Slouching Towards Wall Street… Notes for the Week Ending Friday, 11 May 2012
Everett Dirksen who, according to the Dirksen Congressional Center (www.dirksencenter.org) probably never said “a billion here, a billion there and pretty soon you’re talking real money,” was born at the end of the 19th century, a time when a billion dollars was actually quite a whopping sum. Whatever he may or may not have said on the topic of billions, he was certainly keenly aware of government’s penchant for throwing around lots of cash. He also operated at a time when meaningful budget items could be discussed in “millions” of dollars — a quaint concept to us. Nowadays, as Barry Ritholtz writes in Bailout Nation, not just governments, but mere corporations toss around sums of money so vast we are at a loss to categorize them. Ritholtz suggests we dispense with terms like “astronomical” and proposes “economic numbers,” which he defines as “dollar amounts so vast they dwarf time and space.”
This seems as good a starting point as any for our discussion of Jamie Dimon and JPMorgan’s two billion-plus dollar own goal, apparently the result of a massive hedge gone wrong.
The reporting about this story leaves a couple of points that may never be clarified, because to do so would require a complete reconstruction of the hedges put in place by Bruno Iksil, the “London Whale.” We expect the bank to fight vigorously against a full disclosure of the structure of these transactions — according to all reports, the whole reason these positions generated such losses was that other people got wind of what Iksil was doing and ganged up against JPM’s position. Like other financial institutions, JPMorgan doesn’t want their competition being privy to the way they run their trading strategies. This need for secrecy has given rise over the years to block desks, dark pools, and now London as places to do one’s trading.
Even today two billion sounds like a lot. Two billion one-dollar bills would stretch about four-fifths of the way to the moon. And since Dimon has already said the bank expects perhaps another two billion in losses, it sounds like a near round trip is well within the capacity of the Whale’s portfolio.
Iksil operates within what is being widely described as a near-secret division of the bank, called the Chief Investment Office, or the CIO. According to the Financial Times (12/13 May, “How JPMorgan Loss Hit War On Volcker”) the CIO “hedges positions and invests ‘excess deposits’” of the bank and oversees a portfolio worth $361 billion. The total loss may widen to as much as $4 billion, or a bit over one percent of the value of the portfolio. Not that this is a good outcome, though surely not a game ender for the operation.
The sheer size of the CIO’s book may be reason for concern. The pool of capital is described as a combination of position hedges and excess deposits, which leads us to speculate there may be a commingling of risks — if not assets — within the CIO, meaning the losses may have the ability to trigger FDIC guarantees. Put differently: when you run my money alongside your money in a single pot, who decides who gets the losses? And who audits that process? Meaning the taxpayer could be on the hook for what turned out to be risky bets, undertaken on a capital base at least part of which was not suitable for this type of risk — and that was supposed now to be sequestered under the Volcker Rule.
The FT quotes an ex-JPM banker saying “hedge funds were openly complaining” about these trades’ effect in the market. “Voldemort” — another Iksil nickname — was trading CDS so heavily he started moving the price. This is a trader’s nightmare: far from dominating the market, Iksal had become the market. Once they caught the scent of blood, traders leaned on Iksil’s swap portfolio, with predictable results. The bank now has a massive, largely illiquid position, that it will have to work out of over time. Maybe the best way for them to dump it would be to pay the CIO employees in kind, by giving them the CDS contracts instead of salary and bonuses.
Portfolio Hedging, the loophole in the Volcker Rule that permits this type of activity, throws responsibility back on bank management to do right by the deposit holders. Senator Levin said the portfolio hedging loophole was big enough “that a Mack truck could drive right through it.” To us it is reminiscent of the language in asset management subscription documents.
