By Erik Schatzker, Dawn Kopecki and Bradley Keoun - Jun 13, 2012 5:45 AM GMT+0700
Dimon’s actions contrast with his reputation as a risk- averse manager who demands regular and exhaustive reviews of every corner of the bank. While Dimon has said he didn’t know how dangerous bets inside the CIO had become, the loss on those trades calls into question whether anyone can manage a financial empire as vast as JPMorgan, which became the biggest U.S. lender last year and now has more than $2.3 trillion in assets, larger than the economies of Brazil or the U.K.
“These institutions are too big to manage because even the bank that was considered to be the best-managed turns out to have had a significant glitch,” said Gary Stern, a former president and CEO of the Federal Reserve Bank of Minneapolis and co-author of the 2004 book “Too Big to Fail: The Hazards of Bank Bailouts.”
Testifying Tomorrow
The trading breakdown has undermined Dimon’s authority as a critic of regulatory efforts to curb speculation by deposit- taking banks, and triggered government probes in the U.S. and the U.K. It also cost Chief Investment Officer Ina R. Drew, one of the most powerful women on Wall Street, her job. JPMorgan shareholders saw about $30 billion of market value wiped out through yesterday since Dimon disclosed the loss.
Dimon may have to account for his decisions as soon as tomorrow, when he’s scheduled to testify about JPMorgan’s trading loss before a Senate committee in Washington. The senators, led by South Dakota Democrat Tim Johnson, may ask Dimon why he didn’t ensure that the chief investment office’s risk managers kept pace with the nature of the unit’s business.
Dimon, 56, declined to comment for this article. In remarks prepared for tomorrow’s hearing, he said the CIO “should have gotten more scrutiny from both senior management and the firmwide risk-control function.”
Limits Ignored
The bank’s “fortress balance sheet remains intact,” and the company will be profitable this quarter, he said.
The CIO’s mission includes investing deposits the bank hasn’t loaned. Over the past four years, assets controlled by the unit ballooned fivefold to $374.6 billion in the first quarter, making it one of the largest money managers on Wall Street. Yet the unit was ill-equipped to handle the size and complexity of its credit-derivative portfolio, according to two former CIO executives and one current executive.
As Dimon encouraged the CIO to take more risk in search of profits, the unit raised limits on positions and sometimes ignored them, the former executives said.
London Whale
At the same time, the position of chief risk officer inside the CIO was a revolving door, with at least five executives holding the job in six years, according to people familiar with the matter. Irvin Goldman, appointed in February and replaced in May, had been fired in 2007 by brokerage Cantor Fitzgerald LP for money-losing bets that led to a regulatory sanction of the firm, said three people with knowledge of the matter. Goldman, 51, wasn’t directly accused of wrongdoing.
The division’s London team built up a book of credit derivatives beginning in 2008 that became so large by late 2010 that employees couldn’t unwind it without roiling the markets or incurring large losses, according to current and former executives.
Risk management at the CIO was a world of its own: This year its traders valued some of their positions at prices that differed from the investment bank, people familiar with the situation have said. One trader built up positions in credit derivatives so large and market-moving he became known as the London Whale. It was those bets on credit-default swaps known as the Markit CDX North America Investment Grade Series 9 that backfired and forced JPMorgan to disclose the trading loss.
Elevating Drew
While Dimon allowed risks inside the CIO to mount, members of his board lacked the experience to police it. None of the three people on the board’s risk-policy committee has worked as a banker or had any experience on Wall Street in the past 25 years, and one is a museum director.
Dimon’s push to take greater risks in the chief investment office, first reported by Bloomberg News on April 13, began in 2005, not long after New York-based JPMorgan completed its acquisition of Bank One Corp. and he became CEO.
He created the CIO, elevated Drew from treasurer to chief investment officer, had her report directly to him and encouraged her department, which had invested mostly in government-backed securities, to seek profit by speculating on higher-yielding assets such as credit derivatives, according to more than half a dozen former executives. Sometimes Dimon suggested positions, such as directional bets on economic trends or asset classes, one current executive said.
‘New Vision’
“We want to ramp up the ability to generate profit for the firm,” David Olson, a former head of credit trading for the CIO in North America, recalled being told by two executives when he was hired in 2006. “This is Jamie’s new vision for the company.”
