The Fat Lady Has Yet to Sing for Dimon and JP Morgan

I thought I was late to write about JP Morgan’s $920 million multi-regulator settlement last week on the London Whale, but breathless news of a possible $11 billion settlement of mortgage-related liabilities has pushed the bank and its chief back under the hot lights.

Let’s go in reverse chronological order. The $11 billion settlement, if it comes together, is less of a hit than it seems. JP Morgan’s stock traded up 2.7% when the news broke. First, the $11 billion is really more like $7 billion, which is the cash component. The remaining $4 billion is various forms of borrower relief. If this settlement bears any resemblance to the mortgage settlements of 2011 and 2012, these are junk credits, with the bank being allowed to claim relief for things it would have done anyhow. If the economic value of bona fide borrower relief gets to be as much as 10% of nominal value, that would be a large by historical standards.

The reason the numbers being bandied about are large is that the total includes FHFA putback claims, which the Wall Street Journal puts at $6 billion out of the total. FHFA suits against all the banks were pencilled out as carrying a price tag of as much as $200 billion. But that estimate likely based the total on the value if the agency litigated and prevailed (which frankly was pretty likely, the GSEs have well-defined rights). The Department of Justice is leading the negotiations and the New York state is also a participant.

In addition to an apparently large bid-asked spread (the Morgan bank proposed a mere $3 billion versus the $11 billion bruited as the sought-after figure) and the fact that the bank wants a global settlement for all mortgage-related liability (the DoJ is reluctant to settle criminal liability), another potential sticking point is an admission of wrongdoing.

But in many ways, the $920 million London Whale settlement last week is a much bigger deal. It’s been remarkable to see how much confused or deliberately misleading commentary has been published about the pact. To wit: Jonathan Weil reveals he does not understand that SEC rules implement legislation. Ouch. And Matt Levine wrote such an absurd piece that I don’t need to do a takedown. If he keeps this sort of thing up, he’ll have a great future at the Onion.

I’ll probably have more to say about this in future posts, so let me stick to a few big issues:

JP Morgan is not out of the woods on the Whale matter. This settlement was for the SEC, the FSA, and the OCC. Given how Senate testimony the degree to which JP Morgan flat out lied to the OCC and the severity of the control failures, I’m surprised the dollar value wasn’t bigger. One small consolation is that the CFTC was not part of the deal, and its settlement is likely to be 50% of what JP Morgan has already agreed to pay.

And it’s important to understand how world class terrible JP Morgan’s oversight of the CIO was. The SEC order makes for juicy reading. One of the stunners is that Dimon lied to his audit committee. Some executives were loath to sign valuations that were important components of the CFO’s and Dimon’s certifications of financial statements. And we have this remarkable tidbit:
33. The CIO-VCG staff actively involved in price-testing the SCP’s 132 positions at the end of the first quarter of 2012 consisted of one person, who worked at CIO’s London office. That person was also responsible for price testing all of CIO’s other London-based portfolios.
One person responsible for price testing of a major portfolio? That’s all you need to know that JP Morgan’s controls were utter rubbish. The Globe and Mail adds:
Whale aficionados also now have more information on just how ineffective JPMorgan’s compliance staff were at monitoring their traders. JPMorgan’s senior management did not inform the relevant back-office department in London that it was reviewing the valuation of the Whale portfolio for over two weeks. Given recent rogue trading incidents at Société Générale and UBS, the low regard in which the control function at the bank was held is extraordinary.
An admission of how grossly deficient they were comes in how much the bank is spending to bring them up to snuff. From Reuters:
JPMorgan Chase & Co (JPM.N) plans to spend an additional $4 billion and commit 5,000 extra employees to fix risk and compliance issues after a slew of investigations by regulatory authorities, the Wall Street Journal reported on Thursday. 
JPMorgan will spend $1.5 billion on managing risk and complying with regulations and plans to add $2.5 billion to its litigation reserves in the second half of the year, the Journal reported. 
The bank will also increase its risk-control staff by 30 percent, the WSJ said, citing people familiar with the matter. 
JPMorgan said on Monday that it would add more than $1.5 billion to its legal reserves in the third quarter and 3,000 people had been added to control functions.
Another 2,000 assigned to the bank’s various business lines are also working on compliance issue, a personfamiliar with the matter who would not provide the total cost told Reuters.
Now even though we agree with the Bloomberg editors, who deem the Whale settlement to be too small, why do we still think it’s hugely significant?

