The Volcker Rule & The London Whale: "Dear Big Media, Get A Clue"

Authored by Chris Whalen via The Institutional Risk Analyst,

"It is not down in any map; true places never are."

"Moby Dick"

Herman Melville

News reports that prosecutors have dropped their case against Bruno Iksil, the former JPMorgan (NYSE:JPM) trader many know as the “London Whale,” comes as no surprise to readers of The IRA.  Iksil, who resurfaced earlier this year, has been living in relative seclusion in France for the past few years.

In previous comments posted on Zero Hedge, we dispensed with the notion that the investment activities of Iksil and the office of the JPM Chief Investment Officer were either illegal or concealed from the bank’s senior management.  The fact is that Iksil and his colleagues at JPM were doing their jobs, namely generating investment gains for the bank.

The outsized bets made by the “whale” in credit derivatives contracts resulted in a loss in 2012, but the operation generated significant profits for JPM in earlier years.  As veteran risk manager Nom de Plumber told us in Zero Hedge in 2012:

“This JPM loss, whether $2BLN or even $5BLN, is modest in both absolute and relative terms, versus its overall profitability and capital base, and especially against the far greater losses at other institutions. In practical current terms, the hit resembles a rounding error, not a stomach punch.  As either taxpayers or long-term JPM investors, we should be more grateful than sorry about the JPM CIO Ina Drew.   If only other institutions could also do so ‘poorly’………”

When JPM and other large banks began to implement the Volcker Rule after the passage of the 2010 Dodd-Frank law, the activities of Iksil and his colleagues in New York began to come to light. Principal trading, which is now outlawed by the Volcker Rule, creates enormous opportunities – and conflicts -- for banks that act both as traders and lenders.  We wrote in ZH in 2012:

“[D]ear friends in the Big Media, it is time to get a collective clue.  The real problem with CDS trading by large banks such as JPM is not the speculative positions taken by traders like Bruno Iksil, but instead the vast conflict of interest between the lending side of the house and the trading side, whether the trader is on the arb desk or, in the case of Iksil, working for the CIO trading for the bank’s treasury.”

When caught in the act, the bank naturally cast Iksil’s activities as being somehow illicit and against company policy.  But in fact his trading activities had been understood, blessed and even directed by the JPM’s senior management going back years. Far from being a hedge for other exposures of the bank, in fact the strategy of the CIO’s office was to generate returns as the bank’s internal hedge fund.

When as early as 2010 discussions reportedly occurred about “hedging” Iksil’s illiquid credit derivative positions, presumably those involved understood that this was a risk position taken as part of a deliberate investment strategy. That Iksil apparently believed that he could not be bullied by other counterparties because of the fact of trading for JPM speaks to how he viewed his activities, which were entirely visible to other market participants.

The JPM CIO’s office under Ina Drew ran an active trading strategy, making markets around positions on a continuous basis to provide live valuations and generate short-term returns.  The fact that big banks no longer trade their investment books illustrates the diminution of liquidity that has occurred since the adoption of the Volcker Rule. But for the banks, the legacy of the London Whale and the larger implementation of Dodd-Frank has left a deep mark on risk managers and those concerned with maintaining internal systems and controls at large banks.

But now Iksil has accused JPM"s Chief Executive James Dimon of laying the ground for what was eventually a $6.2 billion loss, Reuters reports.  In an account on his website, Iksil also blames senior executives at the bank for the investment strategies that led to those losses.  Iksil’s account now sounds an awful lot like what we heard from his former colleagues in New York some six years ago.

At the time, JPM’s counsel had already mandated the elimination of the managers and traders in the CIO’s area as part of implementing the Volcker Rule, leading to a number of redundancies in New York.  We know about the Whale because of the implementation of the Volcker Rule.  But the key event that broke the scandal open was the public statement by Dimon, this in response to persistent press queries from The Wall Street Journal and Bloomberg News, that the rumors of losses in the CIO’s office were “a tempest in a teapot.”

But for the public statement by Dimon, which required additional clarification and disclosure, the activities of the CIO that might otherwise have been dealt with in the fine print of JPM’s earnings release.  Instead, JPM was forced to not only enhance disclosure of the CIO’s trading results, but then went through a firestorm of congressional hearings, regulatory questions and litigation that continues to this day.  We recall sitting in the analyst presentation at JPM’s HQ dealing with the London Whale as Ken Langone glared at the assembled audience of Sell Side analysts.

