In June of last year, I was asked by my business school to join a panel discussion on the state of the U.S. economy and the actions investors should take going forward. The panel was filled with investment bankers and private equity investors, and was moderated by a well-known CNBC commentator. There was healthy debate and differing opinions on the direction of the economy and Wall Street. Morgan Stanley's (MS) Facebook IPO fiasco had just occurred and certain attendees and panelists were alarmed by the "greed is good" mantra exhibited by Wall Street. Hadn't we learned anything from the financial crisis? However, the general consensus was that the pendulum had swung too far - there was entirely "too much bashing of bankers" and it needed to come to a halt. And to that we all agreed, including me.
A few weeks ago, lawmakers gave Wall Street another public lashing. Douglas Braunstein, JPMorgan Chase's (JPM) former CFO and Ina Drew, the company's former chief investment officer, testified before the Senate Permanent Subcommittee on Investigations Hearing on JPMorgan Chase Whale Trades. The trades were pursuant to the $6.2 billion loss orchestrated by the famed "London Whale." On the article, "J.P. Morgan: From Predator To Wall Street Prey" we explained the mechanics behind the loss:
In early May JPMorgan Chase reported $2 billion in trading losses on bets gone awry in the bank's Chief Investment Office. The losses were odd given that [i] the Wall Street Journal had reported a month earlier that a JP Morgan trader nicknamed the "London Whale" had made large bets in the debt markets and [ii] during the financial crisis, JP Morgan avoided the missteps of Goldman Sachs ("Goldman (GS)"), Morgan Stanley , and AIG (AIG) from bets on real estate, mortgage-backed securities and credit default swaps. The Whale made bets on a continued economic recovery with complex trades that moved in relation to the value of corporate bonds ... Other casualties of the trading loss were Ina Drew, JP Morgan's Chief Investment Officer, who retired less than a week after the loss was revealed and Irvin Goldman, who was stripped of his duties as oversight of risk in the Chief Investment Office.
After hours of being berated by senators, Braunstein and Drew revealed just how incorrigible JPMorgan was. Particularly damning is that the company's actions came on the heels of government bailouts to AIG, Goldman Sachs, and Morgan Stanley for similar behavior. Here is what we gleaned from the hearings:
"Somebody Else's Fault"
Shockingly, Ina Drew claimed the losses were somebody else's fault. Apparently, the losses were the blame of people out of the London office who reported to her, yet failed to control risks. Prior to the losses ever materializing, the Wall Street Journal had reported how the monster and global hedge fund traders were betting against mispriced trades by the London Whale; Jamie Dimon only became aware of the whale trades after reading about them in the Journal. We heard the "It's somebody else's fault" argument from Wall Street titans during the financial crisis of '08. The fact that the London office engaged in excessive risk-taking without fear of reprisal demonstrated that not only was Drew clueless to the goings on in her shop, she also was not feared by those she was paid to manage.
JPMorgan Engaged in Wildly Risky Behavior
JPMorgan had originally represented that its credit default swaps were used as insurance against declines in its bond holdings; if the bonds declined in value, the hedges would increase in value and operate as de facto "insurance" against the bonds. However, after further examination, it was revealed that the London Whale had taken "net long" positions on the swaps, i.e. he was investing in the swaps for speculative gains, not for insurance purposes. To drive the point home, a report from the Senate Subcommittee invoked "main street":
The "London Whale" incident matters to the federal government because the traders at JPMorgan were making risky bets using excess deposits, portions of which were federally insured. These excess deposits should have been used to provide loans for main-street businesses. Instead, JPMorgan used the money to bet on catastrophic risk.
The fact that JPMorgan was risking billions in capital denied to the "everyman" in America, well I find that particularly shameful.
JPMorgan Stonewalled Regulators
During the financial crisis, Ponzi schemers Bernie Madoff and Alan Stanford of Stanford Financial, elevated the stonewalling of regulators to an art form. Madoff used his outsized reputation as former Nasdaq Chairman to intimidate auditors and regulators, and pull rank by complaining to their superiors. Stanford went so far as to put Leroy King on his payroll. King was the administrator and CEO of the Antiguan regulatory body responsible for overseeing the investment portfolio and reviewing financial reports of the Stanford entities which marketed certificates of deposits to King's countrymen. Via a blood oath, King aided and abetted Stanford in concealing his companies' true financial condition. According to the new book, "Shock Exchange: How Inner-City Kids From Brooklyn Predicted the Great Recession and the Pain Ahead,"
When the SEC was about to expose the Stanford Ponzi scheme to investors, from February 2009 to March 2009 King transferred approximately $560,000 from a New York bank account to his account in Antigua; these payments may give a more true indication of the total bribes King received from Stanford. In August 2009 James Davis, CFO of SFG, admitted in a Houston courtroom that he and others knowingly bilked investors. He also said that Stanford and King performed a "blood oath ceremony" where King agreed to accept bribes in exchange for his not exposing Stanford's fraudulent activities.
After the transgressions of Madoff and Stanford, I was actually shocked to hear that JPMorgan had the gumption to stonewall regulators pursuant to the whale losses. According to the Subcommittee, JPMorgan took the following measures to mislead regulators:
- JPMorgan's Chief Investment Officer amassed a huge portfolio of synthetic credit derivatives. In 2011, the notional size grew from $4 billion to $51 billion in a matter of months, with no regulatory oversight.