Bank of America Corp., Citigroup Inc. and Wells Fargo & Co. (WFC), the next three largest U.S. banks, say their corporate investment offices follow more conservative strategies and don’t trade credit-default swaps or indexes linked to the health of companies, as JPMorgan is said to have done.
In 2006, Drew hired Achilles Macris, 50, a former co-head of capital markets at Dresdner Kleinwort Wasserstein, to oversee trading in London and carry out Dimon’s mandate to generate greater profits, three former employees said. When JPMorgan acquired Bear Stearns Cos. and Washington Mutual Inc. at fire- sale prices in 2008 and with government support, the CIO’s portfolio more than doubled to $166.7 billion from $76.2 billion the previous year.
Surging Profits
Profits surged as assets swelled. The group started making more exotic trades, betting against an index of subprime mortgage bonds in 2007 that resulted in a roughly $1 billion profit that year, according to one former CIO executive and another person briefed on the trade. The following year, the corporate division, which includes CIO and treasury results, earned $1.5 billion, compared with a net loss of $150 million in 2007. Net income for the division was $3.7 billion in 2009.
As large as those numbers were, they understated the CIO’s real profitability. Because Drew, 55, and her traders invested on behalf of JPMorgan’s deposit-taking businesses, some of the income they generated flowed to other departments, such as the retail bank. Macris’s team in London, running a portfolio of as much as $200 billion in trades, had a profit of $5 billion in 2010 alone, more than a quarter of JPMorgan’s net income that year, one former executive said.
Earnings Impact
The CIO may have contributed as much as 80 cents a share to the company’s earnings, according to estimates by Charles Peabody, an analyst at Portales Partners LLC in New York.
“The issue that is still being underestimated is how much of their core earnings power is going to be reduced by restructuring and reining in that CIO,” he said in a June 4 interview on “Bloomberg Surveillance.”
In addition to making speculative bets, the CIO took on a bigger role after the financial crisis, hedging JPMorgan’s potential losses on loans and corporate bonds by taking positions in credit derivatives.
The question of CIO oversight arose in the months after the crisis, when top JPMorgan executives heard what Macris and his fellow traders in the London office were doing and raised concerns to Dimon that the unit’s risk management was inadequate, according to the two executives familiar with the conversations.
William Winters and Steven Black, co-heads of JPMorgan’s investment bank at the time, were among those who sought more information about the CIO’s changing risk profile, according to people who participated in or witnessed the conversations.
Visibility Lacking
James “Jes” Staley, 55, who ran asset management at the time and now heads the investment bank, and John Hogan, then the investment bank’s chief risk officer, also questioned why risk controls inside the CIO weren’t as extensive or robust as in other departments.
“That’s absurd,” said Kristin Lemkau, a spokeswoman for the bank. Winters, Black and Staley never complained about a specific risk in the CIO, she said. If they had, Dimon’s protocol would have been to gather the relevant data, let them talk to Drew and return to him if they weren’t satisfied with her response, a bank executive said. The operating committee, on which they all sat, also could have reviewed the matter if they still had concerns, the person said.
Hogan, in a statement issued through Lemkau, said he never raised CIO risk practices with Dimon while serving as the investment bank’s chief risk officer. “That’s never happened,” he said in the statement.
Chinese Wall
One sore spot for executives inside the investment bank was the lack of visibility into CIO positions, according to two people with direct knowledge of the matter. While the weekly risk-committee meetings held by the investment bank were open to members of senior management and were attended regularly by Macris and occasionally by Drew, parallel sessions run by the CIO were closed to anyone outside the unit, these people said.
Among the explanations offered for Drew’s autonomy: There was a so-called Chinese wall between the CIO and investment bank because Drew’s unit was also a client, according to one current and two former executives. The CIO used the investment bank to place and process trades. Drew didn’t trust that division to refrain from using the data to its advantage by offering non- competitive prices or by trading against her, according to a former executive who participated in those talks.
It also was widely known within the bank that Winters, 50, and Black, 60, didn’t get along with Drew, according to a current and a former executive.
A person close to the bank offered a different description of the circumstances: While Dimon didn’t adopt a double standard for Drew, he and other senior executives became complacent toward the CIO over time as a result of her track record as a consistent money maker, this person said.
Dimon’s Response
Winters and Black proposed redefining the role of Ashley Bacon, then head of market risk for the investment bank, to extend his oversight to the CIO, a former bank official said. The executives also asked that CIO risks be disclosed in greater detail at review meetings and that other members of the bank’s operating committee be involved in assessing them.