In his congressional testimony, Dimon attributes the bank’s loss to a modeling error, but in fact the exposure was simply ignored.  Notice that at no point has the financial media or regulators questioned the company line about what actually happened and when. Iksil’s statements seem to take us back down that road and, specifically, to suggest that senior management at JPM was actively aware of the strategies taken by the CIOs office years before the big losses occurred.  Our old pal Nom de Plumber commented over the weekend:

“In the end, the London Whale disaster reflected the mis-marking of generic Index CDS trades, which then-CFO Doug Braunstein ignored.   The problem was not complex risk modeling or market risk measurement.   The quants tried to re-jigger VaR measurement of the trades, to avoid breaching risk limits-----for CIO trades which Jamie specifically demanded of Ina Drew......regardless of preceding protests from risk managers like John Hogan and Robert Rupp.”

Nom de Plumber tells The IRA that Ina Drew was essentially running a hedge fund directed by Dimon and other senior managers, a fund that was largely kept outside of the bank’s risk management and reporting procedures. Consider the bizarre situation in 2011-2012 when counterparties of Iksil facing the JPM commercial bank were unable to make margin calls, but the JPM investment bank was making margin calls on these same counterparties for positions in the very same indexed credit derivatives.

Bruno Iksil has waited for the proverbial concrete to harden over the past few years before coming forward with his latest accusations. This makes it difficult or impossible for Dimon and his lieutenants to change their story now.  It will be very interesting indeed to see if anyone from the financial media or even the regulatory community picks up the new trail illuminated by Iksil’s statements.

The episode involving the London Whale illustrates how difficult it is to learn the truth about the inner working of large banks.  Big banks profit by exploiting information and conflicts found between the world of credit and the world of securities.  Indeed, the CIO"s office generated big returns for JPM over the decade or so that Iksil was with the bank. 

But the London Whale episode also shows in graphic terms why the Volcker Rule prohibitions against banks trading for their own account need to be preserved and strengthened.  There is a fundamental conflict between a bank acting as a lender and trading credit derivatives. 

More, if the CEO of a bank – any bank – can short circuit the internal controls of his institution in order to enhance returns with a bet at the credit derivative roulette table, then by definition that bank cannot be safe and sound.

Europe's Banking Dysfunction Worsens

Authored by Chris Whalen via The Institutional Risk Analyst,

“While the US and the UK have been mired in political chaos this year, the EU has enjoyed improved economic conditions and some political windfalls. The question now is whether this good news will inspire long-needed EU and eurozone reforms, or merely fuel complacency – and thus set the stage for another crisis down the road.”

Philippe Legrain, Project Syndicate

This week The Institutional Risk Analyst takes a look a the recent reports out of the EU regarding a proposal to “freeze” the retail accounts of failing European banks.  The original story in Reuters suggests that our friends in Europe actually think that telling the public that they will not have access to their funds, even funds covered by official deposit insurance schemes, is somehow helpful to addressing Europe’s troubled banking system.  Investors who think that Europe is close to adopting an effective approach to dealing with failing banks may want to think again.

Judging by the reaction to the story by investors and on social media, it appears that the EU has learned nothing about managing public confidence when it comes to the banking sector.  In particular, the idea that the banking public – who generally fall well-below the maximum deposit insurance limit – would ever be denied access to cash virtually ensues that deposit runs and wider contagion will occur in Europe next time a depository institution gets into trouble.

“The plan, if agreed, would contrast with legislative proposals made by the European Commission in November that aimed to strengthen supervisors" powers to suspend withdrawals,” Reuters reports, “but excluded from the moratorium insured depositors, which under EU rules are those below 100,000 euros ($117,000).

While some Wall Street analysts are encouraging investors to jump into EU bank stocks, the fact is that there remains nearly €1 trillion in bad loans within the European banking system.  This represents 6.7% of the EU economy, according to a report and action plan considered by EU finance ministers earlier this month.  That compares with non-performing loans (NPL) ratios in the US and Japan of 1.7 per cent and 1.6 per cent of gross domestic product, respectively.

But the most basic point to make about the proposal for a “temporary” suspension of access to cash is that such moves never work.  Moratoria are part of the banking laws in Germany and many other European nations, but they are never used because once invoked the institution is dead for all practical purposes.  In Spain, for example, the government had the power to impose a temporary suspension of access to deposits in the case of Banco Popular, but did not do so because it would have killed the franchise.

