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January 17, 2013

JPMorgan Task Force Reports Findings on 2012 Trading Losses

By John M. Jascob, J.D.

A Management Task Force of JPMorgan Chase & Co. (JPMorgan) has released a report of its key observations following an investigation into the 2012 trading losses incurred by the firm's Chief Investment Office (CIO). The report describes the flawed trading strategies and activities that led to large losses in 2012 in the firm's Synthetic Credit Portfolio, which was managed by the CIO and was intended to offset some of the credit risk faced by the firm. The report also offers observations concerning the oversight and risk management deficiencies that were highlighted by the incident, while discussing the remedial measure subsequently undertaken by JPMorgan.

In the Task Force's view, direct and principal responsibility for the losses lies with the traders who designed and implemented the flawed trading strategy. Additionally, the Task Force believes that responsibility for the flaws that allowed the losses to occur lies primarily with CIO management but also with senior firm management.

In particular, the Task Force found that the firm's chief investment officer, Ina Drew, failed in three critical areas with respect to the Synthetic Credit Portfolio. First, the Task Force believes that Drew failed to ensure that CIO management properly understood and vetted the flawed trading strategy and appropriately monitored its execution. Second, Drew failed to ensure that the CIO control functions were performing well and were providing effective oversight of CIO's trading strategy. Third, Drew failed to appreciate the magnitude and significance of the changes in the Synthetic Credit Portfolio during the first quarter of 2012, including increases in the risk-weighted assets, size, complexity and riskiness of the portfolio.

The Task Force also believes that Barry Zubrow, who headed the firm-wide Risk organization, bears significant responsibility for failures of the CIO Risk organization, including its infrastructure and personnel shortcomings and the inadequacies of its limits and controls on the Synthetic Credit Portfolio. In the view of the Task Force, the CIO Risk organization was not equipped to properly risk-manage the portfolio during the first quarter of 2012, and it performed ineffectively as the portfolio grew in size, complexity, and riskiness during that period.

The Task Force found that the firm's chief financial officer, Douglas Braunstein, also bore responsibility for weaknesses in financial controls applicable to the Synthetic Credit Portfolio, as well as for the CIO Finance organization's failure to have asked more questions or to have sought additional information about the evolution of the portfolio during the first quarter of 2012. While the Task Force believes that the principal control missteps were risk-related, the Task Force also stated that the CIO Finance organization could have done more. This failure stemmed, in part, from taking the view that many of the issues related to the Synthetic Credit Portfolio were for the Risk organization and not for Finance to flag or address.

With regard to the chief executive officer, Jamie Dimon, the Task Force found that he could appropriately rely upon senior managers who directly reported to him to escalate significant issues and concerns. The Task Force believes, however, that Dimon could have better tested his reliance on what he was told. Additionally, more should have been done regarding the risks, risk controls, and personnel associated with CIO's activities, for which Dimon bears some responsibility.

With regard to its key observations, the Task Force stated that CIO's judgment, execution, and escalation of issues in the first quarter of 2012 were poor in at least six critical areas: (1) CIO management established competing and inconsistent priorities for the Synthetic Credit Portfolio without adequately exploring or understanding how the priorities would be simultaneously addressed; (2) the trading strategies that were designed in an effort to achieve the various priorities were poorly conceived and not fully understood by CIO management and other CIO personnel who might have been in a position to manage the risks effectively; (3) CIO management failed to obtain robust, detailed reporting on the activity in the Synthetic Credit Portfolio or otherwise appropriately monitor the traders' activity as closely as they should have; (4) CIO personnel at all levels failed to adequately respond to and escalate concerns that were raised at various points during the trading; (5) certain of the traders did not show the full extent of the Synthetic Credit Portfolio's losses; and (6) CIO provided to senior firm management excessively optimistic and inadequately analyzed estimates of the Synthetic Credit Portfolio's future performance. The Task Force concluded, however, that JPMorgan's compensation system did not unduly incentivize the trading activity that led to the losses.

Second, the firm did not ensure that the controls and oversight of CIO evolved commensurately with the increased complexity and risks of CIO's activities. As a result, significant risk management weaknesses developed within CIO that allowed the traders to pursue their flawed and risky trading strategies. On this point, the Task Force concluded that senior firm management's view of CIO had not evolved to reflect the increasingly complex and risky strategies CIO was pursuing in the Synthetic Credit Portfolio. Instead, they continued to view CIO as the manager of a stable, high-quality, fixed-income portfolio. As a result, they were less focused on CIO relative to client-facing businesses and did not do enough to verify that CIO was well managed or that the firm was fully applying its various risk and other controls to the Synthetic Credit Portfolio's activities.

Third, the Task Force found, CIO Risk Management lacked the personnel and structure necessary to manage the risks of the Synthetic Credit Portfolio. As a result, the CIO Risk Committee did not effectively perform its intended role as a forum for constructively challenging practices, strategies, and controls. Furthermore, at least some CIO risk managers did not consider themselves sufficiently independent from CIO's business operations and did not feel empowered to ask hard questions, criticize trading strategies, or escalate their concerns effectively to firm-wide Risk Management. The Task Force also concluded that both CIO management and firm-wide Risk Management failed to fulfill their responsibilities to ensure that CIO control functions were effective or that the environment in CIO was conducive to their effectiveness.

Fourth, the Task Force concluded that the risk limits applicable to CIO were not sufficiently granular. Specifically, there were no limits by size, asset type or risk factor specific to the Synthetic Credit Portfolio. Instead, limits in CIO were applied only to CIO as a whole. The absence of granular limits played a role in allowing the flawed trading strategies to proceed in the first quarter, especially as the positions grew in size.

Fifth, approval and implementation of the new CIO Value-at-Risk model for the Synthetic Credit Portfolio in late January 2012 were flawed, and the model as implemented understated the risks presented by the trades in the first quarter of 2012. As a result, the model suffered from significant operational shortcomings that received inadequate scrutiny by CIO Market Risk, the Model Review Group, and the model's developer in the model approval process. Moreover, although the model produced significantly different results from its predecessor, the personnel involved in reviewing and approving the new model required only limited back-testing.

The Task Force also discussed several comprehensive remedial steps taken by JPMorgan to address deficiencies that were identified since the losses. Among these steps, the firm has terminated the employment or accepted the resignations of the traders and managers who were responsible for the trades that generated the losses and is pursuing the maximum clawback of their compensation. The firm has also appointed a new, experienced CIO leadership team and has adopted a variety of governance measures to improve its oversight of CIO and to ensure that CIO is better integrated into the rest of the firm. Additionally, JPMorgan has overhauled the Risk Committee for CIO and enhanced the independence of the CIO Risk function. The firm has also has implemented more than 200 new or restructured risk limits covering a broad set of risk parameters, including geographic and concentration risks. Finally, under the guidance of its chief risk officer, JPMorgan has conducted a comprehensive self-assessment of its entire Risk organization and, as a result, has implemented a series of improvements both firm-wide and within the lines of business.

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