Friday, March 15, 2013 - But Wait, There's More!

Mark your Calendar, April 5 & 6 and make your reservations for the 2013 Wealth Protection Conference in Tempe, AZ. For conference information visit www.buysilvernow.com or click here or call 480-820-5877. This year's conference features Roger Weigand, Nathan Liles, David Smith, Mark Liebovit, Arch Crawford, Ian McAvity, Bill Tatro, and I will speak on Friday. There is an expanded Q&A session with all speakers on Saturday. I hope you can attend.

But Wait, There's More!

By Sinclair Noe

DOW – 25 = 14,514
SPX – 2 = 1560
NAS – 9 = 3249
10 YR YLD - .04 = 2.00%
OIL + .42 = 93.45
GOLD + 2.60 = 1593.90
SILV - .04 = 28.87

Beware the Ides of March.

The winning streak is over. These things don't last forever. It's just one day.

The bad news continues for JPMorgan Chase. Bank executives have been appearing before the a Seante panel investigating the $6 billion trading losses of the London Whale. Today's hearing and a subcommittee report released on Thursday paint a damning picture of a bank and high-level employees raking in huge payouts while ignoring risks, deceiving investors, fighting with regulators and trying to work around rules as losses mushroomed in a derivatives portfolio.

The Subcommittee investigators, largely the same crew who unraveled financial scandals surrounding infamous Goldman Sachs trades like Abacus and Timberwolf, and also took on HSBC's trans-global money-laundering activities in an extraordinarily detailed report issued last summer, have now taken aim at the heart of the Too-Big-To-Fail issue through its investigation into the CIO trading unit of JPMorgan Chase, and the losses by the head derivatives trader, Bruno Iksil, also know as the London Whale, or sometimes known as Voldemort.

If you want to learn more about the story, there has been some excellent reporting by Matt Taibbi, including live blogging from the hearings.

If you know what the London Whale story is all about, pat yourself on the back; most people think it has something to do with a Disney character. What the better informed people know is that JPMorgan Chase lost a whole lot of money on very complex trades in derivatives, and somehow this was bad, and the rest is a mystery.

Why should we care if a private bank, or more to the point a private banker like Chase CEO Jamie Dimon, loses a few billion here and there? What business is it of ours? And why did we have to have congressional hearings about it last year? There are still Chase banks in town; the ATMs still work. So what if there is a little less profit.

CEO Jamie Dimon seems perplexed at all the attention on Capitol Hill. Dimon appeared before the Senate Committee, and he needs to be called back, though that might not happen. Dimon acted as if the whole thing was some silly grandstanding. It is not.

This new report by the Permanent Subcommittee answers the question of why the public needs to be aware of the London Whale. The report describes an epic breakdown in the supervision of so-called "Too Big to Fail" banks. The report confirms everyone's worst fears about what goes on behind closed doors at such companies, in the various financial sausage-factories that comprise their profit-making operations. And the London trading desk, known as the CIO, was a major profit center for JPMorgan Chase.

If the information in the report is correct, Chase followed the behavioral model of every corrupt/failing hedge fund this side of Bernie Madoff and Peregrine Financial and MF Global, only it did it on a much more enormous scale and did it with federally-insured deposits. The fund used (in part) federally-insured money to create, in essence, a kind of super high-risk hedge fund that gambled on credit derivatives, and just like Sam Israel did with his Bayou fund, when it got in trouble, it resorted to fudging its numbers in order to disguise the fact that it was losing money hand over fist.

Chase for years hid the very existence of this operation from banking regulators and lied about the purpose of the fund (saying it was purely a hedging operation when it stopped being a hedge and instead became a wild directional gamble), and it also changed the way it calculated the fund's value once it started to lose hundreds of millions of dollars. Even worse, the bank's own internal auditors signed off on the phoney accounting of this Synthetic Credit Portfolio (SCP), at one point allowing it to claim $719 million in losses when the real number was closer to $1.2 billion.

