JP Morgan unveiled the key reasons how and why the star of its Chief investment Office (CIO), Bruno Iksil, lost the bank $5.8bn in bad hedging bets, by revealing a systematic failure in its units risk management procedures, models and monitoring.
The bank's CEO Jamie Dimon led the investor conference call for JP Morgan's second quarter earnings, in a previously unprecedented move, alongside CFO Doug Braunstein and Mike Cavanagh, head of the bank's Treasury & Securities Services group, who also the man charged with leading an internal investigation of what happened in the CIO unit.
During the call the senior executives highlighted the main reasons of how the CIO unit was able to not only execute such risky and subsequently costly losses, but how risk management had failed to detect, manage and escalate the risks over the course of a few years.
"[The London Whale incident] was an exception," said Dimon. "We made a mistake and have completely disclosed that mistake. CIO was not where we were expecting a mistake... We should never, ever have gone that big... It is not possible in the real world not to make mistakes. That is only possible in the fictional world. "
Cavanagh added that "the cause for the [London whale trading losses] was a result of several failures in risk management."
"Within the CIO, judgement, monitoring and escalation of [the risk] was poor. Risk management was ineffective. Risk limits were not granular enough and the approval and implementation of the new VaR model was poorly done."
JPMorgan shares up trading 3.5 percent higher in New York today, changing hands at $35.24 each, but have lost investors 8.23 percent so far this year.
Risk Management Failure at the Heart of the Huge Trading Loss
Cavanagh, who has been widely tipped to be Dimon's key protégé, was appointed to lead a "swat team" of senior bankers, in investigating what went wrong at the CIO unit, which resulted in one of the largest legal trading losses in history.
After, Dimon started the earnings call, followed quickly after by Braunstein, Cavanagh revealed the line of failures that led to the, now confirmed, $5.8bn loss.
Cavanagh detailed four main areas as to where it all went wrong.
"The CIO breached risk limits twice in the first quarter," said Cavanagh. "There were numerous risks that grew that people did not understand or understand how to manage these risks. We had a less than robust risk committee supporting the CIO. This event will prompt major changes. The CIO risk team did not challenge the front office enough or escalate concerns [and] we are doing a complete revamp of CIO management."
Bruno Iksil, nicknamed the London Whale for his rumoured preference for large trades, and his colleagues at the London unit of JPMorgan's "Chief Investment Office (CIO)" have reportedly now left the bank, although JPM officials will not confirm this.
The bad hedging bets that have lost JPM billions of dollars prompted an investigation by several US authorities and Dimon had to explain to a US Senate committee twice, why he didn't ensure that the CIO's risk managers adequately keep pace with the nature of the unit's business.
Dimon said the CIO portfolio"... morphed into something that, rather than protect the firm, created new and potentially larger risks. We have let a lot of people down, and we are sorry for it."
In the 13 July investor conference call, Cavanagh confirmed that another part of how and why the CIO portfolio seemingly spiralled out of control was due to when new value-at-risk (VaR) models were approved and implemented poorly.
"There were numerous risks that grew that people did not understand or understand how to manage these risks," said Cavanagh. "The synthetic credit VaR model in CIO was meant to be updated to be more accurate. So the fundamental problem with the process was the implementation communication. There was sloppy implementation. Calculation mistakes led to a lower VaR [risk score] compared to what it should be. We have strengthened the process, since, on approval and implementation processes."
Cavanagh also added that the event has meant that JPM has "stepped up its game" and has employed " a new Chief Risk Officer" who will oversee all functions, not just the CIO" and have installed a "more robust risk committee, which consists of significant senior officers on the committee and external subject experts."
"We also have implemented better market risk limit structures and have strengthened the model review group and questions over escalation. All market VaR models have been reviewed," he added.
The former head of JPM's CIO, Ina Drew offered two years of her own compensation pay in order to help offset the losses.
Dimon made a point on the call to say "she has acted with integrity at all times, even though she was involved in this mistake."
Future Fraud Concerns?
Dimon and JPM may have to tap into the bank's $300m litigation reserves, if traders have been found to falsify trading losses, as it hinted at in it restatement to the US' Securities and Exchange Commission (SEC).
Just shortly before JPM published its Q2 earnings, the group revealed that it the initial estimates for trading losses could be wrong and it is refilling its findings to regulators.
"Our previously filed financial statements for the 2012 first quarter should no longer be relied upon. We expect to file restated financial statements for the first quarter as soon as practical but no later than when we file our financial statements for the second quarter. In addition, we have determined that there was a material weakness in our internal control over financial reporting at March 31, 2012 related to CIO's internal controls over valuation of the synthetic credit portfolio. The control deficiencies were substantially remediated by June 30, 2012," said the filing.
"More specifically, traders in CIO were expected to mark their positions where they would expect to be able to execute in the market," said the filing. "In this instance, while the positions were within thresholds established by an independent valuation control group within CIO, the firm has recently discovered information that raises questions about the integrity of the trader marks and suggests that certain individuals may have been seeking to avoid showing the full amount of the losses in the portfolio during the first quarter."
"As a result, we are no longer confident that the trader marks reflected good faith estimates of fair value at quarter end and we decided to remark the positions utilizing external "mid-market" benchmarks, adjusted for liquidity considerations. While there are a range of acceptable values for such positions, we believe our approach represents an objective valuation and is a reasonable approach under the circumstances. Our internal review of these matters is ongoing. If we obtain additional information material to our periodic financial reports, we will make appropriate disclosure."
Dimon also took the time to hit back at questions about what he thinks about the Libor fixing scandal.
"We are totally open with regulators and investigators. I would be a little patient if I were you and not all companies are in the same position. I wouldn't make assumptions," said Dimon.
Wider Earnings Results
Due to restatement to the SEC on inaccurate estimates, a chunk of losses reported was included in the Q1 results, not the second quarter earnings, meaning the data was a lot more favourable that it should have been.
JPM's first-half 2012 net income came in at $9.9bn, EPS of $2.41 and revenue of $49.6bn. Dimon added that the group will see a one-off $900m gain due to swap termination.
JPM also reported that it had significantly reduced total synthetic credit risk in CIO, substantially all remaining synthetic credit positions have been transferred to the Investment Bank and the CIO synthetic credit group has closed down.
Dimon said that "we have learned a lot since [the London Whale event] and this has shaken the company to the core. But you can see throughout the whole crisis, including the sovereign debt crisis that we still managed to grow."