March 22, 2023

Fair Game: The Problem With Wiggle Room in Securities

Still, the case against Javier Martin-Artajo and Julien Grout, two of the bank’s traders, has larger lessons for investors and regulators. One has to do with the risks inherent in opaque, over-the-counter markets, where securities’ prices can’t be seen and so can be easily manipulated. Another involves the fairly significant leeway that financial firms have in valuing the securities they trade and hold.

According to prosecutors in the Southern District of New York, Mr. Martin-Artajo and Mr. Grout hid or understated losses in credit derivatives trades held by JPMorgan’s chief investment office during 2012.

Lawyers for both men say that they did nothing wrong and would be exonerated.

But the complaints against both men, laced with e-mails and transcripts of phone calls, indicate that the traders ignored the bank’s protocol for valuing the complex bets and chose instead to mark them in a way that would mask and minimize ballooning losses.

The bets were made on indexes that reflected the performance of a group of corporate debt obligations; the trader in charge of the portfolio had gambled that defaults among these debt issuers would rise. They did not.

It was an outsize bet. By the first quarter of 2012, the so-called synthetic credit portfolio had a total exposure of $157 billion, up from $51 billion in 2011. When the trade was finally and disastrously unwound, it cost the bank more than $6 billion in losses.

The exotic instruments that made up this portfolio did not trade on an exchange and so were harder to value than a stock, whose prices reflect actual market transactions. Because the credit derivatives traded privately, in a so-called dealer market, the traders had to get bids and offers from market participants to value the positions. Bids and offers are not the same as actual transaction prices, of course, but the standard procedure is to assign a value that is somewhere near the middle of the bids and offers.

When the trades went against them, the men deviated from that procedure to cover up some of the losses, prosecutors said.

“None of these trades were done on an exchange or exchangelike platform,” said Dennis Kelleher, president of Better Markets, a nonprofit organization that promotes the public’s interest in financial markets. “That’s how they were allowed to do two things — one, build up such a huge position with no one knowing and, two, misprice the securities.”

Indeed, Wall Street has fought to prevent the open trading of instruments like the ones at issue in the JPMorgan situation. Why? Profits are higher when instruments trade one-on-one rather than on an exchange. Customers who don’t know the price of a complex instrument can be easily overcharged.

Despite Wall Street’s objections, the Dodd-Frank law now requires many of these derivatives to be traded on exchanges or similar platforms. When the rules go into effect in coming months, prices and positions will be more apparent, reducing the possibility and surprise of a whalelike loss.

While the regulations have been written, there are still ways for Wall Street to water them down, like seeking certain exemptions, Mr. Kelleher said. And even the toughest laws and tightest rules can’t protect the financial system and taxpayers from risks posed by a major bank with lax internal controls.

ONE of the failures noted by prosecutors in the JPMorgan cases was the bank’s reliance on a single person in its valuation control group to serve as an independent check. That person was responsible for monitoring the values assigned to the chief investment office portfolio, which held tens of billions of dollars in positions. “In practice,” the complaint said, the control group “was neither independent nor rigorous.”

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I.M.F. Warns of Risk as Company Debt Grows

WASHINGTON (Reuters) — Easy monetary policy in the United States has led to looser standards for corporate borrowing as company debt continues to grow, posing a risk to financial stability, the International Monetary Fund warned on Wednesday.

Over all, finances around the world have improved in the last six months, and there were few clear signs of asset bubbles, the monetary fund said in its annual Global Financial Stability Report. But it also said that governments must remain vigilant and ensure they are continuing structural and banking improvements, or risk sinking into a chronic financial crisis.

In addition to companies, pension funds and insurance companies may also be taking on more risk than they should as they search for higher-yielding assets to fill a funding gap, which for pension funds stayed at 28 percent at the end of last year.

All of this is happening while the United States is still only one-third of the way through the current credit cycle, the Washington-based global lender said. Usually, looser borrowing standards emerge only in the later parts of the cycle, as happened in 2007, the I.M.F. said.

