Dimon Fortress Breached as Push From Hedges to Bets Blows Up
David Olson, a former head of credit trading in JPMorgan Chase & Co. (JPM)’s chief investment office, learned about risk as a U.S. Navy nuclear submarine pilot.
When he joined the bank in 2006, his new commander, Chief Executive Officer Jamie Dimon, was transforming the once-conservative unit from a risk manager to a profit center.
“We want to ramp up the ability to generate profit for the firm,” Olson, 43, recalled being told by two executives. “This is Jamie’s new vision for the company.”
That drive has now shattered JPMorgan’s cultivated reputation for policing risk and undermined Dimon’s authority as a critic of regulatory efforts to curb speculation by too-big-to-fail banks. It also cost Chief Investment Officer Ina R. Drew, one of the most powerful women on Wall Street, her job. As U.S. and U.K. investigators descend on the firm following Dimon’s announcement last week of a $2 billion trading loss, lawmakers are pointing to the breakdown at the largest U.S. bank as evidence that tougher rules are needed.
Dimon pushed Drew’s unit, which invests deposits the bank hasn’t loaned, to seek profit by speculating on higher-yielding assets such as credit derivatives, according to five former executives. The CEO suggested positions, a current executive said. Profits surged over the next five years as assets quadrupled to $356 billion and employees were given proprietary-trading accounts, current and former executives said.
‘Wall Street Hubris’
Dimon said on May 10 that the unit made “egregious mistakes” by taking flawed positions on synthetic credit securities and that New York-based JPMorgan could lose an additional $1 billion or more as it winds down the position. The U.S. Securities and Exchange Commission, the Federal Reserve and the Commodity Futures Trading Commission are investigating, according to people familiar with the probes.
The loss was particularly surprising for JPMorgan, the bank whose $2.32 trillion balance sheet makes it the largest in the U.S. and whose traders were the first in the mid-1990s to create credit derivatives, which let firms and investors insure themselves against losses on debt. It was also a blow to Dimon, 56, who has been the most outspoken critic of the Volcker rule, meant to restrict banks from betting their own money.
“It’s classic Wall Street hubris, which we’ve seen so many times before,” said Simon Johnson, a former chief economist at the International Monetary Fund who teaches at the Massachusetts Institute of Technology. “What’s particularly ironic here is that Jamie presents himself, and is believed by others to be, the king of risk management.”
Fannie Mae Loss
It wasn’t the first 10-digit hit for JPMorgan’s chief investment office. In 2008, it lost $1 billion on Fannie Mae (FNMA) and Freddie Mac preferred securities when the government-backed mortgage agencies were put into conservatorship. Olson, who ran the unit’s U.S. credit trading until December, said the only reason he wasn’t fired at the time was because Dimon had been “intimately familiar with those positions.”
Drew, 55, earned about $1.2 million a month over the past two years. She spent three decades at the firm and its predecessors, surviving mergers and changes at the top. She played a critical role steering the company through rocky markets, such as the Russian debt crisis and the collapse of hedge fund Long-Term Capital Management in 1998, disruptions from the World Trade Center attacks and the more recent financial crisis, said Lesley Daniels Webster, JPMorgan’s head of market risk. She worked with Drew for more than a decade.
In 2005, the year Dimon became CEO, Drew was named the bank’s chief investment officer, reporting directly to him. He gave her traders the green light to make investments in riskier products, including asset-backed securities, credit derivatives, sovereign debt and equities -- securities Drew and her staff had less experience with, according to a former senior executive who asked not to be identified because he wasn’t authorized to discuss the matter.
“Her position over the years has always been around hedging, but hedging for profit as opposed to hedging just to counter losses,” said Dina Dublon, a former JPMorgan chief financial officer who worked with Drew for 22 years before leaving in 2004 and now teaches at Harvard Business School. “She’s always been in a for-profit operation, even when she was managing a smaller domain.”
Until recently, Drew did well with her investments, with the corporate division under which she reports earning a peak of $3.7 billion in 2009, up from $1.5 billion a year earlier. The bank doesn’t break out results for the chief investment office.
“She did an excellent job and was considered a very high performer in the bank,” said Don Layton, incoming CEO of Freddie Mac and Drew’s boss from 1992 until 2002.