Dimon’s response, one of the people said, was that the situation was under control. It was an answer that one former executive said he got from Dimon again and again, as risks in the CIO grew to potentially perilous levels.
“You really need people who have a very broad view of things both quantitatively and with market knowledge and have the clout within the firm to actually be heard,” said Emanuel Derman, a former head of quantitative risk strategies at Goldman Sachs Group Inc. (GS), a professor at Columbia University and author of “My Life as a Quant” and “Models Behaving Badly.” “To say that it’s OK with the desk is not the right thing to do.”
‘Good King’
In 2009, Dimon fired Winters and relieved Black of operating responsibility. Staley took over as head of the investment bank, and Mary Erdoes, 44, succeeded him at asset management. Winters, Staley and Hogan declined to comment on the discussions. Black didn’t return phone calls seeking comment.
Dimon and what he called his “fortress balance sheet” meanwhile were being lauded by politicians and the media. He steered JPMorgan through the 2008 financial crisis without a single quarterly loss. New York magazine dubbed him “Good King Jamie,” while a biography by Duff McDonald was titled “Last Man Standing: The Ascent of Jamie Dimon and JPMorgan Chase.”
‘Structural Deficiencies’
“In the wake of the financial crisis, he came to represent this notion that, if well-managed, a bank didn’t need to be regulated all that heavily,” said Rakesh Khurana, a management professor at Harvard Business School in Cambridge, Massachusetts, and author of “Searching for a Corporate Savior: The Irrational Quest for Charismatic CEOs.” “That may have contributed to some structural deficiencies in governance and risk management. It probably created the benefit of the doubt to his direction in the board room and probably a lot of deference to his authority in day-to-day operations.”
Drew spent three decades at the firm and its predecessors, helping steer it through the Russian debt crisis and the collapse of hedge fund Long-Term Capital Management in 1998.
At first, she maintained tight control over the CIO’s trades, former colleagues and employees said. She ran the group’s daily 7 a.m. meetings in a seventh-floor conference room at JPMorgan’s headquarters at 270 Park Ave. in Manhattan, according to former traders. She placed strict limits on how much an investment could lose or gain, and traders were required to exit positions if losses exceeded a certain amount, according to one former manager in London and several former traders.
Longer Leash
Macris gave traders a longer leash and imposed fewer controls, according to three former executives. So-called stop- loss limits, which were supposed to trigger an internal review or require a trader to immediately exit a position if losses grew too large, weren’t always enforced, the executives said. Macris didn’t respond to e-mails or phone calls seeking comment.
The shift in risk appetite led to the departures in 2008 of some traders who specialized in more-liquid markets where risk was easier to measure, such as interest-rate products and foreign exchange, three other former CIO executives said. Under Macris, the CIO’s London office bought European mortgage-backed securities, structured credit and other assets that brought higher yields and more risks than the safest short-term Treasury bonds.
Peter Weiland, who graduated from Princeton University with a degree in chemistry and had been overseeing risk for JPMorgan’s proprietary-trading group, was transferred in 2008 into the same role at the CIO. He immediately saw faults in the division’s risk-management system, said two former executives who worked with him.
Boeing 747
While Drew hired traders and quantitative analysts needed for trading, she failed to add the staff, computer models or technology necessary to evaluate the new risks, a former and a current executive said. The risk-management systems and framework designed to spot potential pitfalls, especially in credit derivatives, didn’t keep pace with the portfolio’s expansion, the people said.
Weiland became concerned that Bruno Iksil, the trader in Macris’s office now known as the London Whale, had amassed a complex and illiquid position, according to two former executives. Weiland, who declined to comment, warned Macris and Drew about the trades on numerous occasions beginning in 2010, the people said. It was a topic of frequent discussions in the CIO’s global weekly meetings, they said.
Weiland compared efforts to reduce Iksil’s outsized position to the difficulty of trying to safely land a Boeing 747 without flying lessons, one executive said. The position was so large and illiquid, Weiland said he couldn’t get the plane below 35,000 feet, the executive said.
Changing VaR
Dimon said in his prepared testimony that the plan to reduce the CIO’s credit-derivative trades was “poorly conceived and vetted.”
“The strategy was not carefully analyzed or subjected to rigorous stress-testing within CIO and was not reviewed outside CIO,” he said.
