J.P. Morgan Shareholder Vote, Remembering Whale Trades

Given the stockholder proxy now confronting voters, it seems appropriate to recall circumstances for JPM. I wrote this piece at the time, but delayed its publication on this space. Banks have been kicked around like a can on a common street. Still, banks supply funding for basic activities, to more complex endeavors. I've always enjoyed Jamie Dimon's moxie. In the U.S., we have a Wall Street and a Main Street. The two meet often. When they meet, you want a banker on your side with a back-bone...even if it's institutionalized.

Once, J.P. Morgan Senate Hearings Explored a London Whale Tale

U.S. Senate hearing today revealed considerable information into the J.P. Morgan Chase "Whale Trade". A fundamental discovery is that of the $6B loss, much of it consisted of excess deposits at the bank that weren't being used for loans to businesses and individuals. Due to deposit money being used, FDIC insured funds were put at risk.

Information out of the Senate hearing today makes the Whale Trade look like a hedge that became its own position. Appears that this hedge was losing so much money, hedging the hedge became a net loss.

Trouble appears to come from the hedge position being a synthetic credit derivative securing a core position. Most derivatives tend to make market movements at faster rates than the security from which they are born. Simple stock options are a derivative. A synthetic is essentially a derivative on a derivative among counterparties to the underlying or core security.

Once a gain is realized in a derivative of an underlying security, the gain is typically in multiples of the underlying's move. Same applies for losses. Derivatives can typically be characterized as put or call positions against an underlying position. A synthetic position is more like a put or call on an underlying derivative of an underlying security.

Changes In Value At Risk Reduced Real Risk, By Appearances

Real problem for JPM is their Value at Risk model (VaR) and how the limits of this model were exceeded during the Whale Trade. Once exceeded, JPM came up with a new VaR model that reduced the "appearance" of risk exposure by 50%.

This move made their positions on their prodigal synthetic derivative hedge, that refused to come home with its losses, look smaller in terms of overall firm risk. Reality now seems that this model wasn't "sufficiently" back tested against the old VaR model. Without sufficient back testing, the new model could look arbitrary to regulators. Perhaps, hind sight is 20/20.

Adding to issues is an apparently contemporaneous development wherein daily profit & loss statements from JPM to their chief regulator, Office of the Comptroller of the Currency (OCC), were suspended. Despite reports having been routinely delivered previously, these reports were suspended for two weeks at what I'm sure is a peripety of this drama.

Suspending daily profit/loss statements to OCC also appears to include major confusion over the extent of losses. Not only was JPM's VaR changed, but representations of the loss made to OCC put the amount at $550M in Q1, 2012.  However, internal memoranda indicated the loss to be around $719M.

What Happened To Risk Management, And How To Capture It Too Late

JPM is a seasoned firm, defined by Securities Exchange Commission rules. Such an incongruity in numbers indicates a break in reporting structures. When reports start to deviate, there is a level of "free lancing", or rogue activity occurring.....somewhere. Corporate structures must then isolate the problem and capture causation. In so doing, corporate must first understand the problem's origin, its nature, then quantify or value the problem, and then control the problem.

Evidently pursuing such a process, it looks like JPM isolated the problem, perhaps apparent in their change in VaR models. This only allowed the problem to grow. By decreasing the value at risk, the huge Whale Trade became smaller. With it being smaller, more money could be committed to correct the hedge, growing it into a frighteningly high risk synthetic derivative core position.

JPM witness statements seem to confirm such a proposition. By April, the firm was indicating an internal loss of $1.2B, despite a previous OCC report of $580M. JPM's chief of CIO at the time stated that she understood OCC was receiving mark to market reports with daily profit and loss statements. All the while, she didn't know of suspending reports for two weeks to OCC.

Passing the buck...At some point, less senior personnel have to know what is going on. If not, more senior personnel will get an "all is well" indication. Next obvious question is the pressure of performance.