The Tale of the London Whale

4/25/2019 - Monocle Journal

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 attacked him on a previous voyage, causing him to lose his leg. After chasing his nemesis at sea for several days, Ahab is thwarted again by the whale, which attacks his ship, killing everyone onboard except for one member of the crew – Ishmael. After he is rescued from the sea by another boat, Ishmael tells the story of Moby Dick, beginning his tale by introducing himself. His opening words have been the source of much debate among literary scholars, for although Ishmael is the first character that readers encounter, he goes to great lengths in the remainder of the first chapter to minimise his role in the story that follows. His introduction to the readers, he claims, is but “a sort of brief interlude and solo between more extensive performances” as he is of little importance to the tale of the “portentous and mysterious monster”, Moby Dick. What will follow will be much bigger than him. 

The London Whale

In 2012, a whale-hunting tale of an entirely different sort broke in the press, when J.P. Morgan Chase & Co. found itself in the position of having to explain to its investors how a single trader by the name of Bruno Iksil had managed to lose the bank $6.2 billion. In a clear reference to Moby Dick, Iksil became known in the press as “The London Whale” because of the size of the damage he had inflicted on the bank. However, it was not only the severity of J.P. Morgan’s loss that was so troubling; it was the fact that only four years after the financial crisis, a trader working in the bank’s Chief Investment Office (CIO) – a unit whose express purpose was to minimise risk on the bank’s book – could have incurred such an enormous loss. It almost beggared belief that after all of the oversight and regulation that had been put in place post-crisis, it was even possible for someone to do this. The CIO was a specialised unit of J.P. Morgan, whose purpose it was to actively manage a number of risks on the bank’s behalf – including credit risk, interest rate risk and trading risk – through hedging activities. 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 of excess deposits – to manage, with a focus on making conservative derivative trades that would offset the risks taken by the bank elsewhere. As J.P. 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 J.P. 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 range of profit and loss amounts 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 investments 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 trade and a proprietary trade. A proprietary trade is a bet that is made using the bank’s own money for the explicit purpose of making a profit, whilst a hedge trade is constructed to offset the potential losses or gains that could be made on another trade. The purpose of a hedge is to reduce risk rather than to make a profit, although it can sometimes inadvertently make or lose money in the process. On the surface, the actual trades may be indistinguishable from one another and so, in essence, the difference between a proprietary trade and a hedge trade is merely a matter of intent. But the intentions of banks had come under harsh scrutiny following the financial crisis – so much so that in 2015, three years after the story of the London Whale broke, the Volcker Rule was implemented as part of the Dodd-Frank Act of 2010. The Rule prohibits banks from engaging in proprietary trading because of the inherent risk of loss associated with certain types of speculative investments, and the ultimate implications of potentially large-scale losses for bank customers. Under the Rule, 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 J.P. 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 indices: 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 market was beginning to move against the bank, which started to lose money on these trades. J.P. Morgan CEO, Jamie Dimon, gave Drew the order to sell the bank’s assets to reduce the amount of risk on its balance sheet. The Basel Committee on Banking Supervision had just released Basel III, 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. As the bonds attracted a higher risk-weighted asset treatment, J.P. Morgan chose to take them off its books. However, selling the CIO’s bonds essentially meant that the credit default swaps on the bonds ceased to function as hedges and became naked positions – and extremely risky ones at that, because of their sheer size.

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 J.P. 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. Deciding that the VaR measure being used was too conservative, 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 in March, J.P. Morgan appeared to be unconcerned. The Subcommittee report noted that at this point, there was sufficient evidence to suggest that Dimon was informed about the SCP’s complex and sizeable portfolio, its growing losses, and the difficulty involved in exiting the SCP’s positions. However, when the press caught wind that the bank was making losses, Dimon dismissed the stories that went to print as “a tempest in a teacup” and remained adamant that the market would soon normalise. The bank’s senior management reassured the public 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. And indeed, this seemed plausible given that Martin-Artajo and Grout had been mismarking the SCP to hide the true extent of Iksil’s losses. However, the problem with believing that the market would simply mean-revert was that it ignored the fact that 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 January 2012, J.P. Morgan reported that the SCP had lost $100 million and by June, this figure had grown to $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.

The Subcommittee report is inconclusive about whether the traders were mismarking the SCP and hiding the bank’s losses of their own accord, or whether they were doing so on orders from higher up in the bank. However, it does note that emails and recordings between the traders discussing the mismarking indicate that they had become “upset or agitated” with what they were doing. It also highlights that it is likely that J.P. Morgan’s senior management was well-aware that if the truth about the SCP losses was widely known, the market would move against it even more – which is exactly what happened. In the weeks after the bank finally disclosed the size of its losses, its stock dropped by 25%.

J.P. 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. In addition, he admitted: “We made a terrible, egregious mistake. There is almost no excuse for it. We knew we were sloppy. We know we were stupid. We know there was bad judgment. In hindsight, we took far too much risk. That strategy we had was badly vetted. It was badly monitored. It should never have happened.”

As a result, by 2013, J.P. Morgan had paid $920 million in penalties to the US Office of the Comptroller 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, J.P. Morgan 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 bank’s losses. Iksil agreed to testify against his former teammates in exchange for a non-prosecution deal from the Department of Justice, although at the time of writing the case had been put on hold as both Martin-Artajo and Grout had 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, lacking enough concrete evidence to make a conviction.

The Senate Subcommittee report told a rather different story to the one provided by J.P. 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 J.P. 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 supposed to be hedging – J.P. Morgan had no records 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, no documentation existed to indicate that the SCP hedges had been monitored to track their effectiveness in offsetting a particular risk, which is a standard practice for hedges. 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.”  

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.

Just as Ishmael seems determined to minimise his role in Moby Dick, so Iksil has remained steadfast in his conviction that his part in the tale of the London Whale is negligible. However, critical readers of Herman Melville’s classic novel will notice that although Ishmael may be only a minor character in the story he tells of Captain Ahab and Moby Dick – merely a sailor who quite by chance happens to board the Pequod as it sets sail on its final journey – his influence on the novel as the narrator is immense. Whether or not he wishes it to be so, his central presence in the book persists until the very last page, as the reader is invited to experience the story through Ishmael’s eyes. He cannot remove himself from the narrative – he does not simply narrate the story, he constructs it and influences its trajectory, so much so that a long debate has ensued between literary scholars about whether it is Ahab or, in fact, Ishmael who is the protagonist of the novel.

Iksil too insists that he played only a minor role in the tale of the London Whale. And indeed, the real action of the story is undoubtedly centred on the failings of J.P. Morgan’s CIO to effectively perform its primary mandate and of management’s lack of oversight of the bank’s activities. It can even be argued that the London Whale is a story much bigger than one individual or even one institution, providing instead an insight into the modern banking system as a whole. After all, 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 in line with a general theme of banking deregulation in the US, which may be in danger of forgetting the lessons learned in cases such as that of the London Whale.

But to dismiss Iksil’s influence in the London Whale trades is to dismiss the power that individuals have to shape larger stories. Whether the trades were his doing or the result of an order from higher up, Iksil was nonetheless complicit in the bank’s actions – and he earned between $6 million and $7 million a year, consisting mostly of shares in the company, for his complicity. Almost all of this was clawed back in the wake of the bank’s enormous losses and Iksil has not worked since his dismissal from J.P. Morgan in 2012. A lucrative book deal may be well-timed for the unemployed trader.

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