By 2010 Iksil’s value-at-risk, or VaR -- a formula used by banks to assess how much traders might lose in a day -- already was $30 million to $40 million, a person with knowledge of the matter said. At times the figure surpassed $60 million, the person said, about as high as the level for the firm’s entire investment bank, which employs 26,000 people.
Drew, who resigned last month after the CIO losses were announced, was on sick leave for about six months in 2010, during which time Macris and Althea Duersten, head of the CIO for North America, ran the division. The daily meetings were moved to a larger conference room near their new offices on the 10th floor to accommodate about 40 people in attendance. Drew relocated to the executive suites, more than 30 floors higher, to be closer to Dimon.
Illiquid
Drew and Macris agreed to reduce Iksil’s positions and tried to do so beginning in early 2011, according to a current and two former executives. The plan was to work down the book gradually as they found opportunities to sell the assets, these people said. The problem: No one was buying. The position was too large and illiquid and couldn’t be reduced without a loss. Drew and Macris decided the bank could hold the trades to maturity and that the risk of being forced to liquidate them under duress was low, according to the former executives.
Early this year, as the size and volatility of its trades were growing, the bank changed the computer-based mathematical formulas for calculating the chief investment office’s VaR. The new model had the effect of understating the risk of losses from Iksil’s trades: It showed an average daily VaR within the CIO of $67 million, about where it stood in the fourth quarter of 2011.
‘Risk 101’
On May 10, when JPMorgan announced the loss, Dimon said the bank had reviewed the effectiveness of the new model, deemed it “inadequate” and decided to go back to the original model. On that basis, VaR doubled to $129 million. So far, the bank hasn’t disclosed how or when VaR for the CIO unit was changed while the model for the rest of the firm remained untouched. Nor has it explained who sought the change and who approved it.
Unable to unwind Iksil’s bets, the bank tried to hedge them this year with other trades, exacerbating the losses, Dimon said on May 10. Iksil had amassed positions in securities linked to the financial health of corporations that were so large he was driving price moves in the $10 trillion market.
Dimon later called it “a Risk 101 mistake.” Shares of the company have dropped 19 percent through yesterday since the losses were announced, and at least half a dozen agencies, including the U.S. Department of Justice and the Securities and Exchange Commission, are investigating.
‘Brightest Angel’
While Dimon hasn’t faced the same public scrutiny that rivals at Goldman Sachs and Bank of America endured after the 2008 credit crunch, the attention surrounding his testimony has echoes with the bank’s own history. In 1933, after Congress was shaken by another financial crisis, J.P. “Jack” Morgan, then CEO of the company, was summoned to testify about preferential treatment that JPMorgan gave certain clients.
The public reaction was “extreme disillusionment: the brightest angel on Wall Street had fallen,” Ron Chernow wrote in his 1990 book, “The House of Morgan.” The scandal “cast it in the mud with other banks.”
The embarrassing disclosures in those hearings led to the Glass-Steagall Act, which forced JPMorgan to split off its investment-banking business from its deposit-taking arm. Dimon’s testimony tomorrow may have a similar effect: Giving ammunition to those who would enforce stricter regulation of banks, including advocates of the Volcker rule, which would bar most proprietary trading by deposit-taking institutions and that the JPMorgan CEO has fought vociferously.
Psychiatrists
He has said former Fed Chairman Paul Volcker, for whom the rule is named, doesn’t understand capital markets. He quipped that bankers will need psychiatrists to evaluate whether their trades qualify as hedges. Last year he took on Fed Chairman Ben S. Bernanke in a public forum, blaming excessive regulation for slowing a U.S. economic recovery and asking whether anyone has “bothered to study the cumulative effect of all these things.”
Now, his own lapses may come back to haunt him.
“The risk management is as amateurish as you can get on Wall Street,” Nassim Taleb, a professor of risk engineering at New York University and author of “The Black Swan: The Impact of the Highly Improbable,” said in a telephone interview about the bank’s loss. “JPMorgan is vastly more fragile today than it was five years ago, and the system is more fragile today with more too-big-to-fail banks with proven incompetence at their management level.”
To contact the reporters on this story: Erik Schatzker in New York at eschatzker@bloomberg.net; Dawn Kopecki in New York at dkopecki@bloomberg.net; Bradley Keoun in New York at bkeoun@bloomberg.net or @liqquidity on Twitter
To contact the editors responsible for this story: David Scheer at dscheer@bloomberg.net
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