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From Securities Regulation Daily, March 15, 2013

Senators Query JP Morgan Whale Figures; Report Seeks Better Controls

By Mark S. Nelson, J.D.

The Senate Homeland Security and Governmental Affairs Committee's Permanent Subcommittee on Investigations today asked key current and former JP Morgan Chase executives about losing derivatives bets known as the London Whale trades. These were derivatives bets made by JP Morgan Chase's London-based traders for its synthetic credit portfolio (SCP) which in 2012 produced $6.2 billion in losses. The subcommittee also released a 301 page report and nearly 600 pages of exhibits.

Senator Carl Levin (D-Mich), the subcommittee's chairman, said in his opening remarks, that "when Wall Street plays with fire, American families get burned." The subcommittee's ranking member, Sen. John McCain (R-Ariz), said that the Whale incident "matters to the federal government because [banks are] using excess deposits, that are federally insured." Sen. McCain suggested that instead of placing derivatives bets, JP Morgan Chase could have used these funds to make "Main Street loans."

Shifting risk limits. The SCP Whale trades occurred within JP Morgan Chase's Chief investment Office (CIO), formerly led by Ina R. Drew, who resigned after the Whale trades became public. Sen. Levin focused on the pliability of JP Morgan Chase's risk limits for SCP trades.

Specifically, Sen. Levin noted JP Morgan Chase's laundry list of risk limit breaches. Citing subcommittee exhibits, Sen. Levin said that before the Whale trades soured, the bank had six breaches in one quarter. But over the ensuing three months the bank incurred 170 breaches, followed by 160 breaches in April 2012. Sen. Levin asked why JP Morgan Chase did not fix its risk models and why its VaR was cut in half.

In her prepared testimony, Ms. Drew said that JP Morgan Chase's London team misled her and that, in retrospect, many actions related to the SCP had not been done in good faith. Ms. Drew disclaimed knowledge of these acts during the relevant period. In reply to Sen. Levin's question about why VaR had been reduced, Ms. Drew said, "I have no idea why."

Sen. Levin also pressed Ashley Bacon, Acting Chief Risk Officer, JPMorgan Chase Bank NA, about the reduced VaR. Here, Sen. Levin posited that the 50 percent VaR drop was "effectively an end-run around the limit." The senator asked Mr. Bacon if this was a good way to manage risk. Mr. Bacon replied that this was "absolutely not the way to do it."

Mr. Bacon said in his prepared testimony that JP Morgan Chase had asked him to analyze the SCP because he was not previously associated with the CIO. Specifically, Mr. Ashley's team had spurred JP Morgan Chase to appoint a new CIO chief risk officer, revamp the CIO risk committee, adopt new and revised risk limits, and perform a self-assessment of the bank's risk organization.

Peter Weiland, former Head of Market Risk, JP Morgan Chase, Chief Investment Office, said in prepared testimony that there was no chief risk officer in the CIO when Ms. Drew hired him in 2008. Mr. Weiland also confirmed that the primary SCP risk limits were VaR, stress, csbpv, and csw10%. He also confirmed that the csbpv limits were the first ones breached; VaR breaches would "sometimes" lead to firm-wide VaR breaches.

Sen. Levin also asked why the CIO derivatives valuations began to deviate from the mid-point. The subcommittee's report explained that mid-point valuations are often the "most representative of fair value" and help firms to meet accounting standards.

Michael Cavanagh, Co-Chief Executive Officer, Corporate and Investment Bank, JP Morgan Chase, replied to Sen. Levin that the bank's analysis had accounted for market knowledge of some trades, but that the investment bank stayed at the mid-point because of its "tighter tolerance bands."

Mr. Cavanagh said in both his prepared testimony and before the subcommittee that JP Morgan Chase's auditor, PriceWaterhouseCoopers LLP, had been consulted about the bank's derivatives pricing. Sen. Levin asked Mr. Cavanagh if he agreed that pricing derivatives to minimize losses is unacceptable. Mr. Cavanagh replied, "[a]bsolutely."

Too big to fail. Two Senators asked if JP Morgan Chase is too big to fail. Sen. Ron Johnson (R-Wis), in an exchange with Mr. Bacon, asked if the Whale trades occurred because JPMorgan Chase is too big to fail. Mr. Bacon said no, but he emphasized that the Whale trades happened due to "egregious mistakes." When asked by Sen. Johnson if the Dodd-Frank Act ended too big to fail, Mr. Bacon said the Act was a step in the right direction.

In a follow-up question, Sen. McCain, pressed Mr. Bacon on whether JP Morgan Chase was too big to fail. Mr. Bacon again said "No. But we need to demonstrate that to everybody's satisfaction."

Disclosures probed. The subcommittee report implied that statements by JP Morgan Chase executives may have run afoul of securities regulations. In particular, the report noted that JP Morgan Chase's disclosures may have violated Securities Act Section 17(a) or Exchange Act Rule 10b-5. Said the report, "[i]n the JPMorgan Chase case study examined by the Subcommittee, the bank, as an issuer, has made disclosures that raise significant concerns about the accuracy of the information it provided to investors and about omissions of key information."