Private asset management clients sign an agreement that spells out the type of trading the manager will undertake. The terms and restrictions generally include permitted levels of leverage and portfolio allocation, including risk parameters of individual holdings, as well as limits on portfolio concentration. Most managers also include a catch-all clause that says, in effect, they can do whatever they deem appropriate to make profits, or protect against losses in the portfolio. That clause does not ensure the client will not lose money. It is a Get Out Of Jail Free card to protect the manager against allegations that they violated the specified parameters in managing the client’s money. It is a private Portfolio Hedging loophole. We agree with Senator Levin on this one. As he has no doubt already allowed in private — this is a s**tty deal.
The press are making much of how secretive the CIO was. JPMorgan Chase — ranked by Forbes as the world’s largest public company — employs over a quarter of a million people. But the CIO had only 400 employees; its head, Ina Drew, is at once among the most successful, and also most low profile women on Wall Street. And as everyone knows, the nickname foist upon trader Iksil — Voldemort — is followed by the ominous phrase “He whose name must not be mentioned…”
We are not concerned that Mr. Dimon may be up to no good. He has, as former FDIC head Sheila Bair observed, “a very stellar record of good decision making.” We fear there may be a breakdown, not in the bank’s internal process, but in Dimon’s own process, one which has made him the only senior Wall Street executive since Ace Greenberg for whom we have any respect. Dimon was the only executive in the gaggle of “Wall Street Fat Cats,” as our President so poetically put it, to exude more Stewardship than Greed. From the Street’s perspective, he was the natural choice to lead the charge against excessive regulation. Because he was the only one with credibility.
The frightening back story is the disintegration of Wall Street’s inner core. “Dis — integrate” — to lose integrity. To come apart at the seams. The inner integrity of Wall Street was the sense of stewardship that, alone among his contemporaries, Mr. Dimon seemed to represent. When the Wall Street partnerships went public, they bifurcated Risk and Reward: the insiders retained the Reward, while the public shareholders bought Risk. This upended the Great Chain of Being. In the days of the partnerships, someone on the inside stood to get hurt badly if the investors suffered. Now, customers are fungible. The Americans didn’t want to buy Goldman’s s**tty deals. Instead of reading that as an imperative to make the deals less s**tty, they found someone else who would buy them. Instead of integrity of one’s own process, Wall Street’s sales machine marches forward on the premise that “our s*** doesn’t stink.” Do we want these people managing our pensions?
Goldman fell from its perch of aggressive risk management, as signaled by a series of witless emails sent within the walls of the firm by a group of salesmen orgasmically exulting that they had sold garbage to their customers. It was a shock to us that a Goldman executive would even think of putting such thoughts in an email. Forgive us if this seems cynical, but Goldman’s culture of risk management was long the industry standard. Yes, the deals Goldman peddled to its customers apparently were truly s**tty, which is bad enough. The Great Chain of Being in the finance industry dictates that each level takes something out of the pockets of its customers: bankers take a spread, brokers take a commission, managers take a fee — and the customer gets what’s left. This is the natural order of things. For Goldman to package products where there was no chance there would ever be anything left over — that was a shock. But the compliance professional in us finds it even more shocking that these emails were sent. A document calling your own product “s**tty” is an unmitigable risk. It got the likes of Henry Blodget and Jack Grubman tossed from the industry for good. Goldman’s executives didn’t get this? Their managers didn’t get it? Blankfein didn’t get it?
Dimon has said publicly that he made a serious mistake. We will learn much about Dimon by how this is handled: who gets blamed, who gets fired, who is shielded. Ultimately, Dimon needs to be right — that this breakdown and the resultant loss signals a flaw of implementation, and not a fundamental breakdown in JPM’s ability to manage risk. The biggest risk is that if Dimon is wrong, he will be the last to know.
We have made no secret of our support for Judge Rakoff’s disdain for the SEC’s practices around settlements and court proceedings. From bouncing the theft of a further $33 million from Bank of America’s shareholders to pay for the bank’s coverup of the billions in bonus payments to Merrill executives, to his sharp insistence that the SEC bring its own case against Rajaratnam, to his disgust over being asked to rubber stamp a cover-up and payoff between the SEC and Citigroup, we have been in his corner all the way.
