Too Big To Fail: 3 Lessons of the “London Whale” Debacle

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Of the many scandals that have plagued Wall Street of late, the “London Whale” trades, which cost banking giant JPMorgan Chase more than $6 billion, has captured the attention of the financial media more than any other. The biggest reason for journalists’ obsession with this story is that it tarnished the reputation of JPMorgan CEO Jamie Dimon, who is widely thought to be one of the most competent bank CEOs in the business, and one of the few who ably steered his bank through the subprime-mortgage crisis. And as far as the media is concerned, the bigger they come, the more people like to watch ’em fall.

But there is more to this story than the comeuppance of the biggest banker on the Street today. The London Whale debacle, and the subsequent Senate investigation, gives us a window into the culture and operations of the biggest bank in America as it adjusts to a postcrisis world in which Dodd-Frank is the law of the land. And the picture painted isn’t exactly comforting. The Senate’s report on the losses, coupled with Friday’s public hearing, describes a bank where complex derivatives and other methods were used to hide risk from bank regulators, investors and themselves, all in an effort to boost profits. Luckily, these trades didn’t come close to putting the bank at risk of insolvency. But that doesn’t mean a similar series of events couldn’t play out at a more poorly managed institution without the competence or scruples to contain the situation quickly. Could it be a $36 billion trading loss the next time around? Let’s hope not. With any luck, lawmakers and regulators will use this episode as an impetus for continued regulatory reform. Here are three lessons we should learn from the London Whale fiasco:

1. Derivatives Are Dangerous

Ironically, the $6 billion London Whale loss occurred in an area of the bank — the Chief Investment Office (CIO) — that was in charge of investing excess bank deposits in a low-risk manner. As part of this effort to manage the bank’s risk, the CIO bought synthetic derivatives (referred to as their synthetic-derivatives portfolio or SCP) designed to hedge against big downturns in the economy. These derivatives theoretically functioned much like an insurance contract, whereby JPMorgan was paid large sums in the event that a certain company or companies defaulted on their debt. If those same companies stayed current on their debt, JPMorgan was obliged to continue making regular premium payments.

At some point along the way, however, the Chief Investment Office, helmed by Ina Drew, seemed to lose sight of the purpose of these hedges. The portfolio became a source of profit for the bank during the financial crisis, and again in 2011, when the European debt crisis fanned the flames of global economic uncertainty. It was in late 2011, after American Airlines declared bankruptcy, that the CIO made a huge windfall profit, and this event apparently encouraged traders at the CIO to quickly build up huge derivatives positions. From the Senate report:

The American Airlines gain also appears to have colored how the CIO viewed the SCP thereafter, as a portfolio that could produce significant profits from relatively low-cost default protection. In addition, it produced a favorable view within the CIO of the SCP’s complex trading strategy that involved combining investment-grade and noninvestment-grade credit-index trades, accumulating massive tranche positions, and sustaining a period of losses in anticipation of a large payoff.

So when the CIO office got word to reduce risk in its portfolio, instead of dumping the sort of hedges that made the CIO tons of money following the American Airlines bankruptcy, JPMorgan traders decided to purchase more insurance against short-term defaults and offsetting derivatives that bet on the solvency of investment-grade companies. But as the economy improved in 2012, the insurance it bought tanked in value while the offsetting investments didn’t appreciate nearly enough to make up for it.

The details of these trades are complicated, but the upshot is that derivatives give traders the ability to rack up big, risky positions very quickly. The Senate report makes it clear that it took traders in the CIO office just a few months do most of the damage that led to the $6 billion loss, before regulators were aware that anything was amiss. The perilousness of derivatives was a lesson we learned from the financial crisis. The Dodd-Frank financial-reform law made a lot of progress in beefing up derivatives regulation, and hopefully we’ll see increased transparency requirements encourage safer use of derivatives. But many rules remain unwritten, and regulators should remain vigilant to the risks posed by derivates as they continue to implement Dodd-Frank.

2. Accounting and Risk Management Are Inherently Subjective …

Much of the report focused on the accounting and risk-management systems at JPMorgan, and how the bank adjusted its practices to hide the true extent of the losses. That this deception is unacceptable goes without saying, and I’m sure there are armies of lawyers amassing at this moment to plan shareholder lawsuits. But this incident should also simply illustrate the fact that if accounting rules and risk models show something a banker doesn’t want to see, there are many avenues to get around that result. JPMorgan, for instance, simply changed its accounting methods and risk models to generate a different answer. And given the subjectivity of risk management and accounting (reasonable people can disagree on the magnitude of hundreds of millions of dollars when it comes to valuing a portfolio of exotic derivatives) there’s nothing necessarily illegal about it.

3. … So We Can’t Trust Bankers to Make Their Own Rules

Given the complexity and subjectivity of these tasks, it’s paramount that regulators not trust banks to make their own rules. Upton Sinclair famously quipped that “it’s difficult to get a man to understand something when his salary depends on his not understanding it.” And this is why it’s disheartening that banks across the globe have been so successful at watering down financial-regulatory-reform efforts since the crisis. The recent Basel III accord — the global agreement that sets minimum regulatory requirements — is far too reliant on the same risk measures that blew up in JPMorgan’s face. As a Bloomberg report from January describes it:

The new capital rules are based on the same principal as the old ones: allowing the largest lenders to use their own mathematical models to determine how much capital they need. The calculations, which assume the banks can predict what’s risky, can involve millions of variables, making them difficult for examiners to review, according to an August report by the Bank of England.

If this London Whale episode teaches us anything, it’s that we can’t cede risk management to the banks. They simply have too many incentives to do whatever it takes to allow themselves to pile on more risk. A much saner approach to regulation reform is for central banks in the U.S. and elsewhere to simply require big banks like JPMorgan to hold less debt relative to equity on their balance sheets. This would avoid a dangerous reliance on Wall Streets’ failed models. And it would assume what the evidence plainly shows: big banks will screw up big time, eventually. And when that happens, we need to make sure they have enough capital to cushion their falls.

1 comments
relmasian
relmasian

Too true.  One can trust banks to avoid risks that would bankrupt them about as far as you can trust drivers to avoid speeding that might kill them; both need reasonable rules of the road to help avoid disasters caused both by their own and their peers actions.