How did they do this? In the years leading up to January of 2012, Chase used a standard, plain-vanilla method to price the derivative instruments in its portfolio. The method was known as "mid-market pricing": if on any given day you had a range of offers for a certain instrument – the "bid-ask" range – "mid-market pricing" just meant splitting the difference and calling the value the numerical middle in that range.

But in the beginning of 2012, Chase started to lose lots of money on the derivatives in its SCP, and just decided to change its valuations, that they weren't in the business of doing "mids" anymore. One executive thought the "market was irrational." As the Subcommittee concluded:

By the end of January, the CIO had stopped valuing two sets of credit index instruments on the SCP's books, the CDX IG9 7-year and the CDX IG9 10-year, near the midpoint price and had substituted instead noticeably more favorable prices.

If you can fight through the jargon, what this basically means is that Chase decided to go into the fiction business and invent a new way to value its crazy-ass derivative bets, using, among other things, a computerized model the company designed itself called "P&L predict" which subjectively calculated the value of the entire fund toward the end of every business day. To make it even more basic; when Chase started losing money, they just started making up numbers to make the losses look better.

But wait, there's more! The Office of the Comptroller of the Currency, or OCC, is the primary government regulator of Chase. The report exposes two huge problems here. One, Chase consistently hid crucial information from the OCC, including the sort of massive increases in risk the OCC was created precisely to monitor. Two, even when the bank didn't hide stuff, the OCC was either too slow or too disinterested to take notice of potential problems. At one point, Chase added nearly $50 billion in risk and failed to mention the fact to the OCC – but the OCC also failed to bat an eyelid when Chase breached its stress limits eight times in a space of six months, often for weeks at a time.

The Senate investigators highlighted a frightening metaphor to explain what they found out about Chase's response to its burgeoning accounting disaster last winter and spring:

The head of the CIO's London office, Achilles Macris, once compared managing the Synthetic Credit Portfolio, with its massive, complex, moving parts, to flying an airplane. The OCC Examiner-in-Charge at JPMorgan Chase told the Subcommittee that if the Synthetic Credit Portfolio were an airplane, then the risk metrics were the flight instruments. In the first quarter of 2012, those flight instruments began flashing red and sounding alarms, but rather than change course, JPMorgan Chase personnel disregarded, discounted, or questioned the accuracy of the instruments instead.

Investigators took note of this and then, sensibly, wondered if Chase was the only bank ignoring all those flashy lights:

The bank's actions not only exposed the many risk management deficiencies at JPMorgan Chase, but also raise systemic concerns about how many other financial institutions may be disregarding risk indicators and manipulating models to artificially lower risk results and capital requirements.

The testimony continued today, and the tactic appears to be trying to build a wall around Jamie Dimon; to make the case that it was rogue traders, with criminal intent, mismarking the books. But, this does not, or at least it should not protect management. And one of the big problems is that management allowed the traders to mark their own books. It is the responsibility of management to know and have procedures in place to alert them to potential fraud or regulatory violations, and the first step in the procedures handbook is you don't let the traders mark their own books. You don't put the fox in charge of the henhouse. You don't let the inmates run the asylum.

And if this is what the bank executives are trying to pawn off on the Senate investigators, they have another problem. It is impossible for the bank's external auditor to sign off on financial statements until and unless the control breakdowns are remediated sufficiently for the auditor to provide assurance. The controls and procedures were so systemically flawed that the bank could not provide an honest external audit. Practically impossible.

The fact that the unit with the weaknesses by all accounts was under the direct control of the CEO throws doubt on the validity of his prior certifications about the quality of the internal controls. The external auditors will be under extreme pressure to either support or refute the earlier certifications. Falsifying the certification is the worst Sarbanes Oxley violation there is, so Dimon is going to have to come up with an airtight rebuttal.

But wait, there's more!

