Unemployed in Greenland.

New York Fed Caught Sight of London Whale and Let Him Go

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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It seems pretty clear to me that JPMorgan's London Whale episode, in which the bank's Chief Investment Office lost $6.2 billion on poorly managed credit derivatives trades, was a huge win for U.S. banking regulators. Like, here is a rough model of banking regulation:

  1. Banks tend to be better at banking than banking regulators are, so they are unlikely to want to defer to the regulators' judgment in most circumstances.
  2. You need the banks to buy into the regulation, and defer to the regulators, for the regulation to produce real broad-based risk reduction rather than mere check-the-box compliance efforts.
  3. One way to get the banks to buy into regulation is for them to fail catastrophically and realize that they're not as good at their jobs as they thought they were.
  4. But catastrophic failure is precisely what, as a regulator, you want to prevent.
  5. Because it's bad.
  6. But also because, if you allow a catastrophic failure, then you're not a very good regulator either, so the failure provides no additional reason for a bank to listen to you.

So 2008 ushered in a new regulatory environment but at, you know, a certain cost, both to the world and to the regulators' credibility.

But the Whale! The Whale was pure win! The Whale thing was super dumb and a catastrophic embarrassment for JPMorgan, making it harder for JPMorgan to push back on regulators' demands. Here's a little hypothetical before-and-after:

Before:

Regulator: You should cut back on Risk X.

Jamie Dimon: I'm Jamie Dimon.

Regulator: Fair point.

After:

Regulator: You should cut back on Risk X.

Jamie Dimon: I'm Jamie Dimon.

Regulator: Remember that Whale thing?

Jamie Dimon: Ugh fine.

And because JPMorgan generally has a reputation for being pretty good at bank stuff, this effect extends beyond JPMorgan.

On the other hand, the Whale's losses, while catastrophically dumb, weren't actually catastrophic. No banks failed, no one lost faith in the financial system. JPMorgan lost about 2 percent of the value of its CIO portfolio. Lots of portfolios lose 2 percent of their value all the time. My S&P 500 index fund lost 2 percent of its value in one day a couple of weeks ago, without triggering any Senate investigations. And unlike mine, JPMorgan's loss was relatively uncorrelated: It managed to lose a few billion dollars through idiosyncratic accident, not a system-wide misunderstanding of risk. Which, as catastrophes go, is much better than the alternative.

So the Whale was bad enough to change behavior, but not bad or correlated enough to be an actual problem. It couldn't have been better for regulators if they'd invented it themselves.

But then they went and dimmed the luster a bit by calling attention to their own shortcomings. Here is the Federal Reserve Board's Office of Inspector General's summary report on the Fed's Whale failings. It is ... a lot of it is pretty boring. There are a lot of references to the OIG's unabridged report, which was not released publicly, and which ends up sounding pretty racy. "Our unabridged report describes our perspectives on management's response and refutes several of BS&R's and FRB New York's comments," ooh. But the abridged public report features 10 recommendations in the most stultifying imaginable bureaucratese:

  1. Issue guidance that reinforces the importance of effective collaboration and cooperation in joint supervisory planning to optimize the intended benefits of the consolidated supervision model, particularly in light of the Federal Reserve's updated framework for supervising large, complex institutions, which emphasizes financial resiliency and horizontal priorities.
  2. Develop procedures that encourage staff to take immediate action to escalate significant concerns regarding interagency collaboration in executing consolidated supervision.

There are eight more, but come on.

The backward-looking diagnoses of the Fed's failings are a bit more interesting. For instance, this is also pretty bland, but worth parsing anyway:

Third, we found that FRB New York staff were not clear about the expected deliverables resulting from continuous monitoring activities. Enhanced clarity concerning the expected deliverables could improve the effectiveness of this supervisory activity.

Compare what Carmen Segarra said about the New York Fed: "It's like the information is discussed, and then it just ends up like in a vacuum, floating on air, not acted upon." That's more vigorous prose, but the same basic idea. The Fed culture seems to have been: You have a meeting, you talk about a problem and then you go home. Nobody ever has to do anything to solve the problem. Your job is "monitoring." You looked at the problem. That's pretty much monitoring it, right? Don't strain yourself.

That attitude might explain the Whale failing that has received the most attention today: Fed teams decided (three times!) that the New York Fed should conduct reviews of JPMorgan's CIO, but those reviews never actually happened. This was "a missed opportunity for the consolidated supervisor and the primary supervisor to discuss risks related to the CIO," says the Inspector General, and it doesn't sound great, does it? They could have stopped the Whale in his tracks! His underwater migratory routes.

But ehh I don't know. The thing about JPMorgan's CIO is, it wasn't doing dumb things in 2008, 2009 or 2010, when these reviews were supposed to be performed. The best flensing of the Whale that I've read is the Senate report, strangely enough, and it paints a picture of a group that lost its collective cetacean mind in 2011. Before then, its synthetic credit portfolio totaled less than $4 billion, and was basically short credit: That is, it was a small and reasonable hedge against the corporate credit risk in the rest of JPMorgan. In late 2011, the CIO made a lot of money on one trade, pretty much by accident, and the profits proved addictive. Over the next few months, the portfolio ballooned to $157 billion, and changed directions, and turned into a creepy long credit bet that ended in tears and blubber.

So if the Fed had looked into the CIO in 2008, or 2009, or 2010, it would have found a sensibly sized derivatives portfolio that was doing good work hedging JPMorgan's actual risks and was not managed by any large marine mammals. So it might have said "OK, fine, nothing to see here," given its stamp of approval to the pre-Whale, and been doubly embarrassed by the later blow-up. That's not a great result. Inattention is probably a better look than complicity.