- Once the trades were exposed through the media and through pending losses, JPMorgan represented to regulators and shareholders that the portfolio was designed to hedge credit risk. However, management was unable to identify the assets being hedged or the effectiveness of the hedges.
- Ina Drew's office concealed losses from the whale trade in 2012 by overstating the value of the credit default swaps. Those values were disputed by both internal bank reviews and counterparties.
- JPMorgan's valuation metric for the credit default swaps had been the midpoint of the daily average "bids" and "asks" in the marketplace. By late January 2012, the company changed its valuation methodology; it started using "prices at the extreme edges of the daily price range to hide escalating losses. In recorded phone conversations, one trader described the mares as 'idiotic.'
- The company began maintaining two sets of books and records for the swaps - one set which valued the swaps based on the midpoint of daily average bids and asks (original method), and another based on extreme edges of the daily price range (new method). At one point, the difference in the hidden losses under the two methods exceeded $600 million.
- When JPMorgan announced $2 billion in losses on the whale trade, counterparties were disputing the valuation of its swaps. In July, the company re-stated its first quarter earnings after an internal investigation revealed that even its own traders thought the valuation of its credit default swap portfolio was mismarked.
- Management told the public that it re-stated earnings because it was no longer confident that traders had fairly valued the positions in the swaps portfolio. The mismarked values were due to management's decision to change the valuation of the portfolio from the original method to the new method. Not only was management complicit in mismarking the values, management orchestrated it.
JPMorgan generated net revenue of $102.7 billion, $97.2 billion, and $97.0 billion for 2010, 2011, and 2012, respectively. Due to its ability to reduce credit losses, its income before taxes increased from $24.9 billion in 2010 to $26.7 billion and $28.9 billion in 2011 and 2012, respectively. The following chart displays JP Morgan's 12-month stock performance. The shares hit a trough at $31.00/share in June 2012 and peaked at 51.00 on March 14, 2013. The shares began to pull back after the Senate hearings, closing at $47.46 at the end of March. Though the bad press may have caused a sell off in the stock, I do not expect the recent Senate hearings to impact the company's revenue or earnings.
If lawmakers want to do something concrete to address JPMorgan's behavior concerning the whale trade or protect taxpayers and depositors from Wall Street's wanton speculation in the future, they should take the following steps:
The Sarbanes-Oxley Act of 2002 was enacted after corporate scandals involving Enron, WorldCom, Tyco and Adelphia Cable in the early 2000s. Sarbanes requires corporate officers to attest to the accuracy of their companies' financial statements. The Senate Subcommittee presented evidence that management at JPMorgan hid the company's true financial condition from shareholders and regulators. If it is determined that executives indeed breached Sarbanes then those involved - Drew, Braunstein and even CEO Jamie Dimon - should be punished to the full extent of the law.
Claw Back Bonuses
The financial panel agreed that the bonus claw-back option would not really apply to the whale trade because JPMorgan did not require taxpayer funds to cover the losses. However, the fact that the losses only totaled $6.2 billion was not due to JPMorgan's quality internal controls. In the cases of losses at Bear Stearns, AIG, Morgan Stanley and Goldman Sachs, their losses did require a taxpayer bailout. For the five years leading up to these firms' bailouts, they paid out tens of billions in compensation and benefits. However, none of the executives who orchestrated the losses had his/her bonuses clawed back by the government to help pay for the losses. Going forward, lawmakers should make it clear that the government will claw back executives' bonuses to the extent they seek future taxpayer bailouts.
Ban Bankers From Securities Industry
If fraud was involved or a JPMorgan's internal controls were breached, lawmakers should ban said bankers/traders from the securities industry and every regulated industry in the country. Joseph Jett was a trader at Kidder Peabody in 1994 when he lost $350 million - a mere pittance compared to losses during the crisis. General Electric (GE), Kidder's parent company, accused him of fraud and negligence and dragged Jett in front of the Nasdaq, NYSE and SEC in order to claw back his bonuses and have him banned from the securities industry. Lawmakers should apply the same treatment to Wall Street employees in cases of fraud and gross negligence.
Return to Glass-Steagall
The Glass-Steagall Act of 1933 separated commercial banks and investment banks and protected depositors from losses due to banks betting their own capital. The law was repealed in 1998 and since the crisis, lawmakers have been waffling over new regulations to best protect depositors and taxpayers from Wall Street's wanton speculation with other people's money. Glass-Steagall was effective for over 60 years, so why not go back to it? According to the Why Andrew Ross Sorkin Is Wrong About Glass Steagall,
The "spirit" of Glass Steagall was to reign in Wall Street risk-taking. And after Glass-Steagall was repealed, investment banks returned to the wanton speculation that defined the 1920s and '30s, and precluded the stock market crash and the Great Depression.
For the avoidance of doubt, I am bearish on the U.S. economy and the stock market, and encourage investors to avoid JPMorgan's stock and the market in general. That said, the Senate Subcommittee did a great job in publicly exposing JPMorgan's misdeeds pursuant to the whale trade, sending the company's stock price lower. JPMorgan's management and traders have proven themselves to be incorrigible, and they will continue to engage in wanton speculation and attempt to hide losses from the public unless lawmakers act swiftly. There is way too much bashing of bankers, and not enough regulation, claw backs of bonuses and bankers being banned from the securities industry.