JPMorgan Chase & Co. engaged in high-risk proprietary trading under the guise of ordinary hedging, said Senate investigators, who urged U.S. regulators to strengthen the proposed ban on such trades known as the Volcker rule.
Regulators should require banks that hold federally insured deposits to explicitly link positions in derivatives to the underlying risk they are hedging, the Senate’s Permanent Subcommittee on Investigations recommended in a 300-page report released yesterday.
The issue of which trades are hedges and which are risky bets that could destabilize a bank is the crux of a stalemate over the Volcker rule, which was adopted as part of the 2010 Dodd-Frank Act designed to rein in systemic risks. The rule, which is in the final stage of drafting by five U.S. regulators, would restrict the kinds of trades permitted by banks holding deposits insured by taxpayers.
Banks have lobbied heavily against the Volcker rule, arguing that it will restrict market-making and other standard banking practices.
The report and its recommendations, issued jointly by the committee’s Democrats and Republicans, is expected to increase pressure on regulators to tighten exemptions in the draft Volcker rule. The Volcker rule was one of the most controversial provisions of the Dodd-Frank Act, generating more than 18,000 comment letters from the industry.
Bank officials and regulators are scheduled to be questioned on the report’s findings in a hearing today.
“JPMorgan’s chief investment office increased risk by mislabeling the synthetic portfolio as a risk-reducing hedge when it was really involved in proprietary trading,” said Senator John McCain of Arizona, the panel’s top Republican.
Subcommittee Chairman Carl Levin, a Democrat from Michigan who sponsored the Volcker rule, said regulators should close a loophole in an early draft of the rule that would permit broad “portfolio” hedges.
“We’re going to continue to work very hard for a final rule that does not allow the kind of manipulation, the kind of concoctions that were created here by the bank to be accepted in the name of hedging,” Levin said in a news conference.
The subcommittee released the panel’s findings after a nine-month probe into JPMorgan’s record trading losses that came to light when Bloomberg News first reported them on April 5. The flawed bet on credit derivatives by a trader in London eventually cost the company more than $6.2 billion and stained Chief Executive Officer Jamie Dimon’s 31-year Wall Street career. The trader was dubbed the “London Whale” because the derivatives positions were so large they moved credit markets.
“While we have repeatedly acknowledged significant mistakes, our senior management acted in good faith and never had any intent to mislead anyone,” Mark Kornblau, a spokesman for JPMorgan, said in an e-mail.
Levin and Senator Jeff Merkley, a Democrat from Oregon, sponsored the measure that eventually became known as the Volcker rule in honor of its original proponent, former Federal Reserve Chairman Paul Volcker, and was included in the Dodd- Frank Act. The law bars federally insured banks from proprietary trading, or trading for their own account, while allowing regulators to make exemptions for market-making and hedging.
The subcommittee found that officials at the bank’s main regulator, the Office of the Comptroller of the Currency, expressed skepticism that the trades were a hedge. In a May 2012 internal e-mail, an OCC examiner referred to synthetic credit portfolio as a “make believe voodoo magic ‘composite hedge’.”
Bryan Hubbard, a spokesman for the OCC, said the agency continues to investigate the matter. As a result of the report’s findings on regulators’ shortcomings, the OCC has taken steps to improve its supervision, he said.
“We are very disappointed that the bank misinformed the OCC which hampered our supervisory efforts,” Hubbard said in an e-mailed statement. “We will take additional action as appropriate.”
The subcommittee said the investigation uncovered evidence that bank officials portrayed the losing trades as a hedge when internal communications suggested otherwise.
For instance, in an April 13, 2012, earnings call, former Chief Financial Officer Douglas Braunstein called the positions “consistent” with the Volcker rule. However, two months earlier, the bank made the opposite assessment, the report said.
Next page: Proprietary Trading
On Feb. 13, 2012, the bank submitted an official comment letter to its regulators, including the OCC, expressing concern that the creditderivatives trading might be prohibited by the Volcker rule. In the letter, Barry Zubrow, a former risk officer who retired in December, wrote that under the proposed Volcker rule this activity “could have been deemed proprietary trading.”
Also, Ina Drew, former chief investment officer for the bank, told Braunstein the day before the April earnings call that the Volcker rule was a “poor fit” with the CIO’s credit derivatives trading; Braunstein said the opposite on the call the next day.
“Mr. Braunstein’s optimistic assessment during the April 13 earnings call may have reassured investors, but that is no justification for misinforming the public about the bank’s official position that the Volcker rule might prohibit the SCP as an example of high-risk proprietary trading,” the subcommittee report stated, referring to the bank’s synthetic credit portfolio.
The report said that Braunstein should have known that his comments contradicted the bank’s own 68-page Volcker rule comment letter.
In addition, the investigation found that the bank considered the unit a proprietary trading operation as early as 2007. In November of that year, the bank’s internal audit group issued a report characterizing the CIO’s credit-trading activities as “proprietary position strategies executed on credit- and asset-backed indices.” The report didn’t mention hedging as a purpose of the unit.
JPMorgan officials told the subcommittee that the trades were intended to function as insurance or to “hedge” against credit risks. Although the original document seeking approval for the synthetic credit portfolio outlined hedging as a goal, the bank was unable to produce documentation over the next five years detailing its hedging objectives, strategies, assets, risks or events it was supposed to hedge.
“The bank was also unable to explain why the SCP’s hedges were treated differently from other types of hedges within the CIO,” the subcommittee report.
Levin said the findings call for regulators to quickly complete the Volcker rule and strengthen it. Specifically, he said any allowance for banks to hedge should be documented and tied to a specific risk.
“We cannot allow the argument of the banks that they can hedge their entire inventory somehow where we get global hedges,” Levin said at the news conference. “If they are going to claim that trades are a hedge, they’ve got to be able to identify what is being hedged against, what are the assets being hedged and what is the proof that it is a hedge.”
JPMorgan’s loss re-ignited the debate in Congress over whether aggregate portfolio hedging is appropriate at all and how to define and spot these trades.
“It has made regulators take another look at hedging and what constitutes appropriate hedging and what may fit within the Volcker rule limits,” Satish Kini, co-chair of the Debevoise & Plimpton LLP’s Banking Group, said in advance of the report’s release.
After the bank disclosed its losses May 10, Levin and Merkley sent a letter to five federal regulators urging them to remove “ill-advised loopholes” from the Volcker draft; regulators have yet to finalize the rule.
Merkley said the PSI report is another reminder for regulators to complete a “strong, simple Volcker firewall.”
“JPMorgan’s huge losses continue to cast a whale-sized shadow over these extended delays, and remind us once again just how important it is to separate risky, hedge-fund-style trading from the banking system that Main Street depends on,” Merkley said in a statement.
Comptroller of the Currency Thomas Curry said in a June 2012 hearing that the JPMorgan incident was a “risk-management issue, regardless of whether or not the Volcker rule was in play.”
“I think our experience here, as it unfolds with JPMorgan Chase, would help inform our views in the final rule-making,” Curry said.
The subcommittee will hold a hearing on the findings today with witnesses from the bank, including Drew and Braunstein, and from the OCC, including Curry.
“The investigation of our Permanent Subcommittee on Investigations into the JPMorgan whale trades opens a window into the hidden world of high-stakes derivatives trading by a major bank,” Levin said. “We found a trading operation that piled on risk, ignored limits on risk taking, hid losses, dodged oversight and misinformed the public.”