London Whale

JP Morgan Chase & Co is one of the largest and leading global financial institutions in the USA that has managed its clientele’s wealth for over 200 years. In April 2012, the Bank was held responsible for the massive trade in credit derivate indexes, and it led to the instability of the world market. The complicated credit derivate used in the transactions was termed as credit default swap (CDS) that acts as an insurance trade policy. The chief investment office (CIO) was responsible for investing the excess cash deposit, especially with high-income bearing securities. Therefore, the bank formulated the synthetic credit portfolio (SCP) to prevent the widening of credit gap particularly in adverse conditions of financial crisis. The CDS is based and standardized on the SCP response position.

The position response of an SCP is virtually determined by the acquisition or disposition of protection against credit scenario of cooperate issues being tied to CDS indices. Owing to great performances in 2009, the Bank significantly increased its SCP size from four billion to 51 billion up to 2011 (Gitman & Zutter, 2015). However, on the onset of 2012, the bank analysts predicted a European default crisis; thus, the CIO had to reduce its SCP exposure and risk on assets. Eventually, these would lead to the loss of $500 million with a return of $400 million, from the sale of position on the current market. The CIO implemented the VAR model that used a range of option portfolio hedge strategy in line with the Comprehensive Risk Measure (CRM) to calculate losses and limits (JP Morgan Chase, 2013).

The model significantly reduced the risk numbers which fostered a wavering support from London traders. However, the model failed in correlating the dealers’ expectations with the market environment, which led to the accumulation of significant losses (Gitman & Zutter, 2015). The CIO traders further enlarged their trading portfolios with large trades that aligned with market prices. These facilitated easier movement of illiquid assets and securities, which significantly reduced traces of their existence with minimal adverse effects in the industry. Other investors and CIO of other banks hedge funds, who were in a trade with JP Morgan, took advantage of this situation and amassed huge amounts of debts (Gitman & Zutter, 2015). The losses grew from a financial base of $100 million to two billion and later 5.8 billion.

The main strategy of the CIO was to maximize on short-term trade gains rather than long-term benefits. Instead of holding the bank risk level at substantial levels, the investment office unit invested the $350 billion, much from the federal reserves, into trade derivate that had high-risk levels and returns instead of focusing on hedging. The excess deposits were the difference between the bank’s and its commercial deposits. Barth and McCarthy (2012) suggest that when banks and relevant authorities fail to regulate large hedge funds, most CIOs perpetuate incentives to invest in risky trades. The trade losses did not affect the operations of the bank or even provide solvency problem due to its vast capitalization strategies. The financial institute did not require to raise additional capital as it was in a position to withstand the losses. Its capitalization focused on expanding capital reserves and liquid assets that could stand to absorb any financial blow in the case of an adverse financial crisis.

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Bruno Iksil and his counterparts focused on doubling their bets even when the losses were still imminent and viable. Iksil’s trades were of small size in nature as compared to the vast activities of the bank until 2012 when the SCP was reduced to make more offsetting bets (Gitman & Zutter, 2015). The seniors of the banks elevated Iksil’s position so he was interrupted, which made his trade hard to unwind due to the broad market scope. Losses occurred since the CIO had failed to rewind to the original SCP position; instead, it formulated a new multi-option portfolio. The original SCP was initially designed to protect the firm even under severe economic situations. The new SCP created discrepancies on previous trades as it focused more on market risks (Gitman & Zutter, 2015). They primarily centered their activities by buying high corporate bonds that were linked to index swaps. Thus, they failed to protect the firm state in a financial crisis, as the primary assumption was that the high-grade institution would deteriorate with the economy.

Several financial regulatory organizations were primarily responsible for the losses JP Morgan Chase had undergone. One of the key organizations that could be linked with trade malpractice was the Office of the Controller of the Currency (OCC) (Freeman, Harrison, & Hitt, 2008). The OCC is a federally chartered regulator for depository banks with liability management programs (ALnM) activities. The OCC covered JP Morgan Chase, its subsidies, and even the CIO. The CIO did not receive much scrutiny from the federal regulators as it was not a facing unit of the bank. The lack of adequate corporate oversight and regulatory compliance failed to monitor its daily ALM activities accurately (Freeman, Harrison, & Hitt, 2008). The absence of regular reporting fostered the development of SCP assets and market value limits portfolio. The risk meetings were infrequent and were only attended only by the CIO personnel who failed to have an oversight of any specific mandate or charter.

The lack of federal oversight in JP Morgan resulted in the CIO engaging in risky and speculative risk derivatives that focused on short-term goals. The strategy failed to align with the traditional investment procedures since they were hedge centered and particularly long-term (Freeman, Harrison, & Hitt, 2008). The OCC further failed to follow on the allegation made by the lack of transparency of the CIO transactions in the firm. The investment decisions were unaccounted for even with the developed of the VAR model that reduced risks for more than 50%, which was quite abnormal. Therefore, it resulted in the questioning of the professionalism and qualification of the CIO personnel to adequately access the risk levels associated with such investments at that period (Freeman, Harrison, & Hitt, 2008). The SCP was constantly pressured by the CIO to exceed its VAR limits, which led to significant losses by the company. The losses can be further attributed to conflict of interest between the trading teams, which aimed at maximizing returns, and the risk team that dealt with managing risks.

The risks attached to “too big to fail” institutions involve the government bailing them in the financial crisis. Crippling of such institutions would automatically slow down the activities of their holding companies as well as their wide array of clients. Such corporations are considered the backbone of the economy, and the fall of one would automatically causes a national disaster. These companies maintain their growth by acquiring assets or shares of other small enterprises building on their capital base. Zeissler and Metrick (2014) illustrate that such establishment losses can be considered great if compared to other institutions but minute if compared to their financial capabilities. Elizabeth Warren argues that the top five us banks would crash the economy if the government fails to bail them out. She further states that the government should push these banks to become smaller and lesser complex. The big banks should avoid reckless mortgage lending that is solely financed by subprime lenders. They should also avoid misleading the public and investors on the quality of mortgages they offer.