The London Whale Trading Incident

Once again I am digging into my digital crates to share an informative post. Here is a small writeup from a Syracuse graduate Enterprise Risk Management class (IST 625) I completed concerning JP Morgan Chase and the “London Whale”. The post is slightly edited from the final version I submitted. The assignment was as follows:

“This assignment requires you to research an organization that has suffered a devastating loss from a so-called ‘low frequency or low probability but-high consequence’ event, to understand what happened to that company during and after that event, and to synthesize what we can learn from their experiences.”

In gambling parlance, a whale is a high roller who bets big and has the potential to cause the house substantial losses if he/she stops betting at the wrong time. Although the whale at the center of this episode wasn’t sitting in a casino, the house (JPMorgan) experienced substantial losses when the betting stopped.

JP Morgan Overview

JPMorgan Chase is the largest financial holding company in the United Sates and has more than 2 trillion dollars in assets. It is also a global financial services firm with more than 250,000 employees (United States Senate pg. 24). The company has more than 5,600 branches and is a strong market participant in the mortgage lending, investment banking and credit card spaces (Hoover’s Company Records, 2014). JP Morgan’s principal bank subsidiary, JPMorgan Chase Banks is also the largest bank in the United States.

The current Chairman and CEO of JP Morgan Chase is Mr. James “Jamie” Dimon. Previous to 2012, Mr. Dimon’s name was associated with the eponymously named “Dimon principle”. “The ‘Dimon principle,’ as it is known, was shorthand for a safe bank with regular profits” (Ebrahimi, Aldrick & Wilson, 2012). With Mr. Dimon guiding the firm, JP Morgan held an excellent reputation with respect to risk management. The same could not be said of similar financial firms who were no longer “going concerns” as a result of the 2008 Great Recession.

“So when the US Government desperately sought someone with the balance sheet for the corporate rescue acts necessary to prevent financial meltdown, it sent for Dimon. In what were admittedly sweetened deals, JP Morgan swallowed bankrupt investment bank Bear Stearns and cash-strapped retail lender Washington Mutual” (Osborne, 2011). Emerging from the 2008 financial crisis unscathed, Mr. Dimon became more powerful and confident. He frequently railed against the need for government regulations with regard to proprietary trading in large financial firms. (Scuffham & Laurent, 2012) quote Mr. Dimon as stating, “We must not let regulatory reform and requirements create excessive bureaucracy and unnecessary permanent costs.”

Unfortunately for JP Morgan Chase and Mr. Dimon, subsequent trading events and risk management failures of 2011 would tarnish the firm and the CEO’s cultivated and highly regarded reputation.

London Whale Trades

(English, 2012) offers an analogy of the high risk/low frequency event that occurred in JP Morgan’s Chief Investment Office (i.e. CIO). Imagine a scalper who purchased 50,000 tickets to a sporting event with a capacity of 75,000 seats. The event is not nearly as popular as was anticipated by the scalper, thus the going price on the tickets plummets rapidly as would be ticket buyers wait for prices to fall further from face value. The scalper intended to hold tickets for the long term expecting high demand but with too many people on the sidelines betting that prices would fall, the scalper had to cut losses and sell at a drastic loss.

The “London Whale” trader at the center of this JP Morgan controversy was a French national and London based trader named Bruno Iksil who was known for being a successful leviathan risk taker. Mr. Iksil worked for the firm’s Chief Investment Office. Since JP Morgan has an excess of deposits after the firm makes loans available to business and consumers, this excess cash is invested by the CIO group to hedge against disparate investment actions undertaken by other areas of the bank.

The stated purpose of the CIO unit was to protect the bank from losses and interest rate risk by acting as a hedge and offsetting the bank’s other credit risks. The CIO unit is not tasked with proprietary or “prop” trading (essentially placing bets) intended to boost profits. Prop trading is the mandate of the company’s Investment Banking Division. In 2009 alone the CIO group’s Synthetic Credit Portfolio (SCP) of financial derivatives generated 1.05 billion dollars for the bank (United States Senate, pg.87). Ultimately JP Morgan would end up being a victim of its own success as it continued to conduct proprietary trades in the CIO division.

