It’s also worth bearing in mind, however, that the new rules are likely to improve things only if banks and regulators live up to their responsibilities. Last week, federal authorities criminally indicted two former JPMorgan Chase & Co. employees who allegedly hid losses related to a trading scandal last year that cost the bank more than six billion dollars. The details of the indictment underscore the fact that one of the most significant instances of Wall Street misbehavior in recent years had less to do with a deficit of rules than with JPMorgan’s failure to follow the ones that already existed, and the government’s failure to notice. The most troubling questions emerging from those trades are these: How did JPMorgan—which played a key role in creating the method of measuring risk that is most common on Wall Street—end up misusing its risk-measurement tool? And how did the government miss the red flags?
The risk-measurement tool known as “Value at Risk,” or VaR, emerged from the seismic changes that shook the financial industry during the last two decades of the twentieth century. Commercial and investment banks were merging, going public, and increasing in scale. Just as these financial supermarkets began attracting ever-larger pools of capital from investors, there was an explosion of trading in exotic and complicated securities based on mortgages and other consumer debt. After the stock-market crash of 1987, banks became much more interested in developing more sophisticated risk-control mechanisms for their increasingly large and volatile portfolios. (Joe Nocera writes that senior managers who had come up through commercial banks, like Dennis Weatherstone, J. P. Morgan’s chairman at the time that VaR took off, were especially concerned: they were accustomed to managing the risks posed by lending to consumers and companies, but they needed help understanding the risks posed by these newly invented trading operations.) To fill this void, J. P. Morgan—the bank that later became part of JPMorgan Chase through an acquisition—helped to develop, and popularize, VaR.
VaR is essentially a probability measurement based on historical prices. It estimates the loss in value that a given portfolio could experience—for example, one might use the average of the worst thirty-three days in the previous year’s performance to estimate how much a portfolio might decline the following day. This is far from a perfect measurement of risk. Critics point out that it doesn’t properly take into account certain risks that may be serious but are unlikely to take place—that is, risks like those that played a role in the financial crisis. Nonetheless, VaR is one of the best risk-measurement tools available to banks and regulators. It has the virtue of being simple: at the end of each day, the bank can estimate how much the bank, and each of its individual portfolios, might lose over the following day, month, or some other period. It also helps senior managers evaluate traders and decide how much capital to let them work with. For example, two traders might each boast a fifteen-per-cent return on a million-dollar portfolio, but if one trader accomplishes that with a significantly less risky VaR, then her senior manager may award her with higher trading limits than her colleague.
So attractive was VaR to the banking industry that, in 1994, J. P. Morgan gave away the tools and data it developed as open software that any other bank could use and improve. By 1997, VaR had become so accepted as a risk-management tool that the S.E.C. began allowing financial companies to use VaR in risk disclosures to shareholders. U.S. and international banking supervisors also use VaR to help them decide how much capital a bank needs to keep in reserve so that it can cover any losses that might take place.
Despite its shortcomings and critics, VaR had been working reasonably well in identifying risks at JPMorgan Chase. The bank also used four other risk-management tools. Then came the notorious trades of 2012 by Bruno Iksil, a former trader since nicknamed the London Whale because of the enormity of his trading positions. Those trades took place in the bank’s synthetic-credit portfolio in its Chief Investment Office, also known as the C.I.O.
In the first quarter of 2012—the quarter when the London Whale trades happened—the synthetic-credit portfolio exceeded the bank’s risk indicators more than three hundred and thirty times, according to a U.S. Senate subcommittee report from March, 2013. Using one measure, the trades were, by April of 2012, ten times riskier than what was allowed by the bank’s own guidelines. The London Whale’s initial trades in the synthetic-credit portfolio, in January, 2012, were so risky and outsized that they caused the bank as a whole to exceed its VaR guidelines for four consecutive days, a fact that was reported to the C.E.O. Jamie Dimon and other top managers. The risk-management dashboard in the C.I.O., where the Whale worked, was, to use a metaphor from the Senate report, “flashing red and sounding alarms.”