It wasn't just a breakdown of controls. The Senate report goes on to detail how management hid the existence and role of the unit within the JP Morgan Chief Investment office that entered into the “whale” trades, the Synthetic Credit Portfolio, from its inception, even as its exposures ballooned, from the OCC

The bank made repeated, knowing misrepresentations about the size of the losses, the severity of the control failures, and the degree of management knowledge to regulators and investors

The contempt for regulators and for the need for timely and adequate disclosure is symptomatic of an out of control environment. Between the beginning of the year and end of April 2012, the SPG breached risk limits 330 times, sometimes even violating bank-wide limits. Yet staff and management regarded them as an inconvenience rather than treating them as shrieking alarms that warranted swift action

JP Morgan managers and risk control officers were aware of and complicit in the mismarking of positions.

The impression the bank gave and the media duly parroted was that this was a big “oopsie,” that the bank had implemented a model that had a serious bug in it and just happened to make the Synthetic Credit Portfolio look much better than it really was. The problem, according to the bank was that the new model for risk, had a few bugs, and the new program required manual entry of data, and there were a few mistakes incorporating the formula and the calculations. But don't worry, we sent an intern over to best Buy and he bought some great new software called Microsoft Excel, so we've worked out all of the IT problems, and it will never happen again. Ooops.

A few times, or maybe more than a few times, I’ve heard it stated that “we should never attribute malice when mere incompetance serves as an explanation.” Reality, and facts, long ago established that the banks do not deserve the “benefit of the doubt”. It would be sweetly ironic though if Jamie did go down over an innocent mistake, rather than for the multiple crimes he has committed. He might shout, as they drag him from the dock, ” I did not commit this (particular) crime! It was an (economic) hedge! We all make mistakes, but when I make a mistake, I don't lose billions of dollars. These guys just operate at a different level, right? Not exactly.

The new model actually allowed the London trading unit to take on much bigger risk, essentially doubling down on a losing bet. And the management of the bank knew it because, this will shock you; some of the lower level traders sent emails to upper level executives that questioned the new model for increased risk and mispricing.

And the discrepancies were huge. Mr. Iksil, the London Whale, estimated in one email that the Portfolio had lost about $600 million, but using the friendlier model the loss was only $300 million, and then on the same day, the bank reported a loss of only $12 million.

On July 13, 2012, the bank restated its first quarter earnings, reporting additional SCP losses of $660 million. JPMorgan Chase told the Subcommittee that the decision to restate its financial results was a difficult one, since $660 million was not clearly a “material” amount for the bank, and the valuations used by the CIO did not clearly violate bank policy or generally accepted accounting principles. The bank told the Subcommittee that the key consideration leading to the restatement of the bank’s losses was its determination that the London CIO personnel had not acted in “good faith”

For a company of JP Morgan’s stature to be compelled to restate prior period financials is a very clear signal of bigger problems with their overall financial reporting. 

But wait, there's more!

If you have been following this story, you may remember that Jamie Dimon once called the Synthetic Credit Portfolio an “economic hedge”. The idea of a hedge is the difference between gambling and insurance; a hedge is supposed to insure assets. But which assets? The traders at the London Trading unit and other bank officials have not been able to identify the assets that the Synthetic Credit Portfolio was supposed to hedge.

Bottom line. They were gambling. They started losing. They doubled down on the bet. They lied. They tried to hide the losses from regulators and investors and the public. They lost more. They lied more. And now, the Senate has delivered the heads of upper management at Chase on a silver platter to the Department of Justice. The question is: will the DOJ will prosecute?

And the answer is...

You know the answer.

If you still aren't sure you know the answer, this article from Wall Street on Parade explained it:

But wait, there's more!

Neil Barofsky served as the special inspector general in charge of oversight of the Troubled Asset Relief Program. And I found this article which basically lays out how the banks tend to act when they think they are too big to jail. The basic problem of the housing crisis is in danger of being repeated, and JPMorgan Chase would love to get some of that action, to the point where they are trying to bully credit agencies, and finally they are encountering resistance, largely due to the $5 billion dollar lawsuit against S&P. Imagine the deterrent effect of Jamie Dimon in handcuffs.  

Have a great weekend!

That is all.