“In the United States, corporate debt underwriting standards are weakening rapidly,” José Viñals, the director of the I.M.F.’s monetary and capital markets department, said in a briefing on the report.

“This is a cause for concern that needs to be monitored.”

The appetite for riskier assets is also spilling over into emerging economies as investors search for higher yields, making these countries more vulnerable to volatile capital flows.

The I.M.F.’s analysis could add to questions about the side effects of aggressive monetary easing, which are likely to dominate meetings of finance ministers and central bankers from the world’s top economies in Washington this week.

The Bank of Japan earlier this month pledged to inject $1.4 trillion into its economy to shock it out of stagnation, fanning concerns about currency wars, rising asset prices and speculative buying.

The United States Federal Reserve’s expansive policies have also prompted worries about asset bubbles, though its easing program is in part meant to push investors to take on more risk to spur economic growth.

While the I.M.F. says it believes it is appropriate for advanced nations to keep up monetary stimulus for now — while inflation remains low and unemployment high — it is also urging policy makers to start thinking about the consequences of ending ultra-loose policies.

“I think when the patient is still under treatment, you should not suspend the medicine,” Mr. Viñals said about monetary policies. “But you should always be vigilant for the side effects of the medicine.”

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Fair Game: Willow Fund as a Cautionary Tale for Investors

With a portfolio that specialized in distressed debt instruments, the Willow Fund had suffered losses of almost 80 percent in the first three quarters of 2012 after its longtime manager switched gears: he had abandoned the corporate debt markets he was familiar with and piled into some colossally bad derivatives trades. The investors, some of whom hadn’t realized they were holding a portfolio filled with risky bets against the debt of European nations, were stunned.

What happened to the Willow Fund is a cautionary tale for any investor who entrusts his or her money to an investment fund. Its demise highlights the dangers when a portfolio manager makes a big change in investment strategy. It also raises questions about how assiduously this fund’s independent directors watched over the manager as he ramped up his portfolio’s risk levels. Both are problems that investors cannot be complacent about.

Ken Boudreau, 70, of Farmington, Conn., is an aggrieved Willow Fund investor who has filed an arbitration case against UBS to recover his losses. Mr. Boudreau began putting money into the fund in mid-2009, investing a total of $350,000. His losses were $300,000.

In an interview, Mr. Boudreau said his UBS brokers had contended that the fund’s investment in distressed debt securities positioned it well for gains in 2009 as the economy recovered from the credit crisis. The experience and track record of Sam S. Kim, the portfolio manager overseeing Willow since it began operations in 2000, was another selling point. Mr. Kim was expert at analyzing distressed debt instruments, Mr. Boudreau said his brokers told him.

“I try to be a disciplined buyer and seller, buying in when markets are down,” Mr. Boudreau said in an interview. “In mid-2009, distressed debt seemed to me a home run.”

Which it might have been, had Mr. Kim, the money manager, not plunged headlong into credit default swaps on government debt of Germany, Sweden, France, Spain and other nations. In these trades, Mr. Kim was buying a type of insurance against the nations’ defaulting; his investors, therefore, would benefit if problems in these nations worsened.

According to regulatory filings, the Willow Fund had an impressive run through 2006. That year, the fund returned almost 25 percent on a portfolio of corporate bonds, bank loans and corporate repurchase agreements, a financing arrangement. Credit default swaps amounted to a minuscule 0.18 percent of the Willow Fund in 2006.

That portfolio was consistent with the fund’s description in regulatory filings. It would “maximize total return with low volatility by making investments in distressed investments,” the filings said, “primarily in debt securities and other obligations and to a lesser extent equity securities of U.S. companies that are experiencing significant financial or business difficulties.” The fund might also hedge its portfolio against risks, using credit default swaps, the filings said, or use those instruments “for non-hedging purposes.”