Judge Rakoff appears to have been a lone voice. His detractors — including folks we respect — say he is a grandstanding dog in the manger of judicial process, and that his thumb in the eye of the SEC is doing more harm than good. As the Rabbi said to the Evangelical Minister: one day the Final Reckoning will come. Only then will we know which one of us had it right. Until then, we’re backing Judge Rakoff.
Now another couple of black-robed outliers are tinkering with the judicial system in a case that seems to be largely off the radar — yet which may have powerful repercussions. An article in on-line magazine Pacific Standard (psmag.com, 23 April, “Caveat Pre-Emptor”) assesses the fallout from what to most of us must seem a technicality so small as to be inconsequential — yet which, says this article, may forever change the world.
The article focuses on New York’s Martin Act, a 1921 piece of legislation passed in response to the wave of “blue sky” laws then being implemented by states. These laws were designed to provide some minimum standard for the offering of securities — that investors could not be sold “stock in fly-by-night concerns, visionary oil wells, distant gold mines,” and other “speculative schemes which have no more basis than so many feet of blue sky,” as quoted in a 1917 Supreme Court ruling that affirmed the constitutionality of state securities laws.
The blue sky laws served two purposes: first, by introducing a disclosure requirement, they helped root out some of the more egregious frauds against investors. But more important for the state banks, they threw up barriers to entry which protected the local banks from a free for all competition. New York State did not suffer from this problem. To the contrary, while powerful local banks could press other state regulators to make competition difficult, Wall Street was the tail wagging the New York dog, and deals were the lifeblood of the State’s revenues — then, as now. Rather than create a maze of disclosure, registration and printing processes and costs for issuers of securities, the Martin Act merely empowered the state attorney general to investigate allegations of fraud and issue cease and desist orders. Over time legal precedent, legislative actions and court rulings have broadened the scope of the Martin Act to cover not merely stocks and bonds and private placements, “but even bags of silver coins or fake Salvador Dali lithographs.” More recently, co-op and condo apartments also were brought under the jurisdiction of the Act.
In 1946 a federal court ruled — and the Supreme Court agreed — that the federal securities laws imply a private right of action. In simple English that means individual investors can bring civil lawsuits for actions that are illegal under the Securities Act of 1933 or the Securities Exchange Act of 1934. This was good for regulators, as the customer was now made part of the self-policing mechanism of the marketplace, something that on its face every card-carrying capitalist should approve of.
But they didn’t. Powerful lobbying efforts were unleashed, leading to Supreme Court rulings in the 1970’s barring investors from suing if fraud were accidental, and creating other exemptions for potential defendants. In the Greenspan-led rush to unfetter Capitalism, Congress in 1995 passed the Securities Litigation Reform Act, which requires a court order before an individual investor can seek discovery in a securities case. This makes sense, if you believe most investor lawsuits are baseless fishing expeditions, or that the real focus is not on improving the markets, but shaking down corporate America by forcing settlements in lieu of court proceedings. Congress agreed, effectively handing the SEC a monopoly on settlement of securities fraud cases. This deprived the regulators of a street-level watchdog, while depriving individuals of any potential for recovery. Win-win?
The Martin Act has been wielded as a club by New York AGs — we all remember Eliot Spitzer. Its application by private investors has been much more problematic, largely because there is no specific language either granting or withholding a private right of action. In 1987 New York’s highest court “refused to interpret the Martin Act as giving private investors” the authority to bring civil cases. Legislation proposed to create an explicit private right of action under Martin has been gathering dust in the New York State legislature. Meanwhile a host of cases have been thrown out of the New York courts — including a case against a Swiss bank that fed money to Madoff, and Mortimer Zuckerman’s $40 million claim against superstar money manager Ezra Merkin, likewise for Madoff losses. In the weird logic of the courts, you can only get your case thrown out of court if the facts are correct. To argue for a motion to dismiss, you have to agree that you did something that is prohibited under the Martin Act. The court then says your actions are subject to the Martin Act — and not available for private remedies. Next case!
