Much fuss was made in Wall Street when top bank JP Morgan Chase revealed a black hole in its books, which had not been detected by internal controls and which left a $2bn loss. The scandal gives us a glimpse into global weak banking controls, particularly at a time when the ‘Occupy’ movement is pushing its crusade in bashing Wall Street. It makes one wonder why Wall Street allows top bankers to escape scrutiny.
The JPMorgan Chase story is another episode in the ongoing financial crisis that has thrown millions of people out of work. We may console ourselves that it is, after all, the story behind our ever-growing wealth inequity – when financial leaders are loaded with bonuses while shareholders foot the bill. It’s the tragicomedy behind Wall Street’s inability to prosecute criminal bankers, regulate reckless ones or propose the economic solutions that the rest of us in Europe so badly need.
It could be asked if regulators have been caught unawares of such loopholes in the system .As usual, there is a tendency to close the barn door after the horse has bolted and it is not surprising that, following the announcement of the massive loss, the Department of Justice and the FBI have opened a preliminary investigation into whether the bank broke any rules. The US Securities and Exchange financial watchdog was said to have begun reviewing the losses perhaps a bit too late, considering that the rating agency Standard & Poor’s quickly revised its outlook on the bank from “stable” to “negative” and Fitch Ratings downgraded it from A-plus to AA-minus. On the day of the announcement, Barclays’ shares lost 2.8 per cent, while Royal Bank of Scotland fell sharply before recovering most of its losses. US banks such as Morgan Stanley and Goldman Sachs were down 4.5 per cent and three per cent respectively.
It is ironic to reflect on the views of Barney Dodd, the US senator and co-author of the 2010 Dodd-Frank law on regulation. He said: “This regrettable news from JP Morgan Chase obviously goes counter to the bank’s narrative blaming excessive regulation for the woes of financial institutions. The argument that financial institutions do not need the new rules to help them avoid the irresponsible actions that led to the crisis of 2008 is at least $2bn harder to make today.”
There is no other way of commenting on the JP Morgan mess, which – some would say – reflects poorly on regulators. For once, the spectre of low quality regulation comes to the fore as the media contemplates the impenetrable complexity of how certain top banks operate. Could the loss have been averted if better controls by government regulators had been in place? The blame may be shared with individuals who grace the boards of big international banks and their audit committees, but really and truly they know very little about the intricate ways certain complex trading positions are taken. In practice, such risky trades are expected to hedge speculative lines.
These so-called credit default swaps theoretically have the potential of yielding a profit for JP Morgan if the debt of highly-rated companies performed significantly better than that of lowly-rated companies. So they can be justified as useful techniques intended to serve as a hedge against the first hedge but, of course, the latter went undetected and unregulated. With three or possibly four huge layers of derivative deals loaded on top of loans of more than $700bn, it is not surprising that the bank was unable to keep track of the risks. Luckily, it did not derail JP Morgan, which is big enough and is generating sufficient profit to absorb the losses from such capricious deals.
On the other hand, the bank’s chairman and chief executive Jamie Dimon was utterly mystified as to how internal controls had been circumvented, permitting the loss to bloom and grow under his watch. Dimon initially dismissed internal concerns as a “storm in a teapot”, but within a week he shocked investors when the bank officially reported the massive loss. It is sweet consolation to hear the CEO’s admission, in his own words: “In hindsight, we took far too much risk, the strategy was barely vetted, it was barely monitored. It should never have happened”
Shareholders had approved a bumper pay package for the chairman and CEO last year, with a non-binding endorsement of his $23 million bonanza. He has often argued against excessive regulation (such as the Volcker rule) by saying that bankers are sufficiently moral and sophisticated to manage their businesses without external overseeing. But he has been making such arguments to a financial community that has seen the wreckage of world banking as a result of greed – amply demonstrated in the sub- prime debacle.
Critics say that Dimon managed to argue simultaneously that no other banker is as smart as he is, and that nevertheless bankers should be unregulated because leaders like him are so smart. The unmistakable facts show that his assertions do not make much sense.
It is a mystery how no heed was taken of advance warnings in the media that one of the bank’s London-based trading desks, home of the famous Whale, was engaging in huge and potentially risky transactions. With hindsight, we discover how more than $13bn was wiped off JP Morgan’s share value (America’s largest bank) when it revealed faulty trading activities of its now famous trader nicknamed “The London Whale” aka Bruno Iksil. He acquired his nickname as a result of his bullish trading habits. Iksil had qualified as an engineer from the École Centrale in Paris and is reputed to be one of the highest-paid dealers in London .To begin with, the size of his trade in credit default swaps attracted the ire of his rivals. His positions were so large that he was said to be moving prices in this market as he offered insurance against companies defaulting on an obscure index of 125 companies known as CDX IG. During his time, Iksil is reported to have generated gains of $100m, and is usually known for his fiendish stances, performing particularly well during downturns.
Back to the loss and one could ask what contributed to such a huge weakness in a top bank to go undetected, when these institutions are so closely supervised under the tougher banking rules introduced after the 2007/2009 crisis. It is true that the Basel Committee, the Financial Stability Board, the European Commission and the G20 had tried to devise ever more complicated and more detailed rules to limit the risks to banks and the wider economy of the unrivalled complexity of the way banks manage themselves. Would it have been more effective to contain the risks of banks by forcing them to become simpler, easier-to-understand institutions?
The straight answer to Morgan’s scandal is that the loss was generated by a series of opaque and complicated transactions (collectively termed “derivatives”). This was unsupervised and its complex trades were woven in a web of intrigue and in a fashion intended to offset or hedge the impact of the risky transactions in the forlorn hope that its cumulative impact would balance the unhedged parts and avert a financial disaster. In its defence, JP Morgan claims it was an honourable attempt to hedge its exposure against the euro downturn as a result of the current severe recession.
As stated earlier, it used derivative contracts, the value of which would have risen had there been a rise in defaults on loans, which would have mitigated the deficits from defaults on the vast loans it makes to companies in the normal course of business. It was a gamble that backfired. Can anyone blame JP Morgan for trying every financial tool in its armoury in an attempt to hedge the devastating impact from volatile euro positions? It is still the number one corporate bank in Wall Street and enjoys the title of “the darling bank”, so it may be excused for having burnt its fingers by dabbling in financial innovations at a time of financial turbulence.
To conclude, is this sad incident of any relevance to tiny Malta? Happily, we do not suffer mega scandals such as these, but then it is all relative to our size and, surely, better banking regulation is a lesson we cannot avoid. Just remember the ongoing La Valette saga, which saw millions lost on a property fund that went bust. Irate investors (mostly investing their nest eggs or pension money) demanded explanations over the La Valette Multi Manager Property Fund that went belly up after it invested in high-risk sub funds that suddenly went bust in 2008.
The fund was managed by Bank of Valletta and Valletta Fund Management, the bank’s investment arm, and the suspension/cessation of trading in the fund’s shares resulted in the loss of some €50 million. It is true that BOV offered partial compensation, but this has not completely settled the matter, as is evident from the accusations of angry shareholders attending the last AGM, who demanded explanations and an admission of responsibility for the losses they had suffered. Some hurled insults at the fund’s director, while others accused the fund manager of having invested the money in property funds with debt levels that were too high to cover the value of their assets. They cast doubt on banking regulations that allegedly allowed the bank to issue “false” annual reports for four years running.
Again MFSA the single regulator is still delaying issuing its final report after two years of investigations. One hopes that lessons are learnt for all from the JP Morgan affair and this clears the way for better governance in banking institutions.
[email protected]
The writer is a partner in PKF, an audit and business advisory firm.