Dimon and the Whale

JP Morgan was one of the few bulge bracket banks to weather the storm of the 2008 financial crisis.  The bank seemed a relatively trustworthy player within the financial services industry. However, the recent $5.8 billion hedging loss, initially estimated at $2 billion by JP Morgan, may cast a measure of doubt on the bank’s institutional character.[i] 

THE PLAYERS

Bruno Iksil (The London Whale).  Bruno Iksil, a trader for JP Morgan’s London office, earned the nickname, the London Whale, for his predisposition to take on big, risky trades.[ii]  Some people called him ‘Voldemort’ because of his perceived aggressiveness and power to move the Credit Derivative Swaps index with his trades.  Yet, before Iksil’s trades were exposed, he was relatively low profile and under the radar. Senior executives apparently supported him with full knowledge of his trades.  As a trader for JP Morgan’s Chief Investment Office, Iksil was part of a team responsible for protecting JP Morgan from risk. Whenever the firm made a big investment bet, Iksil and his team insure it in case the bet went wrong.[iii]  This process is known as hedging, a way to protect JP Morgan against risk even when customers suffer losses.

Ina Drew.  Chief Investment Officer and Bruno Iksil’s ultimate boss, responsible for overseeing Iksil’s trading unit.

Jamie Dimon. The Chairman, President, and Chief Executive Officer of JP Morgan.

Boaz Weinstein. A derivatives trader and hedge fund manager at Saba Capital Management.

THE INSTRUMENTS

Credit Default Swap (CDS). A credit default swap is a financial derivative that works like an insurance policy.  The buyer makes payments until maturity, and the seller must pay off a third party debt to the buyer if the third party defaults on its loan.  Essentially, a buyer of a CDS bets the lender will default, while the seller bets there will be no default. CDSs may be used as a way to hedge default risk for those who own bonds, or they can be used as a way to speculate (commonly referred to as naked credit default swaps) on debt issues and the creditworthiness of other parties without having to hold their bonds.

Credit Derivative Index. The index tracks the spreads on a basket of credit derivatives.

CDX.NA.IG.9 Index. A credit derivative index that tracks the spread on credit derivatives of US corporations.

THE EVENTS

In February 2012, Boaz Weinstein, a derivatives trader and hedge fund manager of Saba Capital Management, gives an important presentation at the Harbor Investment Conference that ultimately leads to the exposure of JP Morgan’s hedging loss.[iv]  Ironically, the conference takes place at the JP Morgan office in Manhattan.  Nearing the end of his presentation, Weinstein advocates buying the index of a certain kind of CDS.  Credit default swaps have been criticized as responsible for the infamous failures of Lehman Brothers and AIG during the financial crisis of 2008. The particular swaps Weinstein recommends are known as Investment Grade Series 9 10-Year Index CDS (maturing on 12/20/2017), and apparently are relatively low risk.  The so called, CDX NA IG 9 is an index that tracks a basket of credit derivatives on US corporate bonds. Weinstein recommends a buy on these particular CDSs because he notes a discrepancy in the way the swaps are trading, saying,  “They are very attractive and can be bought at a very good discount [21%].”[v]

With this discount, the CDS index is fairly inexpensive.  What he and the investing public do not realize at that time, is the London Whale is shorting these derivatives at immense cost to JP Morgan.

Iksil and his team have $350 billion, or 15% of JP Morgan’s assets to invest and speculate.  The problem is that rather than simply using hedges as a means for protection, Iksil pursues outsized bets on complex investment securities.  The large, risky bets of complex derivatives more resemble proprietary trading than risk hedging.  The trades are intended to produce profits.  The investment thesis behind Iksil’s CDS trade is to bet the economy improves and investment grade bonds do not default.