In 2007, the Willow Fund’s exposure to credit default swaps started rocketing. That year, Willow also began generating losses — 9.1 percent, and then 18 percent in 2008 when the credit crisis hit.

As Mr. Kim’s view soured on world economies, particularly in the euro zone, he began trading on these concerns, a letter from UBS to investors said. That meant more of the portfolio went into credit default swaps.

By the end of 2008, corporate bonds amounted to only 6 percent of the portfolio, down from 29 percent a year earlier. The value of the credit default swaps, meanwhile, had ballooned to 25 percent of the portfolio from 2.6 percent in 2007. By 2009, when Mr. Boudreau began investing, credit default swaps amounted to 43 percent of Willow’s portfolio, a fact that Mr. Boudreau said he did not know.

THE fund’s disclosures that it might invest in credit default swaps gave insufficient warning to investors of the risks in these strategies, said Jacob H. Zamansky, a lawyer who represents Mr. Boudreau and other investors in the Willow Fund.

Mr. Zamansky pointed to Securities and Exchange Commission guidance in 2010 telling mutual fund managers in general to be specific about strategies involving derivatives. The S.E.C. was concerned that some funds were making generic disclosures about derivatives that “may be of limited usefulness to investors in evaluating the anticipated investment operations of the fund, including how the investment adviser actually intends to manage the fund’s portfolio and the consequent risks.”

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DealBook: JPMorgan’s Staley to Join BlueMountain Capital

James E. Staley had been JPMorgan's head of investment banking until this summer.Yuri Gripas/ReutersJames E. Staley had been JPMorgan’s head of investment banking until this summer.

James E. Staley, a longtime JPMorgan Chase executive who served as the firm’s head of investment banking until this summer, is leaving the bank to join BlueMountain Capital Management as a managing partner, the hedge fund said on Tuesday.

The firm he is joining, a nine-year-old hedge fund with $12 billion in assets, profited from betting against JPMorgan by taking the other side of a bet on corporate debt that eventually cost the bank billions of dollars in May. The hedge fund then helped the Wall Street firm clear out its positions through another series of trades.

Mr. Staley’s departure from JPMorgan ends a 34-year career at the bank, which stretched back to the original J.P. Morgan Company. He worked in a wide variety of roles, from the Brazilian office to the head of the equity capital markets and syndicate divisions to the head of wealth management.

Revolving Door
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Mr. Staley, an avid sailor known to most as Jes, became the chief executive of investment banking in fall 2009, presiding over the division’s expansion in the wake of the financial crisis.

But several months after the disclosure of the trading loss, JPMorgan shook up its management team. It gave Mr. Staley the new title of head of corporate and investment banking. To some inside the bank, the move effectively sidelined him in a position that was more symbolic than substantive.

At BlueMountain, Mr. Staley will be the firm’s ninth managing partner and will join the management, risk and investment committees. He will also buy an undisclosed stake in the firm.

“I’m very excited to be joining BlueMountain at a time when sea changes in the financial industry, combined with the firm’s unique strengths, open up enormous possibilities to deliver value to clients,” Mr. Staley said in a statement. “I want to thank all my colleagues at JPMorgan, my home for the last 34 years, and I look forward to working with them in the future.”

JPMorgan Chase’s chief, Jamie Dimon, sent a memo to employees on Tuesday morning:

To: All Senior Managers
From: Jamie Dimon
Subject: Jes Staley

This morning it was announced that our colleague, Jes Staley, will be leaving JPMorgan Chase to join BlueMountain Capital Management as a Managing Partner and Member of its Management Committee. Attached is BlueMountain’s press release.

Jes has been an extraordinary leader and a valued partner for many of us at JPMorgan over the years. He joined our company more than 34 years ago, and during this time he served in many critical management roles, including head of our Investment Bank, Asset Management group, Private Bank, and as one of the founders of our equities business. He has served our firm with distinction as a member of our firmwide Operating Committee, and he has been a trusted mentor to many people at our company.