Jochen Sanio, the former president of the German Federal Financial Supervisory Authority (BaFin), commented about banks subject to “temporary” deposit moratoria that “they never come back.”  Sanio, who guided Germany through the 2008 financial crisis and forced the clean-up of insolvent state-owned banks, was retired and gagged for the rest of his life for challenging Germany’s corrupt political status quo of covert bailouts.

So again, one has to wonder, why any responsible official in Europe would support the plan reported by Reuters.  As the US learned the hard way in the 1930s and with the S&L crisis in the 1980s, the lack of a robust national deposit insurance function to protect retail depositors leaves an entire society vulnerable to banks runs and debt deflation.  Until the EU is prepared to do “whatever is necessary,” to paraphrase ECB chief Mario Draghi, in order to protect retail bank depositors, the EU will remain far from being a united political economy.

Readers of The IRA may recall the comments of German Chancellor Angela Merkel last Fall, when she suggested that the German government would not support Deutsche Bank AG (NYSE:DB) in the event that the institution got into financial trouble.  At the time, DB was trading at about $12 per share in New York.  We spoke about DB and the ill-considered comments made by US and German officials from Dublin on CNBC on September 30th.

At the time, we reminded investors that political officials should never talk about a depository institution while it is still open for business.  This is a basic, well-recognized rule that has been followed by prudential regulators around the world for many years.  Yet because of the popular political pressures on elected officials such as Merkel, the temptation to engage in absurd hyperbole with respect to big banks is irresistible.

We see this latest piece of news out of Europe as further evidence that there is still no political consensus about how to deal with troubled banks.  As we learned last year, Merkel could not even make positive public comments about DB for fear of committing political suicide.

The more recent bank resolutions in Spain and Italy were made to look like touch measures in public terms, even as the Rome government quietly subsidized the senior creditors of two failed banks in the Veneto.  We noted in an earlier comment, “Fade the Great Rotation into Europe,” that the EU pretends to play tough on bank rules while bailing out the senior creditors:

“Of note, Italy is being given control over the remaining ‘bad bank’ to wind down as the assets and deposits are conveyed to Intesa SanPaolo.  This permits a bailout of senior unsecured creditors.  So Italy gets what it wants – continued circumvention of EU bailout rules. If a bank disappears, notes a well-placed EU observer, ‘state aid rules do not apply.’”

The Europeans appear to be playing a very dangerous game.  On the one hand, EU officials talk publicly about getting tough on insolvent banks and even suspending access to funds for retail depositors.  On the other hand, EU governments are continuing to bail out banks and large creditors in a display of cronyism and business as usual.

“Under the plan discussed by EU states, pay-outs could be suspended for five working days and the block could be extended to a maximum of 20 days in exceptional circumstances,” Reuters reports.  “Existing EU rules allow a two-day suspension of some payouts by failing banks, but the moratorium does not include deposits.”

Contrast the EU proposal with standard practice in the US, where the Federal Deposit Insurance Corporation (“FDIC”) begins to market troubled banks before they fail and tries to execute bank closures and sales on a Friday to avoid frightening the public.  The branches of the failed bank then open on the following business day as part of a solvent institution without any interruption in customer access to funds.

Importantly, all insured depositors, as well as brokered deposits and advances from the Federal Home Loan Banks, are always paid out by the FDIC when the failed bank is closed in order to avoid precipitating runs on other institutions. 

In Europe, on the other hand, there appear to be a significant number of officials who seriously believe that denying retail bank customers access to funds covered by deposit insurance will not result in financial contagion.  If such a proposal is adopted, the sort of bank runs seen in Cyprus and Greece could intensify and spread to the major countries in Europe.  Imagine that a large bank failure occurs in Italy next year and Italian officials tell retail customers that they will not have access to any funds for several weeks.

As we saw in 2012 in Spain and Cyprus and 2015 in Greece, retail bank runs tend to spill over into other countries and markets, creating a situation where fear takes over from rational behavior.  The trouble is, Chancellor Merkel cannot commit Germany to supporting an EU accord to support the banks in the Eurozone without ending her political career.

“If capital flight from the peripheral economies gathers pace, it could trigger runs on entire banking systems,” notes the infamous “Plan B” memo prepared for Merkel in 2012. “That would put the ECB—and thus, indirectly, the Bundesbank and Germany—on the hook for deposits worth trillions of euros.” 

In the dark days of 2012, Merkel’s government prepared for “Plan B” and was essentially ready to allow the weaker nations on the EU’s periphery – including Spain, Greece, Italy and Ireland -- to fail and drop out of euro as Germany withdrew to a core group of nations.