Weinstein inadvertently plays a large part in sinking the London Whale.  Initially, no one knows JP Morgan is the force skewing the CDS index market.  By February 2012, Weinstein’s convincing buy recommendation on CDX NA IG 9 begins a tug of war against JP Morgan. Hedge fund managers and investment professionals flock in on the opposite side of the Whale’s trade.  Iksil continues to sell but Weinstein and hedge funds persist in buying.  The London Whale is so massive that he initially sinks the bets made by the hedge funds.  Through May, the losses increase to the point where Weinstein’s funds at Saba Capital are down by about 20 percent.  The hedge funds are furious about the losses and suspect a single player has cornered and distorted the market by putting on huge trades. They realize that player is the London Whale. They leak the information to financial media who then begin to uncover Bruno Iksil and his trading positions.  This exposure, combined with renewed concerns about the Eurozone debt crisis, catalyzes the downturn of JP Morgan’s trade. The US and European economies weaken, corporate investment grade bonds become riskier, and Iksil is unable to buy back credit default swaps to cover his losses from the short position. As a result, JP Morgan loses an initially reported $2 billion, which has since been corrected to $5.8 billion.

THE OUTCOME

Bruno Iksil, the London Whale, is fired from JP Morgan and has compensation clawed back by the bank.  He is under investigation by criminal and civil authorities. The authorities are examining whether Iksil’s group mismarked positions to cover up losses.

Ina Drew, resigns as the Chief Investment Officer after seven years at the position.  She forfeits two years’ worth of compensation but is allowed to keep her stock in JP Morgan. According to regulatory filings Ina Drew earned $14m in the past year.

Jamie Dimon is called to Capitol Hill a few times in the face of political and media criticism.  A humbled Dimon openly apologises, “…we have let a lot of people down, and we are sorry for it”, assuring the episode is an “isolated event”,  which will not happen again.[vi]  When the loss first is announced to the media in April, Dimon tries to mitigate concern over the loss by addressing the furor as a “tempest in a teapot”.  It becomes clear when Dimon announces the losses on May 10  the hedging losses are more severe. While he blames traders in the Chief Investment Office as well as the CIO herself, he also has openly accepted responsibility.

Jamie Dimon admits the traders did not fully understand the risk, that he trusted those who managed the division to not compromise the bank, and rightfully takes responsibility for the losses. Dimon even acknowledges the concerns of government and the public by instituting claw backs on executive compensation to ensure against a lower probability of future trading failure.

The Securities and Exchange Commission, the Office of the Comptroller of the Currency and the Federal Reserve are looking into the failed trades at JP Morgan.

ETHICAL ANALYSIS

We analyze this case using a virtue ethics framework. Virtue ethics is a moral theory developed by Greek philosophers, but rediscovered and popularized in the late twentieth century. Aristotle elaborates and refines the theory in his Nicomachean Ethics. In a nutshell, Aristotle states having a virtuous character is the basis for right actionPut another way, an act is ethical if it is one that would be done by a virtuous person. Compare this view with utilitarianism, where an act is judged to be ethical by the consequences of the act. According to virtue ethics, one develops a virtuous character by constantly doing virtuous acts. Virtuous characters possess the virtues of honesty, humility, and prudenceIn this case, JP Morgan betrays its institutional character as a trusted banking institution because the institution and its agents do not exhibit virtues of honesty, prudence, and humility.

Honesty. JP Morgan does not reveal its hedging losses immediately. The bank delays the revelation of losses because inside players (Iksil and Ina Drew) believe they can deal with the losses before the losses are discovered and made public. When the London Whale’s trades blows up, JP Morgan remains non-transparent and announces the bank had lost $2 billion. Actual losses are finally reported to be $5.8 billion.

Prudence. Where were the institutional safeguards to prevent Iksil from engaging in these enormous and risky trades? Iksil himself, does not show any prudence when he puts on large trades in these derivatives. Perhaps the institutional culture of JP Morgan does not encourage the virtue of prudence amongst its employees. Does the culture instead, nurture intemperateness? It appears there were no institutional safeguards that prevented the London Whale from growing such large and risky trades. The lack of prudence is both a cause and effect of the lack of  internal risk management and the inability of of government to provide effective oversight of financial institutions. In financial markets, prudence is possessing the judgement to diffferentiate between appropriate and excessive risk. Traders like Iksil are essentially incentivized to take on big, risky trades because of outsized monetary rewards.  The compensation system demonstrates a problem within the institutional culture of JP Morgan and financial institutions in general.  Prudence can be inculcated by encouraging transparency, which in turn discourages intemperatenessIf senior management demands transparency throughout an organization’s operations, finance professionals may be more prudent thereby, protecting the bank’s credibility.  In JP Morgan’s hedging loss, Iksil and his team act without moderation. They assume no rules or superiors impede their actions and therefore, act in an exclusively self-interested way, disregarding the implications on the broad economy.[vii]  JP Morgan’s internal risk management inadequacy is evident in the lack of knowledge on the risk or size of the trades.

