Waiting for the other shoe to drop

Financial Review

PUBLISHED: May 19, 2012

Anna Bernasek 

Judging by the reaction to JPMorgan Chase’s $US2 billion trading loss, you’d think America’s leading bank had just gone bust.

Prominent politicians, policymakers and commentators have piled in on Jamie Dimon, the bank’s chief executive, with lots of finger wagging and “I told you so”. Ina Drew, a top executive with a seemingly spotless 30-year trading history has abruptly resigned. And everybody is investigating the bank: the Securities and Exchange Commission, the Department of Justice, even the FBI.

Suddenly, the mighty bank that could do no wrong finds itself under the microscope as shareholders, officials and the public want answers.

Meanwhile Dimon, the erstwhile king of Wall Street, is taking it on the chin. “Anyone in business knows you always make mistakes,” he said on Meet the Press. “And so this is a terrible mistake, I’m not making excuses for that, but I know we’re going to make mistakes. When you’re in this kind of job, you hope they are small and few and far between. This one was far too big.”

It all seems a bit puzzling. Why would a $US2 billion markdown of a trading position – apparently a purely notional loss at this point – provoke so much hand-wringing for a bank with assets a thousand times greater, an incredible $2.3 trillion? That’s a 10th of a per cent for goodness sake.

The unit at the centre of the controversy, known as the Chief Investment Office, alone oversaw $356 billion of securities. A $2 billion loss on a portfolio that size amounts to a mere half a per cent.

So why is Dimon, not known as a shrinking violet, letting himself get pushed around?

The answer, it seems, is that this isn’t about the gross numbers. What’s going on both inside and outside the bank has a lot more to do with what the loss signals than the relative size of the loss.

While the $2 billion trading loss is tiny in comparison with the bank’s total assets, it’s more material in relation to its profits. Last year, JPMorgan earned $19 billion in net income so $2 billion is in the order of a 10 per cent hit.

And the position isn’t closed, so the loss could change in size. Depending on how the trade plays out, it’s thought that JPMorgan could lose as much as $4 billion.

Then there’s the fact that this department within the bank was never supposed to lose money. It was billed as a hedging unit created solely to manage the bank’s exposure to complicated transactions.

The whole philosophy behind the Chief Investment Office was to protect the bank against trades that were volatile or extremely risky. So there’s a sense of false advertising or deception that a unit that was supposed to protect the bank actually went out on a limb and hurt it.

Troublingly, the incident shows that the very people in charge of keeping the bank safe couldn’t resist the temptation to gamble.

It’s hard to tell whether the type of trade at issue was proper or flawed from the outset. But it looks certain that the size of the bet got out of hand. Years ago traders used to say: “Pigs get fat, but hogs get slaughtered.”

What happened to internal risk controls? Just as things started to look shaky, executives in the trading unit changed the rules internally on risk reporting. We’ll have to wait to find out if that was a coincidence, or something less innocent.

Perhaps the worst part of all this for Dimon is that it shows management had no handle on the situation. At first he called it a tempest in a teapot. By the time Dimon realised there was a real problem it was too late to do anything about it. One has to wonder what else he doesn’t know about the bank’s machinations.

The biggest problem for JPMorgan Chase may be yet to come. With regulators now scrutinising the bank, officials may find that rules were broken. In particular, investigators want to know whether the bank reported risk appropriately and disclosed that to the public. The issues aren’t always black and white, but that can cut both ways. Especially when public opinion is against you.

Dimon himself hasn’t ruled out bigger problems. Asked whether the bank broke any laws he said: “We had audit, legal, risk, compliance, some of our best people looked into all that. We know we were sloppy. We know we were stupid. We know that there was bad judgment. We don’t know if any of that is true yet. Of course, regulators should look at something like this. It’s their job. We are totally open kimono with regulators. And they will come to their own conclusion and we intend to fix it, learn from it and be a better company when it’s done.”

There may be another shoe to drop before this is all over.