Just as the EU still refuses to deal with Greece’s mounting debt, likewise it cannot seem to accept that protecting the small depositors of European banks is the price to be paid for preserving social order and the EU itself. Otmar Issing, former Chief Economist and Member of the Board of the European Central Bank and the German Bundesbank, summarizes the situation: “The euro crisis is not over.”

Chris Whalen: "The Dollar Super-Cycle Ends"

Authored by Chris Whalen via InstitutionalRiskAnalyst.com,

What do the US residential housing market, the stock market and the dollar all have in common?  All of these markets represent bubbles created and driven by the aggressive social engineering of the Federal Open Market Committee.

We live in an age of asset bubbles rather than true economic  growth.  The investment world is skewed by the latest round of monetary policy experimentation by the Fed, including years of artificially low interest rates and trillions of dollars in “massive asset purchases,” to paraphrase former Fed Chairman Ben Bernanke.  

These bubbles are caused and magnified by supply constraints, not an abundance of credit.  Whether you look at US stocks, residential homes in San Francisco or the dollar, the picture that emerges is a market that has risen sharply, far more than the underlying rate of economic growth, due to a constraint in the supply of assets and a relative torrent of cash chasing the available opportunities.

Likewise with the dollar, the image of the financial markets is one of constraints rather than policy ease.  Since the middle of 2014, the value of the dollar against major currencies has risen sharply, suggesting a shortage of liquidity or at least a relative preference for dollars vs other fiat currencies. 

The vast flow of foreign direct investment drawn into the US and then into asset classes like residential and commercial real estate illustrates the abundance of global dollar liquidity and relatively scarcity of assets. 

Even with the supposedly accommodative policy by the FOMC, key measures of market liquidity continue to suggest either price and/or structural constraints, both in the US and overseas.   Looking at the effective cost of dollar credit, for example, illustrated by the notorious London Interbank Offered Rate or LIBOR, the cost of borrowing dollars in Europe has risen steadily risen since the Middle of 2015.  Again, the chart below makes us wonder if the good folks on the FOMC appreciate the degree of fundamental demand for dollar credit.

With the end of the Mortgage Bankers Secondary Market Conference in New York, American lenders face a market with new origination volumes down 25-30%.  Meanwhile, the reinvestment of prepayments on $1.7 trillion worth of mortgage backed securities (MBS) held by the FOMC is essentially taking up new bond issuance by Fannie, Freddie and Ginnie combined.

We have been on the record saying that the FOMC should adjust its portfolio now to accommodate private market demand for yield.  And there is no need for actual sales.  Simply ending the Fed’s reinvestment of mortgage bond prepayments would allow the interest rate markets to find a natural level and, to us, give the Fed a more accurate picture of demand upon which to adjust supply.

"I think they"re aiming for something in the vicinity of $2.3 to $2.8 trillion, something like that," former Fed Chair Ben Bernanke said Monday on CNBC"s "Squawk Box."  Ending reinvestment of the Fed’s MBS portfolio would lead to a net monthly runoff rate in high double digit billions of dollars.  Or to put it another way, it is time for the FOMC to get out of the way of the private market.  Shrink  the Fed’s bond portfolio and credit the reserve accounts of the banks.

It seems that many market indicators such as the dollar and LIBOR suggest a market that is either schizophrenic or dysfunctional.  Our guess is the latter, in part due to excessive prescription-based regulation of traditional banking and finance, particularly low-margin money market businesses which are being abandoned by the big depositories like JPMorgan (NYSE:JPM) and The Bank of New York Mellon (NYSE:BK).

There are seismic changes going on in the world of trading cash securities and collateral lending, changes that see a host of non-banking firms returning to this traditional nonbank space.  Staring at these charts for the dollar and LIBOR, we wonder how much of the upward price movement is caused by legal and regulatory changes occurring over the same periods.

The clear question from all of this: What happens when this latest dollar super cycle ends? Given that zero or negative rates elsewhere are driving much of the emigration into American assets, why should the dollar ever selloff, right?

Regards the prospect of a dollar drop, Megan Greene tells us on Twitter that “Only way I see it in the short-run is if everyone else gets in trouble and the Fed opens swap lines w other CBs to supply QE #unlikely" 

We hear all of that, but can’t help but ask the question.  All things do come to an end, including the seeming ability of the FOMC to painlessly levitate the fortunes of heavily indebted nations on a sea of easy dollar credit.  This works really well when the dollar is strong, otherwise not so much.