JPMorgan to Admit Wrongdoing in London Whale Loss

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

News that JPMorgan, the largest bank by assets in the United States, is facing massive regulatory and legal pressure is hardly new. Despite navigating the late 2000s financial crisis with with relatively few losses, the post-crisis regulatory crackdown has exposed numerous weaknesses in the firm’s internal security controls, and government investigators have identified several areas where the bank may have broken the law or committed fraud.

As revealed by its most recent 10-Q filing with the Securities and Exchange Commission, the firm is responding to investigations relating to its offerings of mortgage-backed securities between 2005 and 2007. The firm has also been accused of manipulating energy markets in California, failing to identify and prevent money-laundering activities (this includes a dubious case against the firm related to its handling of former client Bernie Madoff), and allegations that it misled customers regarding some credit card purchases and debt-collection practices.

The pile of litigation facing JPMorgan is enormous, but the end may finally be in sight. Or, at least, the beginning of the end. People who were briefed on the matter told The New York Times that the bank has reached an agreement with authorities in the United States and the United Kingdom to settle the London Whale case for $800 million, plus an admission of wrongdoing. The settlement reportedly covers most regulatory authorities with the notable exception of the Commodity Futures Trading Commission.

The news comes about one month after the SEC issued a litigation release 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 — a move that many saw as a precursor to any settlement. From the statement:

“When the portfolio began experiencing mounting losses in early 2012, 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 explained 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,” Dimon wrote. “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 explained: ”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, Sen. 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 fiasco and other events — could be as much as $6.8 billion.

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