March 31, 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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DealBook: JPMorgan Trading Loss May Reach $9 Billion

Jamie Dimon, chief executive of JPMorgan Chase, discussed the trading losses last week before the House Financial Services Committee.Daniel Rosenbaum for The New York TimesJamie Dimon, chief executive of JPMorgan Chase, discussed the trading losses last week before the House Financial Services Committee.

Losses on JPMorgan Chase’s bungled trade could total as much as $9 billion, far exceeding earlier public estimates, according to people who have been briefed on the situation.

When Jamie Dimon, the bank’s chief executive, announced in May that the bank had lost $2 billion in a bet on credit derivatives, he estimated that losses could double within the next few quarters. But the red ink has been mounting in recent weeks, as the bank has been unwinding its positions, according to interviews with current and former traders and executives at the bank who asked not to be named because of investigations into the bank.

The bank’s exit from its money-losing trade is happening faster than many expected. JPMorgan previously said it hoped to clear its position by early next year; now it is already out of more than half of the trade and may be completely free this year.

As JPMorgan has moved rapidly to unwind the position — its most volatile assets in particular — internal models at the bank have recently projected losses of as much as $9 billion. In April, the bank generated an internal report that showed that the losses, assuming worst-case conditions, could reach $8 billion to $9 billion, according to a person who reviewed the report.

With much of the most volatile slice of the position sold, however, regulators are unsure how deep the reported losses will eventually be. Some expect that the red ink will not exceed $6 billion to $7 billion.

Nonetheless, the sharply higher loss totals will feed a debate over how strictly large financial institutions should be regulated and whether some of the behemoth banks are capitalizing on their status as too big to fail to make risky trades.

JPMorgan plans to disclose part of the total losses on the soured bet on July 13, when it reports second-quarter earnings. Despite the loss, the bank has said it will be solidly profitable for the quarter — no small achievement given that nervous markets and weak economies have sapped Wall Street’s main businesses. To put the size of the loss in perspective, JPMorgan logged a first-quarter profit of $5.4 billion.

More than profits are at stake. The growing fallout from the bank’s bad bet threatens to undercut the credibility of Mr. Dimon, who has been fighting major regulatory changes that could curtail the kind of risk-taking that led to the trading losses. The bank chief was considered a deft manager of risk after steering JPMorgan through the financial crisis in far better shape than its rivals.

“Essentially, JPMorgan has been operating a hedge fund with federal insured deposits within a bank,” said Mark Williams, a professor of finance at Boston University, who also served as a Federal Reserve bank examiner.

A spokesman for the bank declined to comment.

In its most basic form, the losing trade, made by the bank’s chief investment office in London, was an intricate position that included a bullish bet on an index of investment-grade corporate debt. That was later combined with a bearish wager on high-yield securities.

The chief investment office — which invests excess deposits for the bank and was created to hedge interest rate risk — brought in more than $4 billion in profits in the last three years, accounting for roughly 10 percent of the bank’s profit during that period.

In testimony before the House Financial Services Committee last week, Mr. Dimon said that the London unit had “embarked on a complex strategy” that exposed the bank to greater risks even though it had been intended to minimize them.

JPMorgan executives are briefed each morning on the size of the trading loss. The tally could shrink if the market moves in JPMorgan’s favor, the people briefed on the situation cautioned.

But hedge funds and other investors have seized on the bank’s distress, creating a rapid deterioration in the underlying positions held by the bank. Although Mr. Dimon has tried to conceal the intricacies of the bank’s soured bet, credit traders say the losses have still mounted.

While some hedge funds have compounded the bank’s woes, others have been finding it profitable to help JPMorgan get clear of the losing credit positions.

One such fund, Blue Mountain Capital Management, has been accumulating trades over the last couple of weeks that might help reduce the risk of the bets made by JPMorgan in a credit index, according to interviews with more than a dozen credit traders. The hedge fund is then selling those positions back to the bank. A Blue Mountain spokesman declined to comment.

As traders in JPMorgan’s London desk work to get out of the huge bet, which started generating erratic losses in late March, the traders based in New York are largely sitting idle, according to current traders in the unit.

“We are in a holding pattern,” said one current New York trader who asked not to be named.

Long before the losses started mounting, senior executives at the chief investment office in New York worried about the trades of Bruno Iksil, according to the current traders.

Now known as the London Whale for his outsize wagers in the credit markets, Mr. Iksil accumulated a number of trades in 2010 that were illiquid, which means it would take the bank more time to get out of them.

In 2010, a senior executive at the chief investment office compiled a detailed report that estimated how much money the bank stood to lose if it had to get out of all Mr. Iksil’s trades within 30 days. The senior executive recommended that JPMorgan consider putting aside reserves to deal with any losses that might stem from Mr. Iksil’s trades. It is not known how much was recommended as a reserve or whether Mr. Dimon saw the report, but the warning went unheeded.

The losses are the most embarrassing fumble for Mr. Dimon since he became chief executive in 2005.

