Some more information has come to light on the more than $7 billion “Whale Trade” derivative losses at JP Morgan—that total being comprised of an amount of over $6 billion in losses on the trade and a further amount of almost $1 billion in fines.
In an article on Bloomberg entitled JP Morgan’s Biggest Mistake, author William D Cohan provides us with somewhat of an insider’s overview on the problems that led to the Whale Trade losses—his sister-in-law sat on the Audit Committee. This article summarises some of Cohan’s main points and identifies the lessons that auditors and other risk professionals should be learning in order to avoid making similar mistakes.
1. The culture within the organisation was such that senior trading managers not only refused to report the losses but they encouraged others not to do so—that was until of course those losses became too big to ignore. As Cohan noted in his article:
“Then we learned that inside the bank there was (still is?) a culture of paranoia and secrecy that encouraged traders to hide their mushrooming losses.”
The main lessons here are as follow:
a. Culture and values, rewards and incentives, fear and sanctions play the most important role in determining how and when rogue trading takes place, the extent of the delay in reporting losses, how those losses are reported as well as their ultimate size.
b. Fear and the perception of sanctions that might follow an error or mispricing are enemies of good banking. In general, human factors are more important than all others in establishing an appropriate and reliable management reporting framework.
c. Management should work to create a set of values within and throughout their banks that positively encourages the free flow of information at all times without fear of the consequences.
d. An effective whistleblowing policy is also essential for ensuring that everyone performs and reports issues in accordance with stated policies.
e. As a point of reference, it should also be noted that one of the problems at Lehman Brothers was that Dick Fuld was so powerful that his reporting managers were fearful of telling him things that he did not want to hear—until of course it was too late.
2. The article states that traders were allowed to misprice their trading portfolios within the bid offer spread. While this may be true, mispricing of a portfolio within the bid-offer spread is unlikely to cause $6 billion in losses. Instead, it is more likely that the greater portion of this loss was in fact due to the earlier reports of changes in the pricing and risk model used for valuing the relevant trades which in effect reduced the reported losses. The lessons for auditors and risk professionals are thus as follows:
a. Establishing appropriate validation and change control procedures over pricing and risk models are extremely important.
b. Risk management should document and explain any changes in pricing and risk models in terms of how they impact the firm’s position and p/l. These should be reported to senior management at the highest level with an explanation of why such a change is deemed necessary.
c. For major trading portfolios, the change(s) in 2 above should always be accompanied by an external and independent evaluation of the changes and should include an overall assessment as to the validity of or necessity for such a change.
d. More importantly and especially in the case of major trading portfolios, no changes in pricing and risk models should be made or accepted into the financial records without first obtaining the specific approval of senior management.
e. Generally, an external and independent validation of risk models should be performed on a periodic basis in order to ensure that their performance is consistent with previously established criteria.
3. The traders were the main source of pricing for the portfolios in question. JP Morgan has since instituted a procedure where three independent pricing sources have to be obtained. The lessons here are as follows:
a. Again, wrong pricing would be more likely to cause large losses than any mispricing within the bid-offer spread.
b. It has always been a cardinal rule that traders should under no circumstances be able to provide their own prices. How this was overlooked or circumvented within JP Morgan is very difficult to explain. Independent Pricing and Valuation or IPV is one of the bedrocks of modern product and risk control within banks.
4. The article notes that an early warning sign as to what was happening came when a demand of $520 million in collateral was made by the counterparties on the other side of the trades within the portfolio. This $520 million collateral demand was a much higher figure than the losses being reported at the time. The lessons here are as follows:
a. It is vitally important that management and operations control are able to reconcile in some way the demand for more collateral or margin payments with movements in the trading p/l.
b. In addition to the above, there should be controls that place management on notice for any large amounts of collateral transfers or cash payments to counterparties on behalf of a particular trader, trading portfolio or trading desk.
c. As a point of reference, it should be noted here that the Nick Leeson debacle at Barings was in a large part due to the fact that management was unable to reconcile margin payments and the demand for cash with what was happening on the trading floor.
5. There was a $237 million loss in one of the spreadsheets used by the traders. The lesson is:
a. The use of spreadsheets for pricing and valuing products should be kept to an absolute minimum—too many trading rooms are still too dependent on their use.
b. Spreadsheets should be subject to the same validation, change management and independent valuation controls as other pricing and risk systems (see 2 above). Some may argue that the controls over spreadsheet should be even more stringent due to their relatively insecure operating environment.
6. JP Morgan is being forced by the Securities and Exchange Commission (SEC) to admit wrongdoing. As noted earlier the bank has been fined almost a $1 billion and its former traders are facing criminal charges. What does this all mean?
a. In the post financial crisis era regulators and prosecutors are much less forgiving of any lapses in governance and internal controls.
Jonathan Ledwidge is the author of the book Clearing The Bull, The Financial Crisis And Why Banks Need A Human Transformation (iUniverse)