Something very important is going to come out of these new criminal charges just filed against two ex-JPMorgan traders… at least, I hope it does.
It’s not about who did what to contribute to the London Whale’s billions in losses. Frankly, who did what in this case is worthless news, unimportant, and a sideshow. Of course, the public will be riveted all the same, and prosecutors can’t wait to ascend their microphoned podium and tell the world, “We got the banksters.”
But I don’t think they will be found guilty. If they are found guilty, it will be because prosecutors prove “intent” and blur the technicalities, which will be mindboggling.
The reason I don’t think they will be found guilty is because the technicalities will likely prove to be such a moving target that the defense lawyers will claim, and rightly so, that they did nothing wrong, because as far as their intent, what they did is being done all the time, and regulators know it.
For heaven’s sake, the regulators gave the banks the leeway to do it.
This is dangerous for all of us…
Bruno Iskil was called the London Whale on account of the size of the positions he amassed. Those positions later cost JPMorgan $6.2 billion. Mr. Iskil is not being charged with any crime. That’s because there’s no crime in losing money.
But it is criminal to falsify books and records, and that’s what the government is saying that Javier Martin-Artajo (49) and Julien Grout (35) did. Allegedly Mr. Martin-Aratajo pressured Mr. Grout to “mismark” derivatives trades to hide mounting losses on the Whale’s growing tail risk.
Let’s assume that Mr. Grout marked the trades where Mr. Martin-Artajo told him to.
The problem with proving intent is proving that the marks were so egregious that the only purpose of marking them where they were marked was to obviously hide the losses.
Now, here’s the rub, sometimes that’s easy to prove. However, in the case of derivatives, especially in this case, that may be impossible to prove, barring emails that literally say, word for word, “mismark the trades to hide our losses.”
In the stock trading world, the practice of “painting the tape” has long been practiced.
Painting the tape, which is kind of what the JPM boys are being accused of, is illegal.
Which, of course, doesn’t mean it isn’t done all the time…
Painting the tape works like this.
Suppose you’re a big trader and you have a bunch of big positions that you bought and it’s the end of the quarter and how much money you’ve made will determine your next bonus. At the end of the trading day today, your positions will be “marked,” which means valued, at the last price that your stocks closed at. It’s in your interest to see those stocks close at the highest price possible at the close. Why? Because the higher the price, the better your profit looks when the books are closed out.
In order to make the prices higher, you buy shares into the close, or maybe you put down some orders to buy a bunch of stock on the close; whatever your plan is, you are trying to get the price to end the day as high as you can drive it.
That’s painting the tape.
At the end of the day, everyone knows what the closing price is because stocks are traded on an exchange and all those prices are determined and publically disseminated.
That’s not the case with derivatives.
Derivatives, which are what the London desk was dabbling in, are priced, or marked, based on bids and offers and sometimes your own made-up numbers.
The convention is generally to get a few quotes on the derivatives you want to (or have to) mark, then price them at the midpoint between the average of the bids and offers. If I call around to a couple of dealers or brokers to get a quote on my CDX N.A. IG9 derivative position (which is what the London Whale was betting big on), maybe the average bid price (what someone will bid or pay to buy the CDX from me) is 102 and the average offer price (what someone is offering to sell me more CDX at) is 106. The midpoint of that spread is 104. Since I own a big position in the CDX, which means I want it to go higher in price, I’d rather mark my position at 106 than the midpoint of 104, and I certainly don’t want to mark my position at 102.
Here’s where technicalities will come into play. It may be the convention to mark at the midpoint, but it isn’t the law.
Here’s why. First of all, the blokes who give me the quotes don’t necessarily have to honor them. If I say to the dealer who gave me a 102-106 quote, “Okay, I want to sell you a bunch of CDX at the 102 you bid,” he could say, “I’ll buy a little there, then I’ll have to get back to you with a new price.” Or the person could just drop his bid price to see how desperate I am to sell my big position.
If I’m smart, I’m not going to tell him how much of this CDX I have to sell. I don’t want him to lower his price. But now I know there isn’t really a lot of interest in him buying any of my stuff at 102.
So I keep calling around. I call brokers who call around to other dealers and get back to me with bids and offers. But say I’m the London Whale and I’ve bought so much CDX and the blokes who sold it to me figured out I own a ton of it, in fact, I practically own all of it.
How big were the London desk’s positions? In the first quarter of 2012 they added – “added” – $390 billion worth of derivatives. Certainly not all of them were CDX. But their positions were huge by any and every measure. And other traders knew it.
Now, if I’ve sold a few billion dollars of CDX to the Whale and I know that he has a giant position and I know who else sold him more CDX, what’s to prevent me from trying to profit by seeing if I can drive the price down and force the Whale to sell and really knock the price down? Nothing. Why would I do that? So I can buy back what I sold him a lot cheaper and make a ton. Oh, and by the way, maybe I’ll call some of the other blokes I know who sold Bruno some CDX.
What do you think is going to happen when Bruno then calls around for quotes? I’d say, “Hey Bruno, how you doing today, it’s a beautiful day isn’t it? My bid on CDX is 95, got any to sell?” And if Bruno and Javier and Julien call around and they get 95 bids, then 93, then 89, don’t you think they know they are being gamed and that if they sell they’re screwed? Of course they know it. Everyone knows it.
But they aren’t selling. They just want a quote to mark their books.
Now what do you do? Now how do you mark your position? Are you supposed to mark it at such a huge loss just because the traders on the other side of your trade are out for blood? And you haven’t even sold anything to them. What if your bet turns around and you start making money? You’ll be a hero. But not if you have to sell at these depressed prices and take a giant hit.
There’s a lot more to the complexities of marking derivatives. That’s why this case will be such a nightmare.
Prosecutors will say that there were real trades being done and they should have marked their positions there. But defense lawyers will argue that they were too small to count, because after all, the Whale didn’t have to sell his positions, and they came to realize that they were being gamed on the quotes.
Should it be self-fulfilling that other traders can force you to mark down your positions so you show big losses and then the whole world knows it, and they can really kill you?
What’s at issue here, what’s important here, is how should derivatives be marked and how often.
Banks have been given leeway to mark their “risk assets” to models they construct. They can get quotes and sometimes they can mark-to-model their positions. If you don’t think marking to your own model isn’t fraught with self-serving painting gone wild, check yourself into Betty Ford, you’re hallucinating.
The entire system of pricing risk assets, tradable assets, is a hodgepodge of giveaways that regulators gave to banks because Congress was lobbied to give them massive wiggle room… precisely because they take massive positions.
And as you see from the London Whale story, when you take massive positions, bad things can happen, including your competitors forcing bad things on you.
But, of course, there’s more. Imagine (you don’t have to; it happened in 2008) a bunch of giant banks are all on the same side of the wrong side of a massive bet on something. Imagine they all need to keep the marks on their positions high enough to hide the truth (oh, they did that too) and they’re allowed to do that. Which they are.
What would happen if there was no turnaround on their positions and no one (none of the regulators) knew who was in trouble because they all lied on their marks?
This case shouldn’t be about whether there was intent to mismark trades. This should be about establishing that there is a problem with the process, and how banks hide their liabilities because they can.
By bringing it to light, we are our own fools if we don’t figure out how to get banks to price everything on their balance sheets to reality.
So we can see how dangerous their mammoth size really is.
And because if they aren’t broken up, the coming reality – and it is coming – won’t be as pretty as the last little crash.