While Jes is leaving JPMorgan Chase, he is joining a respected private investment firm, BlueMountain Capital. BlueMountain is an important client of ours, and we look forward to working with Jes in the future. Please join me in thanking Jes for his decades of dedicated service to JPMorgan, and in wishing him and his family all the best in the future.


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The Trade: Distortion in Tax Code Makes Debt More Attractive to Banks

President Obama, in his tax reform proposal, mentioned corporate debt interest deductibility, though he didn't make any specific proposal about what to do about it.Luke Sharrett for The New York TimesPresident Obama, in his tax reform proposal, mentioned corporate debt interest deductibility, though he didn’t make any specific proposal about what to do about it.

Thanks to a leaked video, we know that Mitt Romney divides the country into those who pay taxes and those who don’t, the makers and the moochers.

There is one perhaps surprising group you can put in the latter category: the nation’s banks. Sure, banks pay taxes, but they pay a lot less thanks to a giant and underappreciated distortion in our nation’s tax code. Moreover, this tax code distortion makes the financial system and the economy more fragile, prone to bankruptcies and runs. Banks profit, and the economy teeters. Great bargain, huh?

It’s the tax code’s favoring of debt over equity.

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For businesses, debt interest payments are tax deductible; equity payments, like when a company pays out a dividend, are not. At the margin, this encourages entities to take on more debt than they otherwise would, as Steven M. Davidoff noted in a Deal Professor column earlier this year. More debt not only makes companies more vulnerable to bankruptcy but also makes investors more susceptible to panics, when they withdraw their capital en masse. More equity would make the world more stable.

“The worst thing the tax code can do,” says Victor Fleischer, a tax specialist at the University of Colorado, “is to make it harder to use a sensible capital structure.” Mr. Fleisher, a contributor to The New York Times DealBook, testified in front of Congress last year about this problem.

Mitt Romney is proposing closing tax loopholes, but corporate debt interest deductibility hasn't been in the conversation.Jim Wilson/The New York TimesMitt Romney is proposing closing tax loopholes, but corporate debt interest deductibility hasn’t been in the conversation.

This distortion is well known. President Obama, in his tax reform proposal, mentioned it, though he didn’t make any specific proposal about what to do about it. The Republican candidate, Mitt Romney, is proposing substantial tax cuts with the loss of revenue made up with the closing of loopholes. He has yet to specify any of those loopholes, but corporate debt interest deductibility hasn’t been in the conversation.

What isn’t well appreciated is how much the debt deduction helps the banks. The first way is direct: Banking is a highly leveraged industry. Banks use more debt than equity to finance their activities. The tax break makes the debt cheaper and encourages banks, at the margin, to gorge on more.

Financing techniques that have become more popular in recent decades benefit from this distortion. Bundling of debt, like credit card receivables or mortgage debt, called securitization, turns out to give banks a tax bonanza. For accounting purposes, banks are typically able to treat their bundling of this debt as a sale. But for tax purposes, banks often get to call it debt. Those payments to the buyers of the securitizations’ bonds are therefore tax deductible to the bank.

More important, there’s an indirect and unremarked benefit. Banks help companies raise money in two main ways: through the sale of stock (equity) and debt, either through loans or the sale of bonds. When a company goes public, selling stock for the first time, the underwriting banks make more money than they do for a comparable debt offering. But banks make it up on volume with debt. Bonds expire. Companies issue more of them all the time.

Partly because of the tax code distortion, corporate debt is underpriced and overconsumed by the bank’s corporate customers. Indeed, the debt business dominates the world of investment banking these days. When corporations raise more debt compared with equity, that fattens bank profits.

Then, too, the trading of debt is more profitable than the trading of equity. Stocks are traded on transparent markets at transparent prices. Debt is traded in opaque ways, where the spread between the offered and requested prices is wider than for stocks. That means more profit for investment banks compared with stocks, whose trading spreads have narrowed for decades. So, too, with derivatives and securities based on debt — things like collateralized loan obligations.

