Mirabile Dictu! JP Morgan Finally on Regulatory Hot Seat for Widespread Control Failures and Alleged Lying by Blythe Masters Under Oath
It’s been far too long in coming, but Jamie Dimon may finally be getting his comeuppance. A New York Times report reveals the Morgan bank is in the crosshairs of multiple regulators for poor controls and dishonest dealings with the authorities:
Government investigators have found that JPMorgan Chase devised “manipulative schemes” that transformed “money-losing power plants into powerful profit centers,” and that one of its most senior executives gave “false and misleading statements” under oath…
In a meeting last month at the bank’s Park Avenue headquarters, the comptroller’s office delivered an unusually stark message to Jamie Dimon, the chief executive and chairman: the nation’s biggest bank was quickly losing credibility in Washington. The bank’s top lawyers, including Stephen M. Cutler, the general counsel, have also cautioned executives about the bank’s regulatory problems, employees say.
The Times reports that the bank faces actions across eight regulators including: FERC, for a series of “schemes” to dupe state authorities to overpay for power and includes allegations that JP Morgan executive Blythe Masters lied under oath; using false documents when collecting credit card debt; and a failure to report suspicious trading activities by Bernie Madoff.
The fact that JP Morgan is in hot water isn’t news. Josh Rosner revealed in an extensive report released in early March that the bank had paid out over $8.5 billion in fines since 2009, nearly 12% of its net income, for violations across virtually all of its operations. This account showed the carefully cultivated picture of JP Morgan as a well-managed operation was an artful fabrication. As Dave Dayen wrote here in his overview:
….as you read the report, it’s hard to see the bank as anything but a criminal racket just days away from imploding, were it not propped up by implicit bailout guarantees and light-touch regulators. Rosner paints a picture of a corporation saddled with pervasive internal control problems, which end up costing shareholders, and which “could materially impact profitability in the future.” ….It’s hard to summarize all of the documented instances in this report of JPM has been breaking the law, but here’s my best shot….
Bank Secrecy Act violations;
Money laundering for drug cartels;
Violations of sanction orders against Cuba, Iran, Sudan, and former Liberian strongman Charles Taylor;
Violations related to the Vatican Bank scandal (get on this, Pope Francis!);
Violations of the Commodities Exchange Act;
Failure to segregate customer funds (including one CFTC case where the bank failed to segregate $725 million of its own money from a $9.6 billion account) in the US and UK;
Knowingly executing fictitious trades where the customer, with full knowledge of the bank, was on both sides of the deal;
Various SEC enforcement actions for misrepresentations of CDOs and mortgage-backed securities;
The AG settlement on foreclosure fraud;
The OCC settlement on foreclosure fraud;
Violations of the Servicemembers Civil Relief Act;
Illegal flood insurance commissions;
Fraudulent sale of unregistered securities;
Illegal increases of overdraft penalties;
Violations of federal ERISA laws as well as those of the state of New York;
Municipal bond market manipulations and acts of bid-rigging, including violations of the Sherman Anti-Trust Act;
Filing of unverified affidavits for credit card debt collections (“as a result of internal control failures that sound eerily similar to the industry’s mortgage servicing failures and foreclosure abuses”);
Energy market manipulation that triggered FERC lawsuits;
“Artificial market making” at Japanese affiliates;
Shifting trading losses on a currency trade to a customer account;
Fraudulent sales of derivatives to the city of Milan, Italy;
Obstruction of justice (including refusing the release of documents in the Bernie Madoff case as well as the case of Peregrine Financial).
In other words, the New York Times account is a pale rendition of the rap sheet against the bank.
In reality, there’s been evidence for years that the image of JP Morgan as a well-run bank with its oft-touted “fortress balance sheet” was more hype than reality. The bank got more credit than it deserved for having lower exposure to subprime loans than other “too big to fail” institutions, which made it the rescuer of choice during the financial crisis. That status resulted at least in part from the banks have suffered large losses in a business it had helped pioneer, that of corporate credit default swaps, when Delphi went bankrupt in 2005 and got gun-shy in taking on more CDS related risk (and recall it was also CDS that turned what would otherwise have been a “contained” subprime meltdown into a global financial crisis by creating economic exposures that were considerably greater than the value of the underlying loans). Mortgage securitization industry participants also say another reason JP Morgan was an also-ran in the mortgage business in the runup to the crisis was that the bank blew hot and cold about hiring people with the needed experience and contacts. In other words, the fact that JP Morgan escaped the worst of the crisis looks to be due to luck rather than great foresight.
Recall that banking expert Chris Whalen has been saying for years that JP Morgan’s balance sheet quality was also mythologized. While the traditional bank looks solid, the risks it is taking in its $75 trillion derivatives clearing operation dwarf that. And the bank hasn’t been the most astute player there either. For instance, it was snookered for months by Lehman into taking collateral that employees of the failing investment bank called “goat poo.” And when the bank realized the risk it was taking, it struck the fatal blow by seizing over $7 billion Lehman cash and collateral that it held. The bank also looks to have played fast and loose in the failure of MF Global. Recall that it suspected that the broker was using client funds, asked for written assurances from assistant treasurer Edith O’Brien that it wasn’t, and didn’t press the matter when she ignored the requests.
