<Some thoughts on JPMFriday, May 11th, 2012
by Roger Ehrenberg

With the web afire with criticism over JP Morgan’s recently announced (and unexpected) $2 billion trading loss, a few “life lessons” came to mind as to how Jamie Dimon – and his PR department – bungled this badly:

Know the facts before taking a stand. When news of a “London Whale” came to light a month ago, and this trader was linked to JP Morgan, Dimon issued a strenuous denial that his was a big deal. According to the Wall Street Journal, and I’d tend to agree with them, Dimon didn’t understand the true extent of his trader’s activities or the risks it posed to the firm. Fast-forward to today: he looks like a terrible leader, one who allowed a trader one of the biggest risk books on the planet without knowing how it was impacting the firm’s financial position. Why on earth would he make a statement about this trader’s activities without truly understanding their impact in depth? His typical bravado backfired in this case. He should have heard the rumblings, did a deep forensic dive into the facts, developed a view and then communicated to the media. He chose not to follow this approach and got absolutely skewered. And deservedly so. He failed Crisis Management 101. Perhaps he should have learned from J&J’s handling of the Tylenol scare. Lives may not be at risk here, but given how far out on a limb he had gone in denying any problem (and now knowledge of the problem) his PR morass is pretty hairy.

Avoid taking self-righteous positions. For all the skill and opportunism with which Dimon navigated JP Morgan through the financial crisis, he has long touted his emphasis on risk management and on prudent risk-taking. He specifically sought to paint his firm as distinctly different than those “cowboys” at Bear Stearns, Lehman and the other investment banks. Better diversification. Greater breadth. Better risk controls. These were the hallmarks of JP Morgan as a world-beater, largely immune to the troubles of its bulge bracket peers. Both the communication breakdown and lack of risk controls giving rise to this massive loss are completely at odds with his characterization of the firm. If you put yourself on the top of Mt. Olympus, you are always prone to a nasty fall if messaging and reality are found to be mis-aligned – as they are in this case.

Stop thinking that VaR has any linkage with reality. While Dimon himself may not have been aware of the magnitude of the Whale’s risk position, certainly his risk managers were. And if they were using VaR, they should be skewered as should Dimon. Have we learned nothing? I was musing about problems with VaR and Sharpe Ratio six years ago, and in between we’ve seen the 2008 crisis and myriad mini-crises in between, and the fact that VaR is still a bedrock of financial disclosure – and financial risk management – is chilling. But hey, we’re still in a world where there are huge arguments over the imposition of true mark-to-market accounting rules, enabling financial firms to present something less than a true picture of how assets and liabilities are valued on a liquidation basis. We should isolate long-term assets and liabilities – those that are truly match-funded on a duration adjusted basis. Then we should look at those short-term assets and liabilities and look at the costs for hedging out the residual risks, understanding the market’s assessment of the true mark-to-market exposure. Why this isn’t current best practice for disclosure is beyond me, but at the very least these tools should be employed within all financial firms, not only the JP Morgan’s of the world (though given their systemic importance they should be mandated by both regulators and the FASB). 

Acknowledge that the SEC will forever be playing catch-up. The metaphors that come to mind are Network Security Specialists vs. Black Hat Hackers. Or WADA (the world anti-doping authority) vs. Steroid Using Cheaters. It is a classic good guys vs. bad guys conflict (though I am operating on the assumption that the SEC are the “good guys” – I believe they are trying, just failing). They are out-manned. Out-paid. Out-incentivized. Out of luck. The fact that Mary Schapiro just uttered “I think it’s safe to say that all the regulators are focused on this” is akin to the fire department showing up after the house has burned down. The system is broken. The accounting rules are flawed. Risk analysis and disclosure is flawed. And the regulatory framework is broken as well. Losses of this nature should not come as a surprise. They have and will continue to occur in the absence of common sense disclosure and elimination of all the obfuscation that has been allowed to pervade balance sheets for generations. It’s just that the ante has risen given the magnitude of the risks being borne, the inter-connectedness of the major players in the financial system and the complexity of the tools being used to take risk. It’s not your father’s bond and risk arbitrage portfolios any more: it’s derivatives of all shapes, sizes and liquidity. Until rigorous mark-to-market rules are enacted that facilitate the transparency required to regulate properly, the SEC is fighting a losing battle. All good things stem from transparency. But a broken SEC is good for shareholder-funded speculators. The longer it stays broken, the longer they get to continue making asymmetric bets in their favor (heads I win – tails you lose).

While to many the JP Morgan trading revelations might have been shocking, they should’t have been. The system for deeply understanding financial institutions’ risk is flawed, both inside and outside the house. Until this fundamental weakness is addressed, it doesn’t really matter what the SEC does. Our banks have more than enough latitude to get themselves – and our financial system – in trouble.

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