fallout from this mess. He has led the charge against the Volcker Rule and other new bank regulations and had considerable credibility in Washington and on Wall Street because his bank largely avoided the near-financial meltdown.
Dimon was known as the smart, hands-on operator who says he knows all the “bones and the joints” of the bank. Is his being shocked! shocked! to discover the $6.2 billion loss proving what many regulators and legislators believe: that big banks are too complicated to manage and should be broken up? If they’re too big to fail, it’s ironic that when asked, in hindsight, what he should have paid more attention to, Dimon quipped, “Newspapers,” no doubt referring to the April 6, 2012 front page Wall Street Journal story about the London Whale.
Furthermore, the London Whale fiasco has not hindered Dimon’s compensation, although he suffered a pay cut at the time. In January 2014, the JP Morgan board raised his pay 74% to $20 million for 2013, a year in which the bank agreed to more than $20 billion in fines and other legal payouts and suffered its first quarterly loss in nine years. In making that award, which included $18.5 million in stock, the board cited “the regulatory issues the company has faced and the steps the company has taken to resolve those issues.”
Well, in contrast to Citigroup, JP Morgan’s stock fell “only” 70% during the financial crisis. Since then, it has rallied 260% to now exceed the May 2007 peak by 8%. And investors didn’t have lasting concerns over the 2012 London Whale losses and lack of controls. Regulators, however, may have the last word.
That lack of investor worry comes despite the huge fines and other penalties being paid by JP Morgan and other big banks over bad mortgages, manipulation of currency, interest rate and commodity markets, and illegally helping Americans to avoid taxes.
The CFTC and JP Morgan settled for $100 million in the London Whale case after the regulator charged the bank with reckless use of manipulative devices. The bank also acknowledged wrongdoing as part of the $970 million settlement with the SEC, OCC, the Fed and U.K. regulators in September 2013 in the same case.
The SEC got $200 million of that total and admissions by JP Morgan that it misstated its first quarter 2012 financial results, failed to properly oversee its traders and didn’t keep its board of directors informed about the trading problems. This is only the second time, after the settlement with hedge fund company SAC, that the SEC obtained admission of wrongdoing and it is in line with Chairwoman White’s promise to get tough and get more admissions. Earlier, U.S. District Court Judge Jed S. Rakoff rejected a $285 million settlement the SEC negotiated with Citigroup, in part because Citi did not admit liability.
Big foreign banks with U.S. operations are not beyond the reach of American regulators. France’s largest bank, BNP Paribas, has finally agreed to pay $9 billion in penalties and plead guilty to criminal charges over concealing about $30 billion in oil and other transactions with countries that are sanctioned by the U.S. including Iran, Cuba and Sudan. Also, as demanded by New York State regulators, 30 people will leave the bank. Starting in January, the bank will lose its permission to clear certain dollar transactions for a year. The alternative to accepting these harsh sanctions was being banned from done business in lucrative U.S. financial markets.
Since French banks dominate trade financing and these transactions between the Americas and Asia are carried out in U.S. dollars, this last penalty is especially meaningful for BNP, although the bank has six months to arrange a transition to other firms that will handle this business during BNP’s absence. French President Francois Hollande called the demands by U.S. regulators “unfair and disproportionate,” but with classic French face-saving, Finance Minister Michel Sapin took credit for the limited scope of the dollar ban. “In line with the demands of the French authorities, this agreement sanctions the activities of the past and protects the future,” he said.
Prosecutors in the Justice Department and Manhattan District Attorney’s office were especially irked by BNP’s slow and incomplete response to their requests for documents and interviews in 2009 concerning transactions that took place between 2002 and 2009. U.S. authorities believe that BNP employees took deliberate steps over several years to hide their dollar transactions with U.S.-sanctioned countries. Transactions were run through intermediate banks to avoid detection, in schemes that resemble money-laundering. BNP apparently did not expect this big of a fine since it reserved only about $1.1 billion. It plans to maintain its dividend and its stock rose 3.6% on the news, although it had dropped 18% since February when the bank announced the provision for possible U.S. fines….