United States Senate

PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

Committee on Homeland Security and Governmental Affairs
Carl Levin, Chairman
John McCain, Ranking Minority Member

.

JPMORGAN CHASE WHALE TRADES:
A CASE HISTORY OF DERIVATIVES
RISKS AND ABUSES

MAJORITY AND MINORITY
STAFF REPORT

PERMANENT SUBCOMMITTEE
ON INVESTIGATIONS

UNITED STATES SENATE

I. EXECUTIVE SUMMARY

A. Subcommittee Investigation

The JPMorgan Chase whale trades first drew public attention in April 2012. Beginning
that same month, Senator Carl Levin’s office made preliminary inquiries into what happened and
subsequently received a series of briefings from JPMorgan Chase. On June 13, 2012, the U.S.
Senate Committee on Banking, Housing, and Urban Affairs held a hearing in which JPMorgan
Chase’s Chief Executive Officer Jamie Dimon testified and answered questions about the whale
trades.1 On June 19, 2012, Mr. Dimon appeared at a second hearing before the U.S. House
Committee on Financial Services.2

In July 2012, the U.S. Senate Permanent Subcommittee on Investigations initiated a
bipartisan investigation into the trades. Over the course of the next nine months, the
Subcommittee collected nearly 90,000 documents, reviewed and, in some cases transcribed, over
200 recorded telephone conversations and instant messaging exchanges,3 and conducted over 25
interviews of bank and regulatory agency personnel. The Subcommittee also received over 25
briefings from the bank and its regulators, including the Office of the Comptroller of the
Currency (OCC) and Federal Deposit Insurance Corporation (FDIC), and consulted with
government and private sector experts in financial regulation, accounting practices, derivatives
trading, and derivatives valuation.

The materials reviewed by the Subcommittee included JPMorgan Chase filings with the
Securities and Exchange Commission (SEC), documents provided to and by the OCC, JPMorgan
Chase board and committee minutes, internal memoranda, correspondence, and emails,
chronologies of trading positions, records of risk limit utilizations and breaches, audio recordings
and instant messaging exchanges, legal pleadings, and media reports. In addition, JPMorgan
Chase briefed the Subcommittee about the findings of an internal investigation conducted by a
task force headed by Michael Cavanagh, a senior bank official who is a member of the firm’s
Executive and Operating Committees. That investigation released its results to the public in a
report on January 16, 2013.4 Bank representatives also read to the Subcommittee portions of
notes taken during interviews conducted by the JPMorgan Chase Task Force of CIO personnel,
including traders, who were based in London. In addition to bank materials, the Subcommittee
reviewed documents prepared by or sent to or from banking and securities regulators, including
bank examination reports, analyses, memoranda, correspondence, emails, OCC Supervisory
Letters, and Cease and Desist Orders. Those materials included nonpublic OCC examination
materials and reports on the whale trades and on the OCC’s own oversight efforts.5 The
Subcommittee also spoke with and received materials from firms that engaged in credit
derivative trades with the CIO.

JPMorgan Chase has cooperated fully with the Subcommittee’s inquiry, as have the
regulatory agencies. However, several former JPMorgan Chase employees located in London
declined Subcommittee requests for interviews and, because they resided outside of the United
States, were beyond the Subcommittee’s subpoena authority. Those former employees, Achilles
Macris, Javier Martin-Artajo, Bruno Iksil, and Julien Grout, played key parts in the events at the
center of this inquiry; their refusal to provide information to the Subcommittee meant that this
Report had to be prepared without their direct input. The Subcommittee relied instead on their
internal emails, recorded telephone conversations and instant messages, internal memoranda and
presentations, and interview summaries prepared by the bank’s internal investigation, to
reconstruct what happened.

B. Overview

The Subcommittee’s investigation has determined that, over the course of the first quarter
of 2012, JPMorgan Chase’s Chief Investment Office used its Synthetic Credit Portfolio (SCP) to
engage in high risk derivatives trading; mismarked the SCP book to hide hundreds of millions of
dollars of losses; disregarded multiple internal indicators of increasing risk; manipulated models;
dodged OCC oversight; and misinformed investors, regulators, and the public about the nature of
its risky derivatives trading. The Subcommittee’s investigation has exposed not only high risk
activities and troubling misconduct at JPMorgan Chase, but also broader, systemic problems
related to the valuation, risk analysis, disclosure, and oversight of synthetic credit derivatives
held by U.S. financial institutions.

[…]

[ipaper docId=130426373 access_key=key-1y26skxosdqk0remwmem height=600 width=600 /]

image: REUTERS

In its investigation, the Subcommittee reviewed over 90,000 documents and conducted over 50 interviews and briefings.  The hearing, which begins at 9:30 a.m., on March 15, 2013, will take testimony from current and former JPMorgan Chase executives and representatives of its primary regulator, the Office of the Comptroller of the Currency (OCC).  At the hearing, the Subcommittee will also release nearly 100 hearing exhibits, including internal bank and OCC records, emails, and telephone call transcripts.  

The Levin-McCain report makes the following findings of fact. 