In appearances before Congress, Mr. Dimon has taken pains to assure investors and lawmakers that the overall health of JPMorgan remained strong and that it had more than sufficient amounts of capital to weather any economic dislocation.

Even as he apologized for the trade, calling it “stupid,” Mr. Dimon emphasized to lawmakers that the loss was an “isolated incident.”

The Federal Reserve is currently poring over the bank’s trades to examine the scope of the growing losses and the original bet.

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DealBook: When a Bankruptcy ‘Event’ Doesn’t Mean Bankruptcy

A subsidiary of Energy Future Holdings operates a natural gas plant in Dallas. Aurelius Capital said the Texas power company is in default on a loan.Matt Nager/Bloomberg NewsA subsidiary of Energy Future Holdings operates a natural gas plant in Dallas. Aurelius Capital said the Texas power company is in default on a loan.

In finance and law, bankruptcy is understood to mean a process for resolving financial distress, like those under the United States Bankruptcy Code or the Companies’ Creditors Arrangement Act in Canada. State law assignments for the benefit of creditors could also been seen as a bankruptcy process under this definition.

In common parlance, bankruptcy is often used more casually, to mean something like broke or insolvent.

Which version, then, would you expect would apply to a bankruptcy trigger in a credit default swaps contract?

You might be surprised.

Section 4.2 of the 2003 International Swaps and Derivatives Association’s credit derivatives definition lists seven categories that could set off a bankruptcy credit event and thus a payout from a protection seller. There is also an eighth category that picks up any event that is analogous to the first seven. The precise language is set forth in the document below.

Take a close look at Part (b) of Section 4.2, which provides that

Bankruptcy means a Reference Entity . . . becomes insolvent or is unable to pay its debtors or fails or admits in writing in a judicial, regulatory or administrative proceeding or filing its inability generally to pay its debts as they come due.

Not exactly polished English grammar, but corporate lawyers are rarely rewarded for that.

Now, one credit default swap protection buyer wants to argue that the phrase “becomes insolvent” means that a bankruptcy credit event involves bankruptcy in the colloquial sense of the work.

The issue involves Aurelius Capital Management, no novices in the world of distressed debt world, which, one can surmise, holds lots of credit default swaps that reference the Texas Competitive Electric Holdings Company.

The Texas Competitive Electric Holdings Company is not a public company, but a subsidiary of two reporting companies. And in a recent registration statement, one of those parent companies said this as part of its discussion of the “risk factors” associated with the registration:

Analyses of TCEH’s business indicate that the principal amount of its outstanding debt exceeds its enterprise value.

Aurelius Capital has asked the International Swaps and Derivatives Association committee that considers these matters to rule that the “becomes insolvent” language in part (b) means insolvency in a balance sheet sense of the word, and that, among other things, the above registration statement language constitutes an admission that the Texas Competitive Electric Holdings Company is insolvent on that basis.

In short, Aurelius Capital wants to say there has been a bankruptcy credit event, without any actual bankruptcy or similar proceeding.

This could have major implications for the broader market for credit default swaps. Among other things, it would seem that if this interpretation is adopted, any company with negative shareholder equity on its books has also triggered the credit default swap contracts that reference it.

That includes a lot of companies, including some that have reasonably good share prices, which presumably reflect the possibility of a brighter future. For example, AMR, parent company of American Airlines, reported assets of $25 billion and liabilities of $29 billion on its 2010 10-K filing.

Has it also triggered a bankruptcy credit event? If so, how do we explain current credit default swap prices, taken from Bloomberg, which show price of about $2,400?

If there has been a credit event, the credit default swap prices should equal the payout on the credit default swap because the buyer would essentially be buying the right to the payout. Of course, one doubts there would be any sellers in such a situation.

Other major companies with negative book equity — based on their most recent 10K as reported on Bloomberg Law — include Ford, Clorox, Cablevision Systems, Lorillard and Moody’s (irony noted).

If all of these have experienced credit events, the credit default swap market is in for some major dislocation.

This is but one reason why Aurelius Capital’s argument can’t be right, no matter how clever and seemingly plausible it is in the abstract. More generally, their proffered reading of Part (b) really makes no sense in the broader context of Section 4.2, which is entirely focused on bankruptcy in the legal and financial sense of the word.

Rather, it seems to me that Part (b) is really trying to capture something like the criteria that would support filing an involuntary bankruptcy petition under Section 303(h) of the Bankruptcy Code. That makes Part (b) consistent with the other elements of Section 4.2.

The drafting is awkward, but does it make any sense to generate a credit default swap based on a financial condition that is not tied to any actual default? Clearly there is no hedging reason for such a thing, and even on the speculative side it seems unlikely that such a provision would be buried deep within the definition of bankruptcy.

All of this is no doubt behind the International Swaps and Derivatives Association’s decision on Thursday that no bankruptcy credit event had occurred.

Here’s betting that the International Swaps and Derivatives Association amends this provision in the next round of credit default swap definitions.

International Swaps and Derivatives Association’s credit events definitions

Stephen J. Lubben is the Daniel J. Moore Professor of Law at Seton Hall Law School and an expert on bankruptcy.

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