JPMorgan Chase London Whale G: Hedging versus Proprietary Trading
In December 2013, the primary United States financial regulatory agencies jointly adopted final rules to implement Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which is often referred to as the “Volcker Rule”. Section 619 prohibits banks from engaging in activities considered to be particularly risky, including proprietary trading and owning hedge funds or private equity funds. Banking regulators designed the final rule against proprietary trading in part to prevent losses like the $6 billion London Whale loss that took place in 2012 at JPMorgan Chase. Given the controversial nature of the Volcker Rule, it is not surprising that the regulatory agencies received 18,000 comment letters, including a 67-page letter from JPMorgan Chase.
JPMorgan Chase London Whale A: Risky Business
In December 2011, the Chief Executive Officer and Chief Financial Officer of JPMorgan Chase (JPM) instructed the bank’s Chief Investment Office to reduce the size of its Synthetic Credit Portfolio (SCP) during 2012, so that JPM could decrease its Risk-Weighted Assets as the bank prepared to adopt the impending Basel III bank capital regulations. However, the SCP traders were also told to minimize the trading costs incurred to reduce Risk-Weighted Assets, while still maintaining the opportunity to profit from unexpected corporate bankruptcies. In an attempt to balance these competing objectives, head SCP derivatives trader Bruno Iksil suggested in January 2012 that the SCP expand a strategy first implemented in 2011 to buy large volumes of certain credit derivatives, while simultaneously selling large volumes of other credit derivatives. The strategy quickly proved unsuccessful, and JPM’s Chief Investment Officer ordered Iksil and the other SCP traders to halt this strategy on March 23. However, losses continued to mount as the credit derivative positions were unwound, ultimately reaching $6.2 billion by December 2012.
JPMorgan Chase London Whale B: Derivatives Valuation
After consistently producing positive results through 2011, the JPMorgan Chase (JPM) traders who oversaw the bank’s Synthetic Credit Portfolio (SCP) grew alarmed by a consistent string of losses beginning in January 2012. (The SCP was maintained by JPM to help hedge default risk and was the source of the 2012 London Whale trading loss.) To minimize the losses reported to their superiors until such time that market prices hopefully turned in their favor, the SCP traders began valuing their largest derivative positions in a manner that was not consistent with Generally Accepted Accounting Principles (GAAP) and JPM policy. The fair values recorded by the SCP traders were reviewed by the Valuation Control Group, as required by banking regulators, and by JPM’s Controller, but neither review raised any objection. However, after the JPM Task Force that investigated the 2012 London Whale incident uncovered evidence that the SCP traders had not estimated fair values in good faith, the bank restated its 1st quarter 2012 earnings on July 13, reducing consolidated total net revenue by $660 million (2.5%), which in turn reduced after-tax net income by $459 million (8.5%).