Humility. Does Jamie Dimon exhibit arrogance when he dismisses the initial questions about the Whale’s loss as a “tempest in a teacup”? It appears Dimon and his senior bankers are overconfident. They believe the bank has in place, the structures to detect and handle risks and top management has sufficient knowledge of transactions taking place in the bank. Dimon may be accused of arrogance in his appearing of possessing knowledge and control of transactional risks at the bank. The JP Morgan CEO never admits the London Whale trades are executed unethically.  He also continues to defend against government regulation, criticizing Dodd-Frank legislation and the Volcker rule.

CONCLUSION

In this hedging case, JP Morgan and its agents fail to show the virtues of honesty, prudence, and humility. These virtues are vital in financial institutions and for the proper functioning of markets. Without these virtues, trust, which binds markets, erodes.

 

BY: Matthew Hsu

Edited By: Dr. Kara Tan Bhala

 

References:

  1. Farrell, Maureen. “JPMorgan’s trading loss: $5.8 billion.” CNNMoney. Last modified July 18, 2012. http://money.cnn.com/2012/07/18/investing/jpmorgan-earnings/index.htm.
  2. Salmon, Felix. “How Bruno Iksil lost $2 billion.” Reuters Blogs. Last modified May 16, 2012. http://blogs.reuters.com/felix-salmon/2012/05/16/how-bruno-iksil-lost-2-billion/.
  3. Moore, Heidi N. “JP Morgan’s Loss: The Explainer.” Marketplace. Last modified May 11, 2012. http://www.marketplace.org/topics/business/easy-street/jp-morgans-loss-explainer.
  4. Pollack, Lisa. “Hedge funds and the Whale, credit index edition.” Financial Times Alphaville. Last modified April 6, 2012. http://ftalphaville.ft.com/blog/2012/04/06/951941/hedge-funds-and-the-whale-credit-index-edition/.
  5. Protoss, Ben, and Michael J De La Merced. “‘Proud’ JPMorgan Chief Apologizes.” The New York Times: DealBook. Last modified June 13, 2012. http://dealbook.nytimes.com/2012/06/13/pro ud-jpmorgan-chief-apologizes/.
  6. Sheppard, Lee. “Did JP Morgan Violate the Volcker Rule?” Forbes. Last modified June 4, 2012. http://www.forbes.com/sites/leesheppard/2012/06/04/did-jp-morgan-violate-the-volcker-rule-2/.
  7. Stanford University. “Virtue Ethics.” Stanford Encyclopedia of Philosophy. Last modified July 18, 2003. http://plato.stanford.edu/entries/ethics-virtue/.
  8. Goodman, Amy. “Bill Black: On JP Morgan’s ‘Hedge’, Jamie Dimon’s Integrity, and the Epic Conflicts of Interest in the Federal Reserve System.” Capitalism Without Failure. http://www.capitalismwithoutfailure.com/2012/05/bill-black-on-jp-morgans-hedge-that.html.
  9. Henning, Peter J. “JPMorgan’s Loss: Illegal, or Just Bad Judgment?” The New York Times: DealBook. Last modified May 14, 2012. http://dealbook.nytimes.com/2012/05/14/ jpmorgans-loss-illegal-or-just-bad-judgment/.
  10. Knowledge@Wharton. “JPMorgan’s Big Loss: Why Banks Still Haven’t Learned Their Lesson.” Knowledge@Wharton. Last modified May 23, 2012. http://knowledge.wharton.upenn.edu/a rticle.cfm?articleid=3008.

 

 

 



[i] Farrell, Maureen. JPMorgan’s trading loss: $5.8 billion.

[ii] Moore, Heidi N. JP Morgan’s Loss: The Explainer.

[iii] Pollack, Lisa. Hedge funds and the Whale, credit index edition.”

[iv] Salmon, Felix. How Bruno Iksil lost $2 billion.

[v] Ibid.

[vi] Protoss, Ben, and Michael J De La Merced. ‘Proud’ JPMorgan Chief Apologizes

[vii] Henning, Peter J. JPMorgan’s Loss: Illegal, or Just Bad Judgment?

 

 

 

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