The bank rewarded her with a $15 million pay package for 2010 and $14 million for her performance last year, according to regulatory filings. Drew’s resignation was announced today, and Matt Zames, head of global fixed income in the investment bank, was appointed to succeed her. JPMorgan, like other banks, has adopted so-called clawback provisions for top executives, including Drew, to retrieve bonus pay for poor performance or “conduct that causes material financial or reputational harm,” according to its most recent proxy statement.
“Ina was one of the first senior executives at JPMorgan who quickly earned Jamie’s respect and ear,” said Austin Adams, a former chief information officer who sat on the bank’s 14-member operating committee with the two. “I found her to be very straightforward, someone I could trust. She didn’t suffer fools lightly.”
Dimon nurtured the office’s shift from its role mitigating lending risks, such as interest-rate and currency movements, to becoming a profit center, former executives said. Drew, who declined to be interviewed, hired Achilles Macris, 50, in 2006 to oversee trading in London. Macris, with Dimon and Drew’s blessings, led an expansion into corporate and mortgage-debt investments with a mandate to generate profits, three former employees said.
When the 2008 financial crisis highlighted the bank’s need to hedge its exposure to corporate loans and bonds it held on its books, Drew’s office expanded into credit derivatives and other risky instruments, according to a former senior officer. Those trades were tightly controlled and monitored at first, the former executive said.
Macris’s mandate drove the bank into riskier products and a less disciplined approach to investing, according to two former CIO executives. The shift provoked an exodus in 2008 of traders who specialized in more-liquid markets where risk was easier to measure, such as interest-rate products and foreign exchange, these people said. Macris didn’t respond to an e-mail or a call.
While Drew liked generating profit, she did so in a controlled way, placing strict limits on how much an investment could lose or gain, former colleagues and employees said. Traders were required to exit positions if losses exceeded $20 million, according to one former CIO manager in London. Those limits were scrapped under Macris.
The London team amassed a portfolio of as much as $200 billion, booking a profit of $5 billion in 2010 alone -- more than a quarter of JPMorgan’s net income that year, one senior executive said.
The CIO’s increased size and market power have made it an important customer to Wall Street’s trading desks and a market influence watched by hedge funds and other investors, the former employees said. Bloomberg News was the first to report, on April 5, that Bruno Iksil, a trader in the CIO’s London office, had amassed positions in securities linked to the financial health of corporations that were so large he was driving price moves in the $10 trillion market. Some market participants dubbed him the “London whale.” Others referred to him as “Voldemort,” after the villain of the Harry Potter series who’s so powerful he can’t be called by name.
Hard to Unwind
A Bloomberg News story on April 13 reported that Dimon was responsible for transforming the CIO and increasing the size of its speculative bets. Some in London were so big they probably couldn’t be unwound without causing losses, the article cited former executives as saying. That day, on a conference call to announce quarterly reports, Dimon called news about the London trades a “complete tempest in a teapot.”
Dimon said when he announced the losses last week that he didn’t know how bad things were until after the company reported its first-quarter earnings on April 13. Dimon reviews the profit-and-loss reports every day on large positions in the CIO, according to a senior JPMorgan executive. Before the quarter ended, he and Drew were both led to believe that the losses were erratic, and the reports showed that the position swung daily between losses and gains, the executive said.
Less than a week after earnings were released, the losses in the daily reports started piling up more frequently and in larger sums -- $80 million, $100 million, $120 million -- this person said. Even Drew was caught unaware, he said.
JPMorgan is now investigating whether the London office intentionally hid the magnitude of its errors, the executive said. While there isn’t evidence that’s the case, the office doesn’t appear to have fully understood the trade itself, this person said. Every time New York executives asked the London team questions, it responded with more questions, infuriating Dimon, the person said.
Shares of the company have lost more than 11 percent since the May 10 announcement of the loss. They dropped 2.3 percent in New York at 10:33 a.m., to $36.13.
Offer to Resign
Drew offered to resign several times last week, and her entire team in London is at risk of dismissal, according to the person. Macris also may leave this week, the Wall Street Journal reported yesterday, citing unidentified people.
