The Tale Of The London Whale Scandal And How It Affected Jp Morgan
“Call me Ishmael” is the famous opening line to the great American novel Moby Dick. Written in 1851 by Herman Melville, the story is a cautionary tale that focuses on the vengeful Captain Ahab, skipper of the whaling ship Pequod, and his fatal quest to find and kill the white whale that bit off his leg on a previous voyage.
In the opening line of the novel, the narrator of the story – the only surviving member of Ahab’s crew – briefly introduces himself. However, as many literary scholars have highlighted, whilst the opening line ascribes the narrator a name and an identity, the casualness with which he introduces himself simultaneously works to minimise his presence in the story. He is of little importance to the tale of Moby Dick, and his first words signal this. What will follow will be much bigger than him.
In 2012, a whale-hunting tale of an entirely different sort broke in the press, when JP Morgan Chase & Co. found itself in the position of having to explain to its investors how a single trader had managed to lose the bank $6.2 billion. In many ways, it seemed that the bank had simply found itself the subject of the latest scandal involving large sums of money that had been lost in a spate of reckless gambling. Indeed, the story even had a catchy narrative hook, with the trader involved – Bruno Iksil – widely dubbed “The London Whale”, because of the sheer size of the loss he had made.
However, the tale of the London Whale seemed to achieve a particularly high level of poignance. It was, after all, post-2008 and to make matters worse, Iksil had been working in the bank’s Chief Investment Office (CIO) – a unit whose express purpose was to minimise risk on the bank’s books. And then there’s the irony that this was JP Morgan – the bank credited with developing the most widely used tool for risk management, Value-a-Risk (VaR).
Although the theoretical roots of VaR can be traced back in one form or another to the early 1900s, it was JP Morgan that developed the firm-wide VaR system that was formally adopted as the standard for market risk in the Basel Committee on Banking Supervision’s 1996 Amendment to the Basel I accord. Based on historical data, VaR enables banks to calculate the maximum loss they can experience within a particular confidence level. VaR models were one of the tools used by the CIO, a specialised unit of JP Morgan, whose purpose it was to manage the bank’s risk, limiting potential losses through hedging. The CIO reported directly to the highest level of management and was headed globally by Ina Drew. By 2012, it had a trading book of $350 billion – comprised predominantly of federally insured deposits – to invest, with a focus on making conservative derivative trades that would offset the risks taken by the bank elsewhere. As JP Morgan stressed, the CIO was not a profit-generating centre.
Iksil joined the London branch of the CIO – headed by Achilles Macris – where he began working on JP Morgan’s synthetic credit portfolio (SCP), alongside Javier Martin-Artajo and Julien Grout. The SCP was a buffer intended to hedge the bank against the potential losses it could incur from a systemic event. From 2007 to 2011, the CIO appeared to be doing its job well, contributing $23 billion to the bank’s earnings and offsetting losses during the difficult period immediately post-crisis. However, apparently emboldened by its success, the CIO started to take larger, more risky positions. In early 2011, the CIO made $400 million in a credit-derivatives bet and by the next year it had lost $6.2 billion – a level of profitability and loss that Michael Santoro (Professor of Business Ethics at Rutgers Business School) notes in The New Yorker “could only occur when substantial risk is being taken – not when banks limit themselves to the safe and prudent investment that are required by law when banks are managing federally insured savings-and-checking deposit funds.”
At the centre of the London Whale case is the slippery distinction between a hedge and a proprietary trade. Whilst a proprietary trade is a bet made for the explicit purpose of making a profit, a hedge is supposed to offset losses or gains rather than make a profit, although it can sometimes inadvertently make or lose money in the process. A hedge is supposed to minimise risk for depositors, whilst a proprietary trade is a bet that inherently carries risk. Crucially, with the inclusion of the Volcker Rule under the Dodd-Frank Act of 2010, banks are no longer allowed to engage in proprietary trading because of the inherent risk of loss associated with these activities, and the implications of this for depositors. Under the original version of the Volcker Rule – which was only finalised in 2013 and implemented in 2015 – banks may only engage in trading in two circumstances: to offset risk when necessary to sustain their business, and to trade on behalf of their clients when the client has given it permission to do so.
The trades that would become so problematic for JP Morgan were a group of credit default swaps on high-yield bonds, where the bank would benefit if the creditworthiness of high-yield bonds decreased. The swaps were tied to two indexes: the CDX (a group of North American and Emerging Markets indices) and the iTraxx (a group of European and Asian indices). In late 2011, the bank was beginning to lose on these trades and JP Morgan CEO Jamie Dimon gave Drew the order to sell the assets to reduce the amount of risk on the bank’s balance sheet. Although the Volcker Rule had not yet been formally implemented, Basel III had just been released, influencing the calculation of banks’ capital reserves such that banks needed to either increase their capital, or decrease the risk-weighted assets on their books. JP Morgan chose the latter, however, selling the CIO’s assets turned out to be a risky move because of the sheer size of Iksil’s SCP positions.