Or: It might have demanded changes to the CIO. The fact that Fed's staff flagged CIO problems three times, even though they never followed up, suggests that they did have worries about the CIO's trading, governance, and risk management. From previous Whale post-mortems, I have no trouble believing that those worries were real, and that the CIO had real cultural and risk-management problems that a smart and committed regulator could have noticed, documented, and tried to correct.

But think how vehemently JPMorgan would have resisted those efforts. Here it was, running a portfolio that was conservatively hedging the bank's risks, that had never lost money, and that was managed by a star officer who was close to Jamie Dimon. And some regulator comes in with fuzzy complaints about culture and risk management? Come on. You regulators are such nit-picking worrywarts. Focus on the data, on the real problems. A hedging desk that never loses money surely isn't one of them.

But the Whale is now! By letting the CIO's problems pass without (much) comment in 2008-2010, the Fed did miss a truly luscious opportunity to say "I told you so" in 2012. But I suspect that JPMorgan will pay more attention to Fed warnings in the future than it would have in 2010. And that's the sort of thing that only bitter experience can teach.

  1. This is of course the point Daniel Tarullo made in a speech yesterday, which we discussed this morning, and which I'll continue to plug.

    Ugh, incidentally, there are two words, "regulation" and "supervision," that I will use in this post with absolutely no attention to the technical distinction between them. Sorry, bank nerds!

  2. More strictly, a bank's job is to (1) make money and (2) avoid failure; it has to balance the risks to (2) in order to achieve (1). A supervisor's job is more or less to avoid catastrophic failure; it has no upside exposure, as it were. So when failure comes, that is a bigger failure for the supervisor -- which had one job! -- than it is for the bank, which had to balance competing jobs. So banks should be less deferential to their supervisors than they were before. This view is heterodox.

  3. I.e.:

    Regulator: You should cut back on Risk X.

    Bank: Nah.

    Regulator: Remember that Whale thing?

    Bank: That wasn't us!

    Regulator: Are you saying you're smarter than Jamie Dimon?

    Bank: Ugh fine.

  4. I don't really know the right denominator here. If you think, like, the CIO had these positions to hedge the rest of its portfolio, the CIO portfolio was in the mid-$300 billions, so $6.2 billion was somewhere under 2 percent. If you think, like, the CIO's synthetic credit portfolio peaked at $157 billion of notional, then the $6.2 billion loss is about 4 percent of that peak notional, or considerably more compared to some longer-run average notional. If you think, like, this was a trade that JPMorgan did, then the $6.2 billion loss was about 0.3 percent of JPMorgan's assets, or about 4 percent of its Tier 1 common equity.

  5. Also to give more impetus to things like a strict Volcker Rule, which was being written when the Whale losses came out.

  6. The quick history, from the Senate report:

    Three years later, in 2011, the SCP’s net notional size jumped from $4 billion to $51 billion, a more than tenfold increase. In late 2011, the SCP bankrolled a $1 billion credit derivatives trading bet that produced a gain of approximately $400 million. In December 2011, JPMorgan Chase instructed the CIO to reduce its Risk Weighted Assets (RWA) to enable the bank, as a whole, to reduce its regulatory capital requirements. In response, in January 2012, rather than dispose of the high risk assets in the SCP -- the most typical way to reduce RWA -- the CIO launched a trading strategy that called for purchasing additional long credit derivatives to offset its short derivative positions and lower the CIO’s RWA that way. That trading strategy not only ended up increasing the portfolio’s size, risk, and RWA, but also, by taking the portfolio into a net long position, eliminated the hedging protections the SCP was originally supposed to provide.

    In the first quarter of 2012, the CIO traders went on a sustained trading spree, eventually increasing the net notional size of the SCP threefold from $51 billion to $157 billion. By March, the SCP included at least $62 billion in holdings in a U.S. credit index for investment grade companies; $71 billion in holdings in a credit index for European investment grade companies; and $22 billion in holdings in a U.S. credit index for high yield (non-investment grade) companies. Those holdings were created, in part, by an enormous series of trades in March, in which the CIO bought $40 billion in notional long positions which the OCC later characterized as “doubling down” on a failed trading strategy. By the end of March 2012, the SCP held over 100 different credit derivative instruments, with a high risk mix of short and long positions, referencing both investment grade and non-investment grade corporations, and including both shorter and longer term maturities. JPMorgan Chase personnel described the resulting SCP as “huge” and of “a perilous size” since a small drop in price could quickly translate into massive losses.

  7. Here's how the OIG report describes the Fed's interest in the CIO:

    First, as part of its continuous monitoring activities at JPMC, FRB New York effectively identified risks related to the CIO's trading activities and planned two examinations of the CIO, including (1) a discovery review of the CIO's proprietary trading activities in 2008 and (2) a target examination of the CIO's governance framework, risk appetite, and risk management practices in 2010. Additionally, a Federal Reserve System team conducting a horizontal examination at JPMC recommended a full-scope examination of the CIO in 2009.

    This all sounds pretty directly related to where the Whale ended up.

  8. I mean, not really. Again, the Whale is a trivial problem, in the scheme of things. But you can't really resist regulators telling you to fix Whale-type problems, now.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Matthew S Levine at mlevine51@bloomberg.net

To contact the editor on this story:
Zara Kessler at zkessler@bloomberg.net