While JPMorgan has refused to describe the trades by Iksil and the London-based CIO team, market participants from hedge-fund managers to credit brokers have tried to piece together the bets from market movements and volumes. The traders say Iksil started amassing positions last year in an older, less active version of a credit-default-swaps benchmark known as the Markit CDX North America Investment Grade Index, which investors use to speculate on the creditworthiness of companies from retailer Wal-Mart Stores Inc. (WMT) to aluminum producer Alcoa Inc. (AA)
As European leaders struggled earlier this year to navigate the region’s sovereign-debt crisis and mounting concerns that Spain may be too big to save, market participants focused on the burgeoning impact of Iksil’s trading. Some calculated that he may have built a position totaling as much as $100 billion in contracts in one index. By the bank’s own math, the positions amounted to tens of billions of dollars, a person familiar with its view said early last month.
JPMorgan sold protection on Series 9 of the index in the form of credit-default swaps and through more leveraged wagers using contracts called tranches, the traders said. The firm collected premiums, and in exchange promised to cover losses if companies in the index defaulted. Market participants surmise that Iksil’s trades weren’t one-way bets.
He may have offset the risk of index contracts expiring in December 2017 by buying similar protection using contracts that mature this December, traders said. In such a strategy, the firm effectively would be paid the difference between those two trades, an amount that for the full index was about $41,000 for every $10 million of protection at the end of March, according to prices from data provider CMA. As the gap narrows, the market value of the trade gains. As it widens, the value declines.
The gap on the full index widened to $51,800 per $10 million on May 10 and jumped even more to $65,800 the day after JPMorgan’s disclosure, prices from CMA show. Iksil didn’t respond to an e-mail seeking comment.
The losses have mounted since they were revealed last week, according to one person with knowledge of the bank’s internal deliberations. The firm’s investment bank is now managing the money-losing trades to minimize risk, and the leadership is still confident the maximum downside is about $1 billion more than the $2 billion loss disclosed last week, this person said, speaking on the condition of anonymity because he wasn’t authorized to speak for the company.
Inside JPMorgan, leadership is stunned by the situation, according to two senior executives. The firm’s top managers are less concerned about the financial impact of the trades, because the bank has surplus capital, than they are about the damage the losses inflict on the bank’s reputation, the executives said.
While the firm has layers of safeguards in place in its investment bank to protect against concentrated trading errors, Drew’s chief investment office wasn’t constrained by such controls, according to current and former executives.
Mark to Market
JPMorgan can stick with the positions that produced the losses if it needs to and isn’t compelled to sell, insiders said. The bank may have to book more mark-to-market losses as prices move against it, in part because JPMorgan’s predicament is now publicly known and traders at hedge funds and others firms are seeking to exploit that by betting against the bank’s positions, one of these people said.
Weeks before the announcement, the bank asked Daniel Pinto, co-head of fixed-income trading based in London, to manage Iksil’s positions in an effort to minimize losses, according to a former member of JPMorgan’s executive and operating committees who was briefed on the developments. Guy America, a Dutchman based in London who is head of European credit trading, and Ashley Bacon, a senior executive in market risk, are also helping to sort through the trade.
Dimon has led the banking industry in pushing back against measures in the Dodd-Frank Act that would restrict proprietary trading by institutions that take depositors’ money. On Feb. 2, Drew and five JPMorgan colleagues met with Federal Reserve staff to discuss the rule, a copy of the central bank’s meeting summary shows. The JPMorgan bankers recommended that the final rule be modified so that the chief investment office’s positions “not be included as prohibited proprietary trading,” according to the summary.
The bank’s loss will make it harder for Dimon to maintain that role said Paul Miller, an analyst with FBR Capital Markets in Arlington, Virginia, and a former examiner with the Federal Reserve Bank of Philadelphia.
“JPMorgan had a little halo around them, and that thing just got knocked off,” Miller said.
In an interview two days before the disclosure of the loss, Olson, the former head of U.S. credit trading, said the failure of Fannie Mae and Freddie Mac taught him a lesson.
“That’s a perfect demonstration there’s always risk out there that you just can’t control,” he said. “And you just can’t see coming.”