In January of 2012, just after the improper trades began, the bank’s C.I.O. adopted a new, error-prone VaR model that had the immediate effect of lowering the VaR of the London Whale trades by fifty per cent compared with the old standard. The analyst who created the new VaR model said he felt “rushed” and under a lot of pressure from traders. (JPMorgan says the change had been in the works for over a year and was unrelated to the Whale trades.) The bank eventually conceded that the new VaR standard was seriously flawed, but not before the change emboldened traders in the C.I.O. to increase the size of the London Whale bet, eventually leading to even greater losses. In other words, the outsized bets were enabled by the bank’s manipulation of its own financial controls to downplay risk.
The failure to properly apply VaR and other risk controls to the London Whale trades is especially perplexing because the C.I.O. is not some obscure outpost. Ina Drew, the head of the C.I.O., reported directly to Jamie Dimon. According to Drew, her office contributed twenty-three billion dollars to the bank’s earnings from 2007 through 2011, “helping to offset business losses incurred during that difficult period of time.” She also testified that “several” of the people who reported to her belonged to the fifty-person executive committee, made up of the highest-ranking officers of JPMorgan. These people included Achilles Macris, the supervisor of the synthetic-credit portfolio. Yet in his Senate testimony in March, Michael Cavanaugh, the co-C.E.O. of JPMorgan’s Corporate and Investment Bank, said that senior management’s view of the C.I.O. had not “evolved” to understand the risks that the unit was taking.
Joseph Evangelista, a spokesman for JPMorgan, pointed to an internal report released by the bank in January, which said that managers of the C.I.O. office were mostly responsible for flaws in the application of VaR risk controls. The report said that senior managers, including Dimon, also bore responsibility, but that “direct and principal” responsibility for the financial loss belonged to the traders.
Bank executives aren’t the only ones to blame. The regulators overseeing the bank at the Treasury Department’s Office of the Comptroller of the Currency didn’t detect the risk accumulating in the C.I.O.’s synthetic-credit portfolio when it increased ten-fold in size during 2011, from four billion dollars to fifty-one billion dollars, and then tripled in size, to a hundred and fifty-seven billion dollars, in the first quarter of 2012. The Comptroller says that JPMorgan went out of its way to conceal and obfuscate the activities of the synthetic-credit portfolio over a period of years. Still, the O.C.C.’s own risk-detection system should have been flashing red and sounding alarms, too.
The O.C.C. should also have taken note that, in the first half of 2011, the C.I.O. repeatedly breached risk limitations. It failed to ask questions when, in 2011, just before the disastrous London Whale trades were initiated, the office made four hundred million dollars in a risky, billion-dollar credit-derivatives bet. (This level of profitability could only occur when substantial risk is being taken—not when banks limit themselves to the safe and prudent investments that are required by law when banks are managing federally insured savings-and-checking deposit funds.) The regulators should also have taken note when the risk profile of the synthetic-credit portfolio suddenly improved by fifty per cent after the C.I.O. watered down its VaR.
President Obama’s pressure on financial regulators comes not a moment too soon. Less than a month from now, we will mark the five-year anniversary of the Lehman Brothers bankruptcy, one of the earliest moments of the financial crisis. Yet our banking institutions still can’t manage risk adequately, and our governmental institutions can’t detect it building in the system. The long-awaited implementation of Dodd-Frank provisions such as the Volcker Rule, which would have explicitly prohibited a commercial bank like JPMorgan from making proprietary bets like the Whale trades, will give regulators new tools and sources of information. But JPMorgan seems to have violated pre-Dodd-Frank laws by failing to properly disclose the London Whale trades, and the government’s failure to detect them resulted more from institutional shortcomings than from inadequate rules. JPMorgan was supposed to be an expert in risk management with a “fortress balance sheet,” as the bank put it. If the London Whale was able to swim undetected there, one has to wonder what problems are lurking in other financial institutions and whether—new rules or no—our government is up to the task of protecting the public interest.
Original Article
Source: newyorker.com
Author: Michael A. Santoro
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