(1)   Increased Risk Without Notice to Regulators.  In the first quarter of 2012, without alerting its regulators, JPMorgan Chase’s Chief Investment Office used bank deposits, including some that were federally insured, to construct a $157 billion portfolio of synthetic credit derivatives, engaged in high risk, complex, short term trading strategies, and disclosed the extent and high risk nature of the portfolio to its regulators only after it attracted media attention.

(2)   Mischaracterized High Risk Trading as Hedging.  JPMorgan Chase claimed at times that its Synthetic Credit Portfolio functioned as a hedge against bank credit risks, but failed to identify the assets or portfolios being hedged, test the size and effectiveness of the alleged hedging activity, or show how the SCP lowered rather than increased bank risk.

(3)   Hid Massive Losses.  JPMorgan Chase, through its Chief Investment Office, hid over $660 million in losses in the Synthetic Credit Portfolio for several months in 2012, by allowing the CIO to overstate the value of its credit derivatives; ignoring red flags that the values were inaccurate, including conflicting Investment Bank values and counterparty collateral disputes; and supporting reviews which exposed the SCP’s questionable pricing practices but upheld the suspect values.

(4)   Disregarded Risk.  In the first three months of 2012, when the CIO breached all five of the major risk limits on the Synthetic Credit Portfolio, rather than divest itself of risky positions, JPMorgan Chase disregarded the warning signals and downplayed the SCP’s risk by allowing the CIO to raise the limits, change its risk evaluation models, and continue trading despite the red flags.

(5)   Dodged OCC Oversight.  JPMorgan Chase dodged OCC oversight of its Synthetic Credit Portfolio by not alerting the OCC to the nature and extent of the portfolio; failing to inform the OCC when the SCP grew tenfold in 2011 and tripled in 2012; omitting SCP specific data from routine reports sent to the OCC; omitting mention of the SCP’s growing size, complexity, risk profile, and losses; responding to OCC information requests with blanket assurances and unhelpful aggregate portfolio data; and initially denying portfolio valuation problems.

(6)   Failed Regulatory Oversight.  The OCC failed to investigate CIO trading activity that triggered multiple, sustained risk limit breaches; tolerated bank reports that omitted portfolio-specific performance data from the CIO; failed to notice when some monthly CIO reports stopped arriving; failed to question a new VaR model that dramatically lowered the SCP’s risk profile; and initially accepted blanket assurances by the bank that concerns about the SCP were unfounded.

(7)   Mischaracterized the Portfolio. After the whale trades became public, JPMorgan Chase misinformed investors, regulators, policymakers and the public about its Synthetic Credit Portfolio by downplaying the portfolio’s size, risk profile, and losses; describing it as the product of long-term investment decisionmaking to reduce risk and produce stress loss protection, and claiming it was vetted by the bank’s risk managers and was transparent to regulators, none of which was true.

The Levin-McCain report makes the following recommendations that may curb derivative risks and abuses.

(1) Require Derivatives Performance Data.  Federal regulators should require banks to identify all internal investment portfolios containing derivatives over a specified notional size, and require periodic reports with detailed performance data for those portfolios.  Regulators should also conduct an annual review to detect undisclosed derivatives trading with notional values, net exposures, or profit-loss reports over specified amounts.

(2) Require Contemporaneous Hedge Documentation.  Federal regulators should require banks to establish hedging policies and procedures that mandate detailed documentation when establishing a hedge, including identifying the assets being hedged, how the hedge lowers the risk associated with those assets, how and when the hedge will be tested for effectiveness, and how the hedge will be unwound and by whom.  Regulators should also require banks to provide periodic testing results on the effectiveness of any hedge over a specified size, and periodic profit and loss reports so that hedging activities producing continuing profits over a specified level can be investigated.

(3) Strengthen Credit Derivative Valuations.  Federal regulators should strengthen credit derivative valuation procedures, including by encouraging banks to use independent pricing services or, in the alternative, prices reflecting actual, executed trades; requiring disclosure to the regulator of counterparty valuation disputes over a specified level; and requiring deviations from midpoint prices over the course of a month to be quantified, explained, and, if appropriate, investigated.

(4) Investigate Risk Limit Breaches.  Federal regulators should track and investigate trading activities that cause large or sustained breaches of VaR, CS01, CSW10%, stop-loss limits, or other specified risk or stress limits or risk metrics.

(5) Investigate Models That Substantially Lower Risk.  To prevent model manipulation, federal regulators should require disclosure of, and investigate, any risk or capital evaluation model which, when activated, materially lowers the purported risk or regulatory capital requirements for a trading activity or portfolio.

(6) Implement Merkley-Levin Provisions.  Federal financial regulators should immediately issue a final rule implementing the Merkley-Levin provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, also known as the Volcker Rule, to stop high risk proprietary trading activities and the build-up of high risk assets at federally insured banks and their affiliates.

(7) Enhance Derivative Capital Charges.  Federal financial regulators should impose additional capital charges for derivatives trading characterized as “permitted activities” under the Merkley-Levin provisions, as authorized by Section 13(d)(3) of the Bank Holding Company Act.  In addition, when implementing the Basel III Accords, federal financial regulators should prioritize enhancing capital charges for trading book assets.

Comments

comments