Beginning at 9:30 a.m. tomorrow, I'm going to be live-blogging a hearing held by Senator Carl Levin's Permanent Subcommittee on Investigations – the best crew of high-end detectives this side of The Wire, in my opinion – who will be grilling J.P. Morgan Chase executives and high-ranking federal regulators in a get-together entitled, "J.P. Morgan Chase "Whale" Trades: A Case History Of Derivatives Risks And Abuses." This follows this afternoon's release of a brutal 301-page report commissioned by Levin and Republican John McCain by the same name.
The Subcommittee investigators, largely the same crew who unraveled financial scandals surrounding infamous Goldman Sachs trades like Abacus and Timberwolf, and also took on HSBC's trans-global money-laundering activities in an extraordinarily detailed report issued last summer, have now taken aim at the heart of the Too-Big-To-Fail issue through its examination of the much-publicized catastrophic derivative trades made by its amusingly-nicknamed "London Whale" trader, Bruno Iksil, last year.
Most ordinary people dimly remember the London Whale episode now, and even at the time struggled to understand even the vaguest contours of the story while mainstream reporters (including people like myself) were trying with all their might to make sense of it from afar. What most people got out of that story was that J.P. Morgan Chase somehow lost buttloads of money through some sort of impossibly complex derivative trade – billions, though nobody could ever settle on an exact number – and that this was somehow a very bad thing that required the attention of the federal government, although even that part of it was a bit of a mystery to most ordinary people.
Why should we care if a private bank, or more to the point a private banker like Chase CEO Jamie Dimon, loses a few billion here and there? What business is it of ours? And why did we have to have congressional hearings about it last year? The whole thing certainly seemed a big mystery to Dimon himself, who dragged himself to Washington and spent the entire time rolling his eyes and snorting at Senators' questions, clearly put out that he even had to be there.
This new report by the Permanent Subcommittee answers the question of why the public needed to be involved in that episode. What the report describes is an epic breakdown in the supervision of so-called "Too Big to Fail" banks. The report confirms everyone's worst fears about what goes on behind closed doors at such companies, in the various financial sausage-factories that comprise their profit-making operations.
If the information in the report is correct, Chase followed the behavioral model of every corrupt/failing hedge fund this side of Bernie Madoff and Sam Israel, only it did it on a much more enormous scale and did it with federally-insured deposits. The fund used (in part) federally-insured money to create, in essence, a kind of super high-risk hedge fund that gambled on credit derivatives, and just like Sam Israel did with his Bayou fund, when it got in trouble, it resorted to fudging its numbers in order to disguise the fact that it was losing money hand over fist.
Chase for years hid the very existence of this operation from banking regulators and lied about the purpose of the fund (saying it was purely a hedging operation when it stopped being a hedge and instead became a wild directional gamble), and it also changed the way it calculated the fund's value once it started to lose hundreds of millions of dollars. Even worse, the bank's own internal auditors signed off on the phoney-baloney accounting of this Synthetic Credit Portfolio (SCP), at one point allowing it to claim $719 million in losses when the real number was closer to $1.2 billion.
How did they do this? In the years leading up to January of 2012, Chase used a standard, plain-vanilla method to price the derivative instruments in its portfolio. The method was known as "mid-market pricing": if on any given day you had a range of offers for a certain instrument – the "bid-ask" range – "mid-market pricing" just meant splitting the difference and calling the value the numerical middle in that range.
But in the beginning of 2012, Chase started to lose lots of money on the derivatives in its SCP, and just decided to change its valuations, that they weren't in the business of doing "mids" anymore. One executive thought the "market was irrational." As the Subcommittee concluded:
By the end of January, the CIO had stopped valuing two sets of credit index instruments on the SCP's books, the CDX IG9 7-year and the CDX IG9 10-year, near the midpoint price and had substituted instead noticeably more favorable prices.
If you can fight through the jargon, what this basically means is that Chase decided to go into the fiction business and invent a new way to value its crazy-ass derivative bets, using, among other things, a computerized model the company designed itself called "P&L predict" which subjectively calculated the value of the entire fund toward the end of every business day.
If this all sounds familiar, it's because it's the same story we've heard over and over again in the financial-scandal era, from Enron to WorldCom to Lehman Brothers – when the going gets tough, and huge companies start to lose money, they change their own accounting methodologies to hide their screw-ups, passing the buck over and over again until the mess explodes into the public's lap. The difference is that Chase is a much bigger and more dangerous company to be engaging in this kind of behavior.
An even scarier section of the report regards the reaction of the Office of the Comptroller of the Currency, or OCC, the primary government regulator of Chase. The report exposes two huge problems here. One, Chase consistently hid crucial information from the OCC, including the sort of massive increases in risk the OCC was created precisely to monitor. Two, even when the bank didn't hide stuff, the OCC was either too slow or too disinterested to take notice of potential problems. From the report:
During 2011, for example, the notional size of the SCP grew tenfold from about $4 billion to $51 billion, but the bank never informed the OCC of the increase. At the same time, the bank did file risk reports
with the OCC disclosing that the CIO repeatedly breached the its stress limits in the first half of 2011, triggering them eight times, on occasion for weeks at a stretch, but the OCC failed to follow up with the bank.
In other words, Chase added nearly $50 billion in risk and failed to mention the fact to the OCC – but the OCC also failed to bat an eyelid when Chase breached its stress limits eight times in a space of six months, often for weeks at a time. Do you feel safer now?
This episode proves what everyone already implicitly understands about these gigantic banking institutions: that their accounting is often little more than a monstrous black box within which any sort of mischief can and probably is being hidden from shareholders, counterparties, and the public, which has a direct interest in the health of these banks because (a) their enormous size makes them systemically important, i.e. we'd all be screwed if any of them collapsed, and (b) they are the supposedly cautious and conservative guardians of billions in federally-insured deposits.
The Senate investigators highlighted a frightening metaphor to explain what they found out about Chase's response to its burgeoning accounting disaster last winter and spring:
The head of the CIO's London office, Achilles Macris, once compared managing the Synthetic Credit Portfolio, with its massive, complex, moving parts, to flying an airplane. The OCC Examiner-in-Charge at JPMorgan Chase told the Subcommittee that if the Synthetic Credit Portfolio were an airplane, then the risk metrics were the flight instruments. In the first quarter of 2012, those flight instruments began flashing red and sounding alarms, but rather than change course, JPMorgan Chase personnel disregarded, discounted, or questioned the accuracy of the instruments instead.
Investigators took note of this and then, sensibly, wondered if Chase was the only bank ignoring all those flashy lights:
The bank's actions not only exposed the many risk management deficiencies at JPMorgan Chase, but also raise systemic concerns about how many other financial institutions may be disregarding risk indicators and manipulating models to artificially lower risk results and capital requirements.
Anyway, officials from Chase and the OCC are being dragged in tomorrow to answer some heavy questions about all of this. Expect a lot of double-talk, sweaty foreheads, pompous "You just don't understand because you don't make enough money" excuses, and other sordid behaviors. Tune in here for updates.
In the meantime, kudos to Senator Levin and to his Republican partner in this investigation, John McCain, for taking on this topic. Increasingly, key voices in the upper chamber like these two, plus Ohio's Sherrod Brown, Iowa's Chuck Grassley, Oregon's Jeff Merkley, Vermont's Bernie Sanders and others are starting to act genuinely worried about the Too Big to Fail issue. Their determination to keep it in the public eye is, to me, a signal that a consensus is forming behind the scenes on the Hill.