July 13, 2012
In one of the most anticipated earnings releases and conference calls of the second-quarter earnings season, JPMorgan Chase CEO Jamie Dimon offered some fresh insight into the whale-sized losses incurred in the bank’s London investment office. Fittingly, the bank set aside a full two hours for the conference call, to allow Mike Cavanagh, head of Treasury & Securities services, to fill everyone in on the investigation that he has been conducting into what went awry.
Anyone looking for reasons to remain faithful to the “House of Dimon” probably came away with plenty of ammunition, in the shape of repeated assurances from Dimon that the trading loss was an aberration, that controls have been strengthened, that the bank’s balance sheet remains a “fortress” and its operations are solid. On the flip side, anyone already concerned about what the risk management failures say about the bank probably didn’t walk away feel significantly more upbeat.
Here are some key takeaways, gleaned from the marathon conference call:
$5.8 billion and counting: That’s how much JPMorgan has lost on the trade put in place by the London Whale (aka Bruno Iskil, the trader who has been sent packing) so far, including $4.4 billion in the second quarter of 2012. “It’s costly to do,” Dimon said of winding down the positions.
The synthetic credit portfolio that generated those losses was intended to offset losses in other parts of the bank’s business during a “stressed” credit environment. But all told, those gains amounted to $2 billion from 2007 until 2011, and were more than wiped out by the magnitude of the losses. JPMorgan said the London-based Chief Investment Office will no longer trade those derivatives. The bank also said that the trades could still cost another $800 million to $1.7 billion before they are completely unwound.
Overall, though, JPMorgan Chase still posted a second-quarter profit of $4.96 billion, down from $5.43 billion a year ago, on revenue of more than $22 billion.
The traders went rogue: At the end of 2011, the bank’s top management told the CIO to cut back the amount of risk in the credit portfolio as the result of an annual risk budgeting process. As Cavanagh told the conference call, “it appears, and that’s all it is, an appearance, that they thought about it a bit, but they believed that it would be more expensive than the approach they chose, which obviously proved to be wrong.” In other words, they over-rode instructions. The traders may have also hidden losses, which could lead to criminal charges.
Risk managers were wimpy: This has been a common theme across Wall Street for decades, so it’s hardly surprising to find that either the actions of the London trading group weren’t overseen – to quote Cavanagh, “it was a very risky approach they took that should have been discussed in more senior levels, but it was not” – and that risk managers decided that instead of sticking to their guns, they would view the world through the rose-tinted spectacles of the traders. When positions violated limits established by the bank, the CIO’s market risk officer “granted relief from the limit on the basis that the measure was an unsophisticated tool for measuring risk in the circumstances,” Cavanagh reported. “CIO risk wasn’t forceful enough in challenging the front office and never developed a sufficient understanding of the risk of the portfolio to escalate concerns to senior risk leaders outside CIO during the first quarter.” Whoops.
Hitting traders where it hurts: In a Wall Street first, JPMorgan said it would claw back money from managers involved and said it would take the maximum allowed under its policies – about two years’ worth of compensation. Ina Drew, the Dimon deputy who headed the Chief Investment Office and resigned after the trade blew up, also volunteered to return that amount in pay. She had earned more than $15 million in each of the last two years. Yet, in Dimon’s view, Drew is actually an unsung heroine. One former bank chairman, he said, wrote to him arguing that “she saved the company, in his judgment.” As for Dimon himself, he sees her as having “acted with integrity and tried to do what was right for the company at all times, even though she was part of the mistake.”
Will the Libor scandal spread?: Is JPMorgan involved? The question was asked during the conference call, and it’s one that lurks beneath investor unease about the bank going forward. “It gets people thinking about, gee, if the CIO office didn’t have controls in that part of the world [i.e., London], why should we believe that the rest of the organization did?” “I can never prove a negative,” Dimon said, rather huffily. “We think (controls) are pretty good.”
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The bottom line: Had Dimon been discussing controls six or nine months ago, the odds are high he would have made precisely the same statement – that in his opinion, the controls were good. Have models been overhauled? Absolutely. And management pointed out that they will be relying more on stress testing going forward, which could have revealed the trading losses – or the violation of risk management limits – at an earlier stage.
“I think it's silly for anyone in the business world to think you're not going to make mistakes,” said Dimon. “It is not possible in the real world. I just think the mistakes should be smaller, fewer and far between, this being an exception.” But confidence that this is an exception – especially on the day that the bank reported the size of the loss on the CIO trade and restated its first-quarter results – may be hard to come by. Certainly analyst Mike Mayo wasn’t feeling the love. “We saw how the sausage is made,” he commented on the conference call. “It makes me wonder if I might get food poisoning sometime in the future.”