Now comes the Next Case, Assured Guaranty v. JPMorgan Investment Management, a 2008 case accusing JPMIM of failing to properly diversify a client’s portfolio and over-concentrating the assets in subprime mortgage securities. JPM’s attorneys, appearing in a New York court, argued the claims should be dismissed “because the claims were similar to the kinds of misbehavior prohibited by the Martin Act.” This argument assumes investors do not have a private right of action under Martin — an assumption others have gotten away with. But the Assured Guaranty action was not brought under the Martin Act. JPM’s lawyers argued that “investors also cannot bring any claims that resemble Martin Act allegations.” If you don’t understand the logic, you obviously need a good lawyer.
Enter Judge Victor Marrero, presiding over yet another Madoff-related case, Anwar v. Fairfield Greenwich Ltd, whose defendants are likewise seeking dismissal because of claimed Martin Act jurisdiction. Marrero has ordered the case to proceed, writing that all Martinesque dismissals rest upon an “unwitting perpetuation of error” by the courts.
The error, writes Judge Marrero, arises from a wrong use of language in a 1996 decision where a court dismissed a sequence of claims on the basis that “the claims was really an attempt to pursue a private right of action under the Martin Act.” The court erred, writes Judge Marrero, in the language it chose in rendering its decision. The order re-characterized the original 1987 decision that there is “no implied private cause of action for violation of the antifraud provisions” of the Act — which is why, if you want a New York court to throw your case out, you have to admit that you violated the Act’s antifraud provisions — instead the court wrote there is “no private right of action for claims covered by the Martin Act.” Judge Marrero says in subsequent practice “covered by” came to replace “in violation of,” and “Martin Act preemption quickly went viral.” Judge Marrero has refused to dismiss the claims and has urged other courts to revisit their position on the Martin Act.
Assured Guaranty made it all the way to New York’s Court of Appeals where the defense had another rude awakening. Rather than the lay-up they expected, the appeals court wrote that the Martin Act “does not expressly mention or otherwise contemplate the elimination of common-law claims.” Translation: you still can’t bring private lawsuits for actions covered explicitly by the Martin Act, but there’s no reason you can’t bring private actions for anything else — even if it looks like Martin Act behavior. Walking like a duck has, at least for the moment, been defined as not the equivalent of being a duck.
One law blogger picked this up immediately and crowed that now the courts “can be used as an alternative to police excess” in the financial system. He envisions labor unions using their position as major investors — through pension funds — to start a wave of actions designed to “Occupy” the courts.
The finding by two judges of a misstatement of fact by a prior court does not automatically overturn decades of practice. We have yet to see old cases will re-opened in light of these two judges’ findings — though we would not put it past the clout of Mortimer Zuckerman. For the moment, the courts have “unclogged the principle obstacle to private enforcement of the securities laws. Investors whose advisers loaded up on subprime mortgages or entrusted their money to Bernie Madoff can sue.”
It remains in the hands of Congress and the lobbyists to determine how long this window will remain open. Which, we suspect, means it won’t be around very long. But public sentiment is shifting — and JPMorgan has not helped Wall Street’s cause in recent days. All it takes is one judge.
Until this window slams shut, the neglected half of the “well-functioning capitalist marketplace” — the customers — can indicate their displeasure with the way their funds have been invested. Yes, this will open the door to excess by lawyers looking to shake down Wall Street. But it also gives investors an edge when they were shaken down. And it means regulators will get some help from the grass roots level, as policing of fraud relies on victims to shine a light on criminal activities. Admitting that there is a history of abuses on both sides, we still think this makes the playing field more level, not less.
Finally, now that private investors stand a chance of getting some money back, they may be motivated to speak up. Money, we hear, is a powerful motivator.
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