According to a report compiled by the US Senate Permanent Subcommittee on Investigations, by January 2012, Iksil’s SCP positions had grown so large and risky that they had caused JP Morgan to spike VaR for four consecutive days. The SCP’s net notional value had increased from $4 billion to $51 billion and this was reported to Dimon and other senior management. The bank responded by allowing the CIO to adopt a new VaR model – one that immediately made the trades appear half as risky as the original measure had. Hoping to counter the losses he had thus far incurred, Iksil further increased the size of the SCP positions in March, with the SCP’s net notional value more than tripling from $51 billion to $157 billion. This no longer looked like conservative hedging but seemed to have rapidly morphed into risky gambling.
Despite the fact that the losses associated with the SCP were mounting rapidly – swelling in total from $100 million in January 2012 to $6.2 billion by December – JP Morgan appeared to be unconcerned. This was largely because the senior management of the bank had been misled about just how severe the situation was, as Martin-Artajo and Grout had been mismarking the SCP to hide the true size of Iksil’s losses. Remaining relatively calm about the more modest losses they had observed, senior management believed that the SCP positions would soon “mean revert” – the credit derivatives market was not behaving in line with historic norms, but the bankers believed that this would only be temporary, and that the SCP positions would return to their former profitability.
Dimon dismissed the drama in the press surrounding the company’s losses, calling it “a tempest in a teacup”, and remained adamant that the market would normalise. However, as the Senate subcommittee highlighted in its report, the reason the market was not performing as expected was precisely because Iksil had disrupted it by accumulating such extraordinarily large positions in markets with relatively few participants. These trades became targets for hedge funds, which placed bets against them, and when Iksil started to exit the trades, he found he could not do so without incurring massive losses. In June, JP Morgan reported that the SCP had lost $4.4 billion. In July, the bank disclosed an additional $660 million. By December, it admitted that SCP losses for the year had amounted to $6.2 billion.
JP Morgan initially insisted that the CIO had only been hedging, but when the case came under scrutiny by Senate, Dimon admitted that the portfolio had diverged from its initial purpose and that rather than protecting the firm from risk, it had, in fact, created risk. However, he never explicitly stated that the CIO had knowingly been engaging in proprietary trading. He acknowledged that he and other senior managers bore some of the blame for the loss as they had failed to apply VaR controls responsibly. As a result, by 2013, JP Morgan had paid $920 million in penalties to the US Office of the Controller of the Currency, the US Securities and Exchange Commission (SEC), the Federal Reserve and the Financial Conduct Authority for misstating its financial results and failing to ensure internal controls were in place to prevent financial fraud amongst its traders.
In addition, the bank payed out $150 million to settle a lawsuit brought against it by its investors. However, the bank maintained that ultimately the responsibility for the loss it had suffered rested with the traders involved, and with the London Whale in particular. Iksil, Macris, Martin-Artajo and Grout were fired, and the SEC furthermore initiated a case against Martin-Artajo and Grout, accusing them of securities fraud for the role they had played in hiding the losses from the bank’s management. Iksil agreed to testify against his former teammates in exchange for a non-prosecution deal from the Department of Justice, although the case has been put on hold as both Martin-Artajo and Grout have avoided extradition from Europe to the US. And although the Fed appeared to be pursuing legal action against Iksil, in 2017 it decided to stop proceedings.
The Senate subcommittee report told a rather different story to the one provided by JP Morgan, one in which the bank had not been the victim of a single irresponsible trader or even a team, but rather of a broader systemic failure. For the investigating team, it seemed clear that several individuals, at all levels in JP Morgan’s hierarchy, had failed in their duties to adequately manage the bank’s risk and protect its investors. The Senate subcommittee’s report highlighted that an analysis of the compensation history of employees working on the SCP made it clear that employees had been financially rewarded for making profits, rather than for demonstrating effective risk management. In addition, the report pointed out that it was unclear what the London Whale trades were supposedly hedging – JP Morgan had no record describing the credit risk that the trades were supposed to offset or indicating a range in which the SCP hedge was to be constructed.
Moreover, the SCP hedges did not appear to have been monitored like other CIO hedges routinely were to track their effectiveness, and documentation that should have been standard on the hedges was non-existent. The report summarised its findings on the case in its closing remarks as follows: “The bank’s initial claims that its risk managers and regulators were fully informed and engaged, and that the SCP was invested in long-term, risk-reducing hedges allowed by the Volcker Rule, were fictions irreconcilable with the bank’s obligation to provide material information to its investors in an accurate manner.” Much like in Moby Dick, it appeared to be a story far bigger than one individual.
For Iksil, however, the Senate subcommittee’s findings still implied more fault on his part than he was willing to accept. In an open letter sent to several media houses, he claimed that he was instructed to take the positions he did by Macris and stressed that he had repeatedly tried to alert senior management that the bank was at risk of losing billions of dollars. His warnings, however, were ignored and he was told to continue with the trades. With his career and personal reputation in ruins, Iksil has written a book to tell his side of the story, although to date nobody has offered him a publication deal.
Banks have been pushing back against the Volcker Rule since its inception on the grounds that it is costly, difficult to implement, and that it diminishes liquidity in the bond market. And regulators seem to agree – in 2018, the Fed approved a proposal to amend the Volcker Rule, in a move that SEC Commissioner Kara Stein argues will effectively euthanise the Rule and reintroduce untenable levels of risk into the monetary system. The amendment of the Volcker Rule is, however, in line with a general theme of banking deregulation in the US, which may be in danger of forgetting the lessons articulated in tales such as that of the London Whale.
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