And these complex debt securities give society — what? The system we have subsidizes the middleman to create dubious products. Those products help the middlemen — the banks — but they make the financial system more fragile. So the tax code distortion doesn’t just lead to more debt in corporate America and more leveraged banks. It also helps create a finance-heavy economy where the banking sector accounts for a bigger proportion of gross domestic product and corporate profits than it otherwise would. Granted, the tax code is far from the only force in American society that creates a larger financial sector or overleveraged corporations. But it’s one of the least recognized.

As most of us have come to understand since the financial crisis, having a bigger finance industry than necessary wastes resources. Banking is supposed to provide capital to help companies create real goods and services, not be an end unto itself.

As it is, lawyers, accountants and investment bankers spend thousands of billable hours analyzing transactions to figure out if there are ways to treat them like debt, rather than equity.

Are there solutions to this distortion?

There are two choices: reduce or eliminate interest deductibility or introduce some deduction for equity.

Neither seems particularly feasible for some time. Reducing the deductibility would be elegant but generate screams of bloody murder from corporate America.

Making dividend payments tax deductible, which would start to level the playing field, might be easier and more popular. Of course, that would reduce revenue to the government and have to be made up somehow, though tax increases elsewhere or decreased services.

Mr. Fleischer suggests that one way to limit the distortion would be to eliminate the deduction to the extent a financial institution exceeds a ratio of debt-to-equity of 5 to 1. If a bank has borrowed $6 for every $1 in stock, then it doesn’t get to deduct the interest payments on that extra dollar of debt. That would make debt more expensive and make banks less inclined to borrow as much.

And it would help stop banks from being moochers.

Debt-to-Equity Ratios for Four Largest Banks

Jesse Eisinger is a reporter for ProPublica, an independent, nonprofit newsroom that produces investigative journalism in the public interest. Email: Follow him on Twitter (@Eisingerj).

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DealBook: A Call for a Write-Down on Irish Debt

A branch of the Bank of Ireland in Dublin.Peter Morrison/Associated PressA branch of the Bank of Ireland in Dublin.

DUBLIN — A major write-down on Greek debt appears to be inevitable. But what about Ireland?

Bailed-out Irish banks continue to pay interest to their bondholders on 75 billion euros in debt — about half the country’s gross domestic product — and despite Ireland’s improved economic performance over the past year, many here believe that these institutions should suffer the same haircut that the banks holding Greek debt are expected to absorb.

“We need to write this stuff off,” said Peter Mathews, a voluble banking and real estate consultant who was recently elected to the Irish Parliament on a robust bank-bashing platform.

Mr. Mathews estimates that if you include household and nonfinancial corporate debt, Ireland’s total debt burden is a shocking 490 percent of its G.D.P. — which, he claims, makes Ireland the most indebted country in the world.

Of course, such a figure is gross, and does not take into account the significant assets that households and corporations have.

But it is arresting nonetheless, and it is what fuels his anger at the thought of banks continuing to pay bondholders even though they were the ones that brought his country to the verge of bankruptcy.

For months now he has been pestering the government to take action on the matter and he even went so far to corral a perplexed Herman Van Rompuy, the president of the Europe Council, and make the case to him on a recent trip he made to Dublin.

“Japan has lost two decades of growth — what the hell are we going do with debt of 490 percent of G.D.P.,” Mr. Mathews said. “I have to say I am getting ready to take off my shoe just like Nikita Krushchev did.”

While his view may be a popular one in a country that reviles its bankers, there is little sign that the Irish government will run the risk of angering the European Central Bank and investors by proposing such a measure — especially now as its bond yields have nearly halved to about 7.8 percent from 14 percent this summer.

Nonetheless, Mr. Mathews says he will stay on the case.

“There are losses out there,” he said. “Let’s face up to them and get them financed by countries that can afford it, like Germany.”

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