Bruno Iksil and the London CIO office were steadily racking up daily losses in the hundreds of millions of dollars by investing in synthetic derivatives (i.e. Credit Default swaps or CDS). The trading positions that the CIO office held were not hedging against other bank investments, as was the purported charge of this office. Credit default swaps are financial derivatives the provide investors insurance on bonds against potential default. Mr. Iksil, “has been selling protection on an index of 125 companies in the form of credit-default swaps. That essentially means he is betting on the improving credit of those companies, which he does through the index—CDX IG 9—tracking these companies” (Bianco, 2012, para 5).

Needless to say, the companies in the index did not improve. The initial 100 million dollar position that the CIO office held in the CDX IG 9 index was essentially cornering the market and when there were no willing buyers, the firm had to sell at massive loss.

In April of 2012 the press began running stories about the identity of the “London Whale”. The massively large trades in credit default swaps (the same complex financial instruments that doomed A.I.G during the 2008 financial crisis) began to affect credit markets worldwide. Initially, by the end of the week on May 11, 2012 when the firm held a hastily convened conference call regarding transparency around the London Whale trades, JP Morgan suffered a loss of 14.4 billion from its market capitalization as its stock price fell 11.47% in two days (Ebrahimi, Aldrick & Wilson, 2012). By the end of May the synthetic derivatives portfolio alone had lost 2 billion dollars. By the end of June the losses doubled to 4.4 billion and eventually reached 6.2 billion by the end of the year (United States Senate, pg. 12).

Initial Management Response

Once the CIO division management learned of Bruno Iksil’s precarious investment positions, “it could have announced the maximum possible losses from the trades. Instead it said what the losses were at that moment in time, and hoped a change in sentiment and some clever trading would stop them spiralling [sic]”. To the London Whale’s credit, once he observed the potential for disaster, he suggested that the division take a loss or “full pain” which would have been an additional 100 million dollars wiped out (Farrell, 2012), far less than the eventual 6.2 billion dollar total loss number.

Amazingly, Mr. Iksil’s management began to take actions that would conceal the magnitude of losses reported. Recorded telephone calls, instant messages and a shadow spreadsheet containing actual projected losses, revealed how traders were pressured to minimize the expected losses of the SCP (Synthetic Credit Portfolio) (United States Senate Report, pg. 20).

Internal CIO management also disregarded their own risk metrics such as the VaR or value at risk, which estimates the maximum risk of loss over the course of a day. This warning sign metric was ignored and then actually raised. CEO Jamie Dimon, Chief Risk Officer John Hogan and CIO head Ina Drew, “approved the temporary increase in the Firm-wide VaR limit, and Ms. Drew approved a temporary increase in CIO’s 10-Q VaR limit.” (JPMorgan Chase & Co, 2013 pg. 79)

Senior bank management was told that potential losses were massive and no longer functioned as a hedge to the bank; management then proceeded to downplay those issues until the losses mounted into the billions of dollars (United States Senate, pg.21). On an April 13, 2102 first quarter conference call CEO Jamie Dimon dismissed the initial publicity surrounding the London Whale trades by characterizing them as a “complete tempest in a teapot” (United States Senate pg. 17). By June 2013, Mr. Dimon’s stated to a Senate Panel on the trading losses, “Let me first say, when I made that statement, I was dead wrong” (PBS NewsHour, 2012).

Remediation and Outcomes

CEO Jamie Dimon stated, “CIO will no longer trade a synthetic credit portfolio and will focus on its core mandate of conservatively investing excess deposits to earn a fair return” (JPMorgan Chase & Co., 2012(a), pg. 3). Management instituted a number of changes as a result of the CIO trading imbroglio. All CIO managers based in London with any responsibility for the Synthetic Credit Portfolio were separated from the firm with no severance and without 2012 incentive compensation. (JPMorgan Chase & Co., 2012(a), pg.22).