The London Whale fiasco alone demonstrated beyond doubt that JP Morgan was, as Rosner put it, out of control. Even before the Senate investigation, media reports provided compelling evidence of astonishing risk management failures, such as having risk management reporting to the CIO, rather than being independent. Sarbanes Oxley expert Michael Crimmins saw the risk management and control failures to be so severe as to firing Dimon. As he wrote last July:
The first stunner, that JP Morgan was restating the first quarter financials, should have caused a deafening ringing of alarm bells. For a company of JP Morgan’s stature to be compelled to restate prior period financials is a very clear signal of bigger problems with their overall financial reporting. In isolation we would normally expect to see a massive selloff with an event of that seriousness. Analysts and reporters may have missed the significance since it was dropped into a footnote and overshadowed by the other disclosures. …
But the real cause for alarm is the reason for the restatement. JPM was forced to disclose that it relied on its traders to provide honest and accurate valuations for its financial statement disclosures. That’s like putting the foxes in charge of not just the henhouse, but the entire farm. Much to its chagrin that was a costly choice. Note that was not a mistake, but a conscious choice….
It appears that JPM is attempting to make the case that rogue traders, with criminal intent, mismarked the books. That may be so and relevant criminal charges against those traders should be pursued. But that strategy does not protect management. If there was mismarking, especially to the extent that occurred here, it is the responsibility of management to know or have procedures in place to alert them to the potential for fraud. Step one in that control process: Don’t let your traders mark their own books. If you do you have no excuse. Your controls are worthless and as CEO, you are responsible for ignoring that fundamental control gap. Full stop.
Which leads to the second underreported stunner.
It is a very big deal when a firm is compelled to disclose a material weakness in internal controls. That’s the worst level of internal control failure a going conern can report. In JP Morgan’s case its more damning since Dimon, as recently as May 10, 2012, certified that all was well with internal controls as of the end of 1Q2012.
That assessment means that it is impossible for the firm’s external auditor to sign off on the financial statements until and unless the control breakdowns are remediated sufficiently for the auditor to provide assurance. The description of the control weaknesses at JP Morgan appear to be design flaws, so it’s likely the weaknesses existed in periods earlier than the first quarter of 2012, when it was ‘discovered’. The fact that the unit with the weaknesses by all accounts was under the direct control of the CEO throws doubt on the validity of his prior certifications about the quality of the internal controls. The external auditors will be under extreme pressure to either support or refute the earlier certifications. Falsifying the certification is the worst Sarbanes Oxley violation there is, so Dimon is going to have to come up with an airtight rebuttal.
But the lapdog financial media refused to take these stunning lapses seriously, apparently more taken by the Dimon mythology, as reflected in Warren Buffett recommending Dimon for Treasury chairman last November.
And the Senate hearings revealed Dimon’s and the CIO’s conduct to be markedly worse that the previous press reports had unearthed, including:
Management hid the existence and role of the unit within the JP Morgan Chief Investment office that entered into the “whale” trades, the Synthetic Credit Portfolio, from its inception, even as its exposures ballooned, from the OCC
The bank made repeated, knowing misrepresentations about the size of the losses, the severity of the control failures, and the degree of management knowledge to regulators and investors
The contempt for regulators and for the need for timely and adequate disclosure is symptomatic of an out of control environment. Between the beginning of the year and end of April 2012, the SPG breached risk limits 330 times, sometimes even violating bank-wide limits. Yet staff and management regarded them as an inconvenience rather than treating them as shrieking alarms that warranted swift action
JP Morgan managers and risk control officers were aware of and complicit in the mismarking of positions (this is a very big deal in a financial institution)
And despite this impressive history of bad conduct, JP Morgan was getting special treatment from regulators as recently as January of this year. Marcy Wheeler noted the OCC failed to clean up “previously identified systemic weaknesses” in its anti-money laundering compliance. Eighteen months of intransigence and all the OCC did was scold a bit. It issued no fine.
Even though regulators are finally waking up to the fact that JP Morgan is a dangerous institution that thinks it can act as a law unto itself, the bank does not appear ready to change its ways. The New York Times reports that FERC recommended pursuing Masters and traders over its energy market violations:
For now, according to the document, the enforcement officials plan to recommend that the commission hold the traders and Ms. Masters “individually liable.” While Ms. Masters was “less involved in the day-to-day decisions,” investigators nonetheless noted that she received PowerPoint presentations and e-mails outlining the energy trading strategies.
Masters has apparently lied under oath in offering the usual “I was in charge and I knew nothing” defense. The normal behavior is to cut miscreants loose and at least make a good show of wanting to operate lawfully. But the bank is taking the high-handed route:
“We intend to vigorously defend the firm and the employees in this matter,” said Kristin Lemkau, a spokeswoman for the bank. “We strongly dispute that Blythe Masters or any employee lied or acted inappropriately in this matter.”
Fish rot from the head, and JP Morgan looks to be no exception. Dimon repeatedly made statements to the media and in Congressional testimony about the London Whale trades that were flagrantly false. He wasn’t sworn in and apparently thinks he’s not obligated to be honest with investors, lawmakers, or the public. That sort of arrogance is mirrored in the bank’s pervasive rulebreaking. The upside of JP Morgan’s continued defiance of the law in the interest of its profits is that this latest round of scandals might finally engulf the perp-in-chief.