Why Did London Whale Swallow Only Half of Dimon's Pay?

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By Paula Dwyer

It sounds harsh. The board of JPMorgan Chase & Co. said today it is cutting in half the 2012 pay of Chief Executive Officer Jamie Dimon, following a review of trading losses. The board found that Dimon bears ultimate responsibility for the fiasco, which took place in the bank's chief investment office and cost the company more than $6 billion.

But don't cry for Jamie. His compensation will still come to $11.5 million, including a $1.5 million salary and a $10 million bonus. (Dimon's total compensation was $23 million in 2011 and $20.5 million in 2010.)

Ask yourself: In what other industry could a CEO be held responsible for losing $6 billion and still get paid $11.5 million? Losses on that scale, when combined with the bank's own postmortem showing glaring oversights up and down the management chain, should have resulted in much worse for Dimon, including clawing back past bonuses.

To rewind the tape, JPMorgan lost big on derivatives bets by U.K. trader Bruno Iksil, nicknamed the London Whale because his positions were so huge. They looked more like speculation than hedging. The blunders prompted probes in the U.S. and overseas, and this week led to the first regulatory sanctions after bank regulators found weaknesses in internal controls.

The chief investment office's job was to manage excess cash. At first it invested in good quality fixed-income securities, including municipal bonds, mortgage-backed securities, corporate bonds and sovereign debt. Beginning in 2007, the investment office launched what it called a synthetic credit portfolio, which was intended to protect the bank against defaults by bond issuers.

The portfolio took positions in so-called credit derivatives, or indexes based on insurance written on baskets of corporate bonds. The instruments were designed to generate revenue if the economy weakened and defaults grew. The bank, in essence, was hedging risk by buying credit insurance, which meant that it was entitled to payment whenever a company in the basket defaulted on its debt, even though JPMorgan didn't own the underlying asset. In exchange, JPMorgan made regular payments to its trading partners on the other sides of these deals, similar to premiums on insurance policies. Its trades became so large, however, that the bank couldn't easily unwind them without the market taking advantage of the bank.

And take advantage it did. Two internal reports, one by the board and a lengthier one by a task force led by Michael Cavanagh, the co-head of JPMorgan's Corporate and Investment Bank, make for fascinating, and sometimes scary, reading. A few highlights:

In January 2012, the chief investment office breached limits on how much capital it could put at risk, causing the bank overall to exceed its limit. This breach wasn't reported to JPMorgan's Risk Policy Committee, composed of three independent board members acting as the bank's last line of defense.

An internal audit of the controls for market risk resulted in a "needs improvement" rating. Among the deficiencies were shoddy asset valuations, the use of unapproved models for calculating market risk, failure by the chief information officer to measure its synthetic credit portfolio's sensitivity to certain risk measures, and the lack of a stress-test method. The audit conclusions, amazingly enough, weren't given to the Risk Policy Committee.

The trading strategies of the investment office were poorly conceived and vetted, says one of the internal reports. Neither the trades nor their effect on the bank's balance sheet were fully understood by the office. Incredibly, the CIO, Ina Drew (who has since resigned), did not ask for or receive regular reports on the positions in the synthetic credit portfolio, or any other portfolio under her management. As a result, the report says, "she does not appear to have had any direct visibility into the trading activity, and thus did not understand in real time what the traders were doing or how the portfolio was changing."

Once the problems were discovered, the traders working under Drew did not provide good-faith estimates of the exit prices for all the positions in the synthetic credit portfolio, which caused the bank to have to restate its earnings and deprived management of the opportunity to avoid some losses.

At times, pure math errors wreaked havoc. One calculation involved plugging in fresh figures to a model the bank was using to guide its trading. The model called for an old rate to be subtracted from a new rate, then divided by their average. But the sum of the two figures was used instead of their average, making the portfolio seem less risky than it really was.

For at least two weeks, $400 million in losses in the synthetic credit portfolio failed to show up because of an error in cutting and pasting figures onto a spreadsheet.

Dimon told the task force that the CIO's synthetic credit portfolio should have gotten more scrutiny from senior management, and that the bank's risk committee should have asked more probing questions and imposed stricter limits. "In the rest of the company we have those disciplines in place," Dimon told the task force. "We didn’t have it here."

So explain to me why Dimon is getting paid $11.5 million and doesn't have to return any of last year's $23 million pay package?

True, Dimon should be able to rely on senior managers who directly report to him to escalate significant issues. But even the board's internal report concludes that he "could have better tested his reliance on what he was told."

It's also true that JPMorgan today reported 2012 net income of $21.3 billion, the third consecutive year of record profits.  Still, those figures shouldn't cover up Dimon's mistakes.  JPMorgan already said it would be recovering two years of compensation paid to the bankers involved in the trading fiasco. It's only right that millions of dollars should be clawed back from Dimon's bonuses, too.

Reclaiming some of his pay could be done through the 2002 Sarbanes-Oxley Act, which gave the Securities and Exchange Commission the right to take back pay from executives when a company has had to restate its financial results, as JPMorgan has done. The law allows recovery of bonuses, including profits from stock sales, within 12 months of the release of financial information, but only if there was a restatement because the company cooked the books or was involved in misconduct -- even if the executives themselves weren't accused of wrongdoing.

If that seems implausible, JPMorgan's board could invoke its own bylaws, which since 2010 have allowed clawbacks if an executive's conduct results in large losses or harms the bank's reputation.

We now know that Dimon failed in the single-most important part of his job -- making sure his managers were doing their jobs. It's only fair that he give back the money paid to him when the board considered him the smartest executive on Wall Street.

(Paula Dwyer is a member of the Bloomberg View editorial board. Follow her on Twitter.)

Read more breaking commentary from Bloomberg View at the Ticker.

-0- Jan/16/2013 20:41 GMT