JP Morgan instituted significant changes for the better in the CIO Risk Management organization. A new Chief Risk Officer was empowered to hire additional senior level officers to “extend the capacity of the Risk function within CIO, Treasury and Corporate, and he has made 20 such hires since May 2012” (JPMorgan Chase & Co., 2012(a), pg.114). Along with upgraded personnel skills in the CIO Risk organization, management rightfully instituted a common sense approach to structural issues.

In the pre “Whale trades” environment, the CIO Risk Committee met infrequently and did not contain any members from outside of the CIO organization. This lack of diversity in the realm of “risk-thought” fostered a group think/rubber-stamp mentality. CIO Risk managers did not feel “sufficiently independent” from the CIO business to ask hard questions or criticize trading strategies (JPMorgan Chase & Co., 2012(a), pgs. 12-13).

Industry Impact

“Dimonfreude” was a term coined in the wake of the trading losses, “it means taking great satisfaction in the misfortunes of the JPMorgan boss” (Foley, 2012). Yet, the fall out from JP Morgan’s episode was more than mere embarrassment for the firm and the CEO’s reputation in the area of risk management. To the chagrin of Mr. Dimon, this episode strengthened the case for more government oversight of the financial industry. In the words of then Treasury Secretary Timothy Geithner, “I think this failure of risk management is just a very powerful case for financial reform” (Shorter, Murphy & Miller, 2012, pg. 24).

References

Bianco, J. (2012). Understanding J.P. Morgan’s Loss, And Why More Might Be Coming. The Big Picture. Retrieved February 2, 2014, from http://www.ritholtz.com/blog/2012/05/understanding-j-p-morgans-loss-and-why-more-might-be-coming/

English, S. (2012). How London Whale’s errors attracted the market sharks. The Independent. Retrieved from Factiva.

Ebrahimi., H., Aldrick, P., & Wilson, H. (2012). The day JP Morgan’s Jamie Dimon lost his sparkle; Breathtaking risk failures at JP Morgan have left the bank’s reputation on the edge. The Telegraph Online. Retrieved from Factiva.

Farrell, M. (2013). JPMorgan slashes Dimon’s bonus by 53%. CNN Wire. Retrieved from Factiva.

Foley, S. Jamie Dimon Chief executive, JP Morgan Chase (2012). The Independent. Retrieved from Factiva.

Hoover’s Company Records. (2014). JPMorgan Chase & Co. Austin, U.S. Retrieved from http://search.proquest.com.libezproxy2.syr.edu/docview/230565788?accountid=14214

JPMorgan Chase & Co. (2012)(a). JPMORGAN CHASE REPORTS SECOND-QUARTER 2012 NET INCOME OF $5.0 BILLION,OR $1.21 PER SHARE, ON REVENUE OF $22.9BILLION. Retrieved February 1, 2014 from http://files.shareholder.com/downloads/ONE/2939707738x0x582870/6a286dff-ad7e-40ba-92ef-e6ff1b3be161/JPM_2Q12_EPR_Final.pdf

JPMorgan Chase & Co. (2012)(b). CIO Task Force Update. Retrieved February 1, 2014 from http://files.shareholder.com/downloads/ONE/2939707738x0x582869/df1f2a5a-927e-4c10-a6a5-a8ebd8dafd69/CIO_Taskforce_FINAL.pdf

JPMorgan Chase & Co. (2013). Report of JPMorgan Chase & Co. Management Task Force Regarding 2012 CIO Losses. Retrieved February 1, 2014 from http://files.shareholder.com/downloads/ONE/2272984969x0x628656/4cb574a0-0bf5-4728-9582-625e4519b5ab/Task_Force_Report.pdf

Osborne, A. (2012). JP Morgan $2bn loss: Dimon’s in the rough; Be careful what you wish for. The Telegraph Online. Retrieved from Factiva.

PBS NewsHour. JPMorgan Chase’s Big Losses, Big Risk: Blip on Radar or Systemic? Retrieved February 1, 2014 from http://www.pbs.org/newshour/bb/business-jan-june12-jamiedimon_06-13/

Scuffham, M. & Laurent, L. (2012). Trader known as ‘London Whale’ for his huge, hidden bets. The Globe and Mail. Retrieved from Factiva.

