Monday, 20 August 2018

Upfront: Should have known better

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  • Jamie Dimon, chairman and chief executive of JP Morgan Chase and Co

Should Jamie Dimon and other senior management at JP Morgan have uncovered the trading blunder that has brought about losses of US$2bn (and counting) at an earlier date?

It’s hard to come to any other conclusion when faced with raw data that the US bank filed with the US Federal Reserve at the end of the first quarter.

At a time when its competitors were loading up on investment-grade credit protection – fearful no doubt of the world becoming a nastier place to do business – JP Morgan did exactly the opposite.

Its net long position in investment-grade credit through CDS jumped eightfold to US$84bn. Even for a bank with a US$2.3trn balance sheet, that is a huge number.

So why hadn’t JP Morgan senior management already abandoned a trading strategy that was, in Dimon’s words, “flawed, complex, poorly reviewed, poorly executed and poorly monitored”?

Dimon said the positions came to the firm’s attention in the second quarter when they started losing money, but this explanation seems flimsy.

The bank reported a US$304m loss in credit trading revenue at the end of the first quarter – the firm’s first in this area since September 2009 and in stark contrast to the US$3.4bn of revenues in the previous quarter.

Meanwhile, the total amount of CDS protection JP Morgan sold over the quarter also more than doubled from US$65bn to US$148bn.

Then there is the fact that the bank was ramping up its long position in credit at the very time when the rest of the industry was scrambling to buy protection against a market downturn.

These were all massive red flags and call into question Dimon’s claim that his bank only noticed abnormal trading positions some six weeks later.

Both JP Morgan and its regulators had ample information at their fingertips to see something was wrong. The fact that such extreme anomalies went unnoticed for so long casts doubt on the bank’s risk management practices – not to mention the ability of its supervisors to unearth inappropriate risk-taking.

Time for a change

There was much hysterical coverage last week of the actions of the banks involved in Facebook’s wobbly IPO. Much of it focused on the actions of the underwriters after Facebook refiled its prospectus to admit that revenues from those using its sites on mobile devices were unlikely to live up to previous expectations.

According to some wilder accusations, the banks were guilty of securities fraud because when they changed their projections as a result of Facebook’s admission they only told “favoured” clients.

In reality, of course, the banks were doing the only thing they could do. Because of fear of law suits from aggrieved investors, they are told by their lawyers not to publish projections ahead of an IPO and are only able to communicate verbally with clients. That inevitably means that only institutional firms get phone calls.

In other words, selective disclosure is not only allowed, but inevitable under current securities regulations.

As a result, while the last-minute revision might well have dampened institutional interest in the deal and contributed to the first-day fizzle, it is unlikely that any of the myriad lawsuits focused on this particular issue will be found to have merit.

But the banking industry and regulators should not allow that fact to blind them from the obvious injustice inherent in the selective disclosure – and the need to do something about it.

There is in fact a clear case for the rules to be rewritten to ensure that banks have a responsibility to give all parties considering an investment the same information – and that means publishing the kind of pre-IPO research that is routine in the rest of the world.

For that to happen, though, regulators will also have to ensure that aggrieved investors can’t sue banks when honest projections about a company’s future performance prove fallible. One option would be to introduce something akin to the “safe harbour” rules that enable companies already listed to make forward-looking statements without fear of being taken to court.

Quite simply, investors can’t have it both ways: they should not be able to sue because of a lack of transparency, but neither should they when published forward estimates fall short.

There may be lessons to be learnt from the newly-minted JOBS Act, which allows research coverage at the time of the IPO. At the moment, though, companies with more than US$1bn of revenue are not covered by the act. Facebook’s IPO – and the inherent selective disclosure it highlighted – should act as a catalyst for that to change.

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