JPMorgan: Still Counting Losses from London Whale


“The ‘London Whale’ episode not only cost us money,” commented JPMorgan (NYSE:JPM) Chairman and CEO Jamie Dimon in an April letter to shareholders, “it was extremely embarrassing, opened us up to severe criticism, damaged our reputation and resulted in litigation and investigations that are still ongoing.”

It’s a mixed blessing, but those investigations may finally have an end in sight. On Wednesday, the Securities and Exchange Commission issued a litigation release that could be among the last associated with the incident, formally alleging that Javier Martin-Artajo and Julien Grout, two former traders at the bank, fraudulently overvalued investments in order to hide losses in their portfolio.

“When the portfolio began experiencing mounting losses in early 2012,” reads the statement, “Martin-Artajo and Grout schemed to deliberately mismark hundreds of positions by maximizing their value instead of marking them at the mid-market prices that would reveal the losses. Their mismarking scheme caused JPMorgan’s reported first quarter income before income tax expense to be overstated by $660 million.”

The Synthetic Credit Portfolio at JPMorgan’s Chief Investment Office was created in 2007 to protect the bank from adverse credit conditions, reports the SEC. In its allegation, the SEC explains how the portfolio worked.

“Investments in the SCP consisted primarily of credit derivative indices and portions (or ‘tranches’) of those indices, constructed to track a basket of credit default swaps (‘CDS’) that referenced the debt of corporate issuers. A CDS is, in essence, an insurance contract on an underlying credit risk. For example, to insure against the risk that a certain company would default on its debt, an investor can “buy protection” in the form of a CDS. The counterparty on the CDS would be “selling protection,” which means that it would agree, in return for periodic premium payments, to pay the investor in the event the referenced company defaults on its debt. The buyer or seller need not own the underlying asset, such as the corporate debt, in order to buy or sell the CDS.”

In the April letter to shareholders, Dimon explains that the SCP was originally intended to “help protect the firm’s overall credit exposure by offsetting losses in the event there was a credit crisis. It worked and essentially accomplished its intended objectives for many years.” The portfolio earned JPMorgan as much as $2 billion in revenue between 2008 in 2011. However, as credit conditions began to improve and regulators advanced the Basel accords in the wake of the financial crisis, JPMorgan decided to wind down the portfolio, recognizing that its short-risk high-yield position was no longer a winning strategy.

“It was at this point that a new strategy was devised, which actually added to the risk,” commented Dimon. “This new strategy was flawed, complex, poorly reviewed, poorly executed and poorly monitored. Given the portfolio’s success over time, we had become complacent, and we weren’t as rigorous and skeptical as we should have been.”

The SEC explains that, ”As credit conditions improved, the SCP was poised to lose money on its short risk high-yield investments but make money on the long risk investment-grade investments. However, in early 2012, the value of the investments in the SCP moved in such a way that losses on the short risk high-yield investments exceeded, in the aggregate, gains on the long risk investment-grade positions, causing the SCP to sustain net losses. Given the large notional size of the portfolio, these losses were very substantial.”

In March, Senator Carl Levin, who heads the Permanent Subcommittee on Investigations, called the trading strategy a “runaway train that barreled through every risk warning.” Without caps on the notional size of the portfolio, it increased from $51 billion to $157 billion in the first quarter of 2012 as the managers tried to hedge their short-risk high-yield position. It’s unclear what the total costs of the London Whale incident will end up being. JPMorgan has lost as much as $6.2 billion on the portfolio so far alone and has disclosed that possible losses associated with its ongoing legal and pending proceedings — for the London Whale and other events — could be as high as $6.8 billion.

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