Pay Clawbacks For Executives Would Be In Order On JPMorgan Loss

| About: JPMorgan Chase (JPM)

by Boyd Erman

JPMorgan Chase & Co. (NYSE:JPM) chief executive officer Jamie Dimon wants to keep the regulators out of banking – so here's his chance to prove his institution is willing to regulate itself. It's not enough to push out the people at JPMorgan who were responsible for the $2-billion (U.S.) trading loss that the company disclosed last week, which led to a $14-billion disappearance of shareholder value on Friday. The bank and its board ought to demand those involved return much of their pay.

Ina Drew, the chief investment officer who oversaw the trading, earned about $31-million over the past two years. The top traders under her would also have earned millions. As they are escorted out the door, much of that money should be returned to the bank and its shareholders. And Mr. Dimon, as a champion of Ms. Drew's group, should probably give up some of his compensation as well.

Even those many millions wouldn't go far to close the gaping hole in the bank's profitability their mistakes opened, but it would be symbolic of an industry that at least takes its pledges seriously to align pay with risk. JPMorgan Chase has the ability to claw back money, as part of a mechanism purported to align "near-term rewards to longer-term risks." According to the firm's proxy statement, a clawback can be used if "the employee engages in conduct that causes material financial or reputational harm to the firm or its business activities."

Is a loss of this magnitude material? Here's a clue: JPMorgan felt the need to disclose the problem trade, which suggests the bank itself felt the situation had reached the threshold of materiality.

For members of the operating committee, a top management group that included Ms. Drew, the bank can also demand to be paid back if employees "improperly or with gross negligence fail to identify, raise, or assess, in a timely manner and as reasonably expected, risks and/or concerns with respect to risks material to the firm or its business activities."

It would seem that missing the risk that a trade may yet generate as much as $3-billion in losses might fall under that clause, especially since Mr. Dimon himself characterized the trade as "flawed, complex, poorly reviewed, poorly executed and poorly monitored." What exactly JPMorgan's traders did wrong is still not clear, but the leading theories bouncing around the market aren't flattering. The betting among some smart derivative traders is that the JPMorgan team misread the so-called negative gamma of their trade – in other words, how fast the rate of losses would accelerate if markets moved against the bank's position.

In many trades where a bank is selling credit insurance, as JPMorgan appears to have done, there's an expectation of some losses. The key is to price the insurance correctly so the premium income overwhelms the losses. It's the same logic used by a home insurance company. Some houses will burn down, but if the premium income is high enough, there is still a profit to be had in selling policies. But you have to correctly understand the worst-case scenario for house fires.

The bank may have simply mispriced the premiums after underestimating the losses, perhaps because of a bad computer model. In the context of a high-powered trading desk, putting on a huge trade with excess customer deposits, it's a mistake that it is hard to understate.

However, there's a deeper question. JPMorgan has characterized the trade as a hedge, which conveniently puts it outside the activities banned by the so-called Volcker Rule. Yet if the bank was simply selling credit insurance, as has been reported, there's almost no way to construe that as a hedge against its core business as a huge global lender.

Any bank, by nature, is a giant bet on companies and individuals paying back their loans. Selling credit insurance is a bet on the same thing. One does not hedge something by doing more of it. So either there's a second half to the trade that the market hasn't yet figured out, or JPMorgan isn't being completely forthcoming.

These possible causes for the loss, and its sheer magnitude, point to the same conclusion: There's no way that the people involved should keep their big pay packages. To have any credibility as stewards of proper compensation practises, bank boards have to not only bare their claws for clawbacks, they have to be prepared to use them.

Disclosure: No positions

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