Specifically, the report said that statements by Douglas L. Braunstein, Vice Chairman JPMorgan Chase Bank NA, that the SCP portfolio was known "at the firm-wide level" may be contradicted by other evidence that implies the bank's firm-wide risk managers were unaware of the SCP's details. Mr. Braunstein allegedly made this statement when the SCP portfolio had already exceeded multiple risk limits. The report said that investors could have concluded that Mr. Braunstein's statement implied that credit derivative positions had been approved by JP Morgan Chase's risk management team.

Sen. Levin asked Mr. Braunstein about his statements at the April 13, 2012 earnings call. Specifically, Sen. Levin pointed to a February 4, 2013 letter from Mr. Braunstein to the subcommittee's senior counsel, Zachary I. Schram (Exhibit 97), regarding, among other things, Mr. Braunstein's statement that "JP Morgan was ‘very comfortable' with the positions."

Sen. Levin asked if "those" trades (i.e., the Whale trades) referred to the information that JP Morgan Chase should have regularly reported to the OCC. Mr. Braunstein replied "No," but the OCC "got summary information." Sen. Levin remarked that it is hard to believe Mr. Braunstein's earnings call statements were not meant to "calm the seas" but many of these statements were "inaccurate."

OCC misled, criticized. The subcommittee report said that JP Morgan Chase failed to apprise banking regulators, including the OCC, of developments regarding its SCP portfolio. Similarly, the report criticized the OCC for not pressing JP Morgan Chase about numerous risk limit breaches and for not seeking monthly CIO reports that had allegedly not been received.

In prepared remarks and an oral statement, Thomas Curry, Comptroller of the Currency, said: "[h]ad the bank's risk management and audit processes worked as intended, this activity should have been highlighted to us. Nonetheless, there were red flags that we failed to notice and act upon." Mr. Curry, however, said that once the OCC grasped JP Morgan Chase's problems, the regulator took action to get detailed information about the SCP and conducted a review of both the bank's CIO function and the OCC's own actions.

The OCC's Scott Waterhouse, Examiner-in-Charge, OCC National Bank Examiners, JPMorgan Chase, similarly told Sen. Levin that "[c]learly we should have been more aggressive in looking at the [JP Morgan Chase SCP] portfolio." Mr. Waterhouse also said that bank managements first have an obligation to keep regulators updated and that regulators should then get any required reports so they can understand banks' risks.

The subcommittee asked who at JP Morgan Chase had allegedly given orders to stop sending reports to the OCC. According to many accounts, James Dimon, Chairman and CEO, JP Morgan Chase, allegedly had shut-down the flow of data from the bank to the OCC. In reply to a series of questions from Sen. Levin, Mr. Waterhouse recalled that Mr. Braunstein allegedly had said that he had resumed reports to the OCC and that Mr. Dimon allegedly "expressed his dismay" at this development. According to Mr. Waterhouse, Mr. Dimon allegedly said "I don't think we need this amount of detail."

OCC Chairman Curry, interjected that banking regulators decide what information banks must provide to them, not the banks. OCC's Mr. Sullivan observed that JP Morgan Chase's SCP portfolio "was obscure, but not hidden."

In this morning's session, Sen. Johnson had asked Mr. Bacon if banking regulators are competent. Mr. Bacon replied that banking regulators generally are competent. But Mr. Bacon added that it is "hard for regulators, especially when the bank itself does not understand what happened."

Mr. Braunstein also told Sen. McCain that JP Morgan Chase had been concerned about confidentiality of the reports the firm allegedly had stopped supplying to the OCC. Sen. McCain observed that the interaction of JP Morgan Chase and the OCC was "a testimony to the lack of action on the part of regulators if they expected those reports."

Recommendations. The subcommittee report made seven recommendations. For one, the report said federal regulators should require banks to include performance data on all internal investment portfolios in their periodic reports. This requirement would apply to portfolios that meet a size threshold and would also mandate annual reviews to find undisclosed derivatives trades.

Other recommendations would require banks to document and periodically test their contemporaneous hedging policies and procedures. Banks would have to improve their credit derivatives valuation methods by using independent pricing services, reporting counterparty valuation disputes to regulators, and justifying prices that vary from the mid-point. Regulators also would be urged to monitor banks' risk limit breaches and to investigate changes to risk models that may lower banks' risk or capital requirements.

Additionally, the report urged federal regulators to "immediately" adopt the final Volcker rule. The report said the Volcker rule's limits on proprietary trading should lessen the amount of risky assets held by insured banks. The report also said regulators should impose new capital charges for derivatives trades that fall within the Volcker rule's permitted activities exception and that Basel III implementation should impose higher capital charges on trading book assets.

Companies: JP Morgan Chase; JPMorgan Chase Bank NA; PriceWaterhouseCoopers LLP

MainStory: TopStory Derivatives DoddFrankAct

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