Shorter, G., Murphy, E., Miller, R. (2012). JP Morgan Trading Losses: Implications for the Volcker Rule and Other Regulation. Congressional Research Service. Washington, DC. Retrieved from https://www.fas.org/sgp/crs/misc/R42665.pdf

United States Senate. (2013). JPMorgan Chase Whale Trades: A Case History of Derivates Risks And Abuses. Staff Report. Washington, DC. Retrieved from http://www.hsgac.senate.gov/download/report-jpmorgan-chase-whale-trades-a-case-history-of-derivatives-risks-and-abuses-march-15-2013

This post does not necessarily represent the views of my employer and is solely my own analysis from a graduate school paper.

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Enterprise Risk Management at Microsoft

This is a brief writeup from an Enterprise Risk Management class that I took back in 2013. The case describes Microsoft from the mid to late 90’s and its efforts to implement an Enterprise Risk Management group. The case mentions former head of treasury Brent Callinicos, who went on to become a regional CFO at Microsoft and the CFO for Uber.

For those who are interested in the case details, check out “Making Enterprise Risk Management Pay Off: How Leading Companies Implement Risk Management” by Thomas L. Barton, William G. Shenkir & Paul L. Walker.

Introduction

Historically, the technology sector has always been subjected to swift, rapid changes. Microsoft has always tried to anticipate new threats and technology advances (i.e. dealing with both existing risks and unanticipated risks). Back in the late 1990’s, technological changes due to the rise of the internet provided Microsoft a different landscape from the historical era of the unconnected, standalone PC. In Microsoft’s 1999 annual report, the first item discussed under “issues and uncertainties” is “rapid technological change and competition”[1].

Additionally as the mid 90’s era Microsoft launched new products, it also ventured into new business models. The launch of Expedia in 1996 positioned Microsoft as a player in the travel agency business and its Home Advisor product made the company a licensed mortgage broker. These novel business models exposed the organization to a new set of risks, which in-turn exposed the risk management group to new challenges.

Moving to an Enterprise-wide Risk Management Approach

Microsoft has always competed in a very competitive landscape replete with technologically savvy competitors and condensing product life cycles. As a result, an enterprise wide commitment to risk management was a necessary and prudent choice to remain competitive in the company’s markets.

The momentum that triggered a more enterprise wide view of risks at the company was the establishment of the risk management group in 1997. Prior to 1997, there was no such group to start the process of implementing an ERM framework. Within the treasury group, the risk management group head Brent Callinicos (also notably the eventual CFO of Uber) set out to develop a consolidated risk identification, measurement and management approach.

The treasury group started with finance risk management changes by increasing the complexity and effectiveness of VAR analyses. Furthermore, treasury presented a paper to the finance committee of the board of directors that analyzed the derivative losses of several major companies. This report precipitated a more integrated approach to the various financial risks handled within treasury. The creation of Gibraltar (a treasury information system) allowed the company to view all of its risks “holistically rather than on a silo basis” [1].

From a business risk perspective, the risk management group worked closely with business unit managers in order to develop risk-financing plans and to aid business units with appropriate quantitative risk modeling. This evangelist approach was an effective method for gaining buy-in regarding the risk management group’s aims.

Microsoft’s Enterprise Risk Management Structure

Microsoft’s risk management group is nestled within the treasury function of the organization. The leader of the risk management group is the corporate treasurer who reports directly to the CFO. Treasury manages somewhere in the neighborhood of $80 billion for the software company [2]. Business risk is divided into worldwide products, worldwide sales & support and worldwide operations. The company does not have a CRO as it decided that a CRO would not be practical.

In my opinion, I believe that Microsoft housed their risk management under the treasury function because they viewed a standalone risk organization under a CRO as duplicative. Treasurers concentrate primarily on managing financial risks but by nature must also be generalists with respect to many types of risk. In a multinational technology company such as Microsoft, various market currency risks exist that require appropriate anticipation and response.