Dimon screwed Corporate America. Did you notice the howling about the $920 million settlement from much of the financial media? They may be upset about the precedent set by JP Morgan admitting to wrongdoing. But far more significant is something that the SEC perversely did not play up, which is that JP Morgan ‘fessed up to Sarbanes Oxley violations. And that means that the normal fig leaf of having a complaint auditor say everything was fine is no protection.

Remember, heretofore Sarbanes Oxley has been a dead letter, at least from an enforcement perspective. To my knowledge, there were only two previous times the SEC tried using it: in HealthSouth, where it lost in court (not necessarily a meaningful indicator, since Richard Scrushy had huge home court advantage with an Alabama jury [he went to considerable lengths to taint the juror pool by large donations to and regular appearances in black churches]) and against Angelo Mozilo, where the SEC lost a ruling that seemed to put it off trying to use Sarbox (discussed at length in this post).

The reason that this is a big deal is Sarbanes Oxley was designed expressly to get past the “I’m the CEO and I have no idea what happened” defense. Sarbanes Oxley requires corporate executives, which generally is at least the CEO and the CFO, to certify the adequacy of internal controls. And for a big bank, that includes risk controls. You can’t pretend to have adequate controls when, as the SEC describes, management is shocked to learn that your counterparties are demanding hundreds of millions in collateral because everyone in the market (as well as your own investment bank!) is marking positions differently than your biggest trading unit in the bank. But it isn’t just banks that have to now take Sarbanes Oxley seriously, although they are the most obvious targets. Everyone who signs Sarbox certifications is now at risk, as they were supposed to be all along.

Dimon is not out of the woods. The SEC only settled liability with the bank; it is still looking into charging individuals. The Wall Street Journal reported:
“Our counsel has had discussions with the SEC staff and the staff has informed us that, based on the evidence now known to them, they do not anticipate recommending any actions against our CEO,” a J.P. Morgan spokesman said
A compliance expert e-mailed to say that Dimon met all the conditions for a criminal prosecution under Sarbanes Oxley. So it’s the reluctance of the regulators to take on a TBTF CEO (particularly one that has no credible successor in the wings) that is keeping him safe for now.

But remember, the CFTC’s investigation and resulting order may provide additional damning information. And recall the FBI and the Southern District of New York are trying to extradite two Whale traders. One is likely to be beyond their reach, but the other may not be. If he turns useful state’s evidence, the desire among the officialdom to Do Something About Dimon could change.
I was hearing concerns voiced about Dimon over two years ago. Among other things, he’d browbeaten Ben Bernanke and Mark Carney, then the head of the Bank of Canada, within a span of week (Carney kept his cool and issued what everyone recognized was a dressing down within 24 hours). The concern was that either Dimon was becoming more erratic, or the bank was actually in trouble of some sort, and Dimon was going on the offense to divert attention from his problems. And worse, even though all TBTF are systemically dangerous, if anything JP Morgan is more so by virtue of its massive tri-party repo operation.

Now even if more damning fact emerge about Dimon, they’d have to be awfully damning for him to be the target of litigation. But I could see the threat of litigation to be used to get JP Morgan to clean up its corporate governance act. At a minimum, the bank needs to split its CEO and Chairman roles (Dimon threatened to quit over that, but that was before the Whale shoes started to drop and analyst Josh Rosner released his rap sheet against JP Morgan, cataloguing the astonishing range and costs of regulatory sanctions) and force Dimon to have a real successor lined up, not some candidates who are clearly years away from being ready to take the helm.

It’s way too early to tell how meaningful these actions against JP Morgan will prove to be. One robin does not make a spring. But they are at least an improvement over the abject regulatory dereliction of duty we’ve seen by regulators in the wake of the crisis, and if we are lucky, may represent them re-learning how to use their muscle.



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