Microsoft is inherently technologically driven. The company has very smart, knowledgeable people naturally embedded into its lines of business. These smart people understand the risks of their technological products and desire to see these products succeed. To the benefit of the organization, the embedded personnel have an inherently risk minded mentality. Therefore the job of the risk management group is to partner with and support the lines of business and various operations groups by adding “incremental value”; i.e. information that the business units may not have considered.

“Microsoft is first run by the product group, then maybe by sales, and finance and risk management will come after that. The risk management group or treasury group will not run the company”[1].

Microsoft previously looked at risk in separate silos. In order to look at risk holistically, the risk management group had to step back and take a strategic assessment, which is a much more challenging endeavor. With this holistic approach, the grouping or correlation of risks are considered as opposed to dealing with one specific risk at a time. For example, Microsoft considered property insurance as the legacy best way to manage the risk of building damage in an earthquake. With a new scenario analysis approach employed by the risk management group, additional risks must be considered that are correlated to property damage. This new correlation mentality required partnering with multiple areas of the company to incorporate additional risks for an appropriate risk assessment.

Use of Scenario Analysis

Scenario analysis is used to understand the risks with respect to situations where it is very hard to quantify or measure the precise impact to the organization. Sequences of events regarding severe earthquake damage or severe shocks to the stock market are risks that are difficult to quantitatively measure and thus scenario-based tactics are applicable to try and gauge the fallout. Additionally, Microsoft uses scenario analysis to conduct stress testing which consider hard to measure impacts of political and geographic circumstances. An order of magnitude approach is used in scenario analysis as opposed to an exact measurement approach. Microsoft uses qualitative language such as, “..the quantification of business risks is not exact…”  and , “Does this feel about right for this risk” in their scenario analyses.

Once the risk management group has identified the risks associated with each scenario, it then partners with other business units to understand impacts. The risk group will also investigate other external organizations that have experienced similar events in order to learn how these organizations weathered their experiences.

The Main Benefits of Enterprise Risk Management

One substantial benefit for Microsoft in moving to an ERM approach is that the company can view and assess its risks holistically as opposed to assessing risks in an independent/uncorrelated fashion. This is evident in initiatives such as the company’s Gibraltar treasury system which provides an aggregated view of market risks.

Another benefit is that the risk management group works across the organizational footprint and can provide input to various groups so that each group can “stay current on what is happening in the business” [1]. The risk management group can diffuse information across the organization by working closely with business unit managers. Face time with product and operations managers allows the risk group to understand risks across the enterprise which contributes to a holistic understanding.

This approach is mutually beneficial for both groups as the risk group gains understanding of new risks (continuous cataloging of risks) and the business units gain insight into risks they may not have previously considered.

“By having the business units educate us on the intricate details of their business, the risk management group can be aware of perhaps 90 percent of the risks facing Microsoft”[1].

Closing Thoughts

At Microsoft, the risk management group doesn’t necessarily have to posses the all-encompassing best risk solution for every line of business. Risk management considers the product managers and the respective lines of business as the most knowledgeable sources of risk within their own domains. The risk group is on hand to provide additional insight for incremental improvement and to enhance or build upon the risk knowledge already contained within the lines of business.

This approach makes sense for a technology company that is teeming with very risk aware and knowledgeable personnel at the operational levels who are designing or working with complex products.

In my work experience at a traditional bank, the risk group was assumed to have the best procedures, templates and analyses with respect to handling credit, market and operating risks.  From Microsoft I have learned that highly efficient and capable risk management can also be a synthesis of understandings from risk management proper and the lines of business.

References:

[1] Barton,T., Shenkir,W., Walker, P. (2002). Making Enterprise Risk Management Pay Off.

[2] Groenfeldt, T.  (Nov, 2013). Microsoft Treasury Wins Best Risk Management Award. Forbes. http://www.forbes.com/sites/tomgroenfeldt/2013/11/19/microsoft-treasury-wins-best-risk-management-award/#4fcade2124ed

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