JPM Displays Pervasive Desire of Traders to Hide Losses

JPMorgan reported its second quarter earnings this morning and provided an update on the CIO situation. While the company continues to be very profitable, losses from the CIO disaster were revised higher to over $5 billion and part of the position remains open. What is more striking is the following quote highlighted by Zero Hedge:

'the recently discovered information raises questions about the integrity of the trader marks, and suggests that certain individuals may have been seeking to avoid showing the full amount of the losses being incurred in the portfolio during the first quarter. As a result, the Firm is no longer confident that the trader marks used to prepare the Firm's reported first quarter results (although within the established thresholds) reflect good faith estimates of fair value at quarter end.

First of all, let me say that the notion traders are marking books in their favor should not be surprising to anyone. What should be surprising is that JPMorgan is being publicly forced to disclose this fact, which I can assure you is far more pervasive than a few select individuals in the previous quarter.

Several years ago I worked as an equity options trader, trading some of the well-known, high priced names within the technology sector. Unlike many highly traded equity securities, most options at that time did not trade at penny spreads. While my positions may not have been large in comparison to those at many banks, they were large enough that moving the mark from bid to ask (or reverse), on certain strikes, could alter my profitability by upwards of 20-30% on any given day. Not surprisingly, since those strikes often represented the largest open positions on the underlying security, trades frequently went through at the market close to make that mark. By frequent, I mean that this occurred daily on several different strikes (often the same ones for a stretch of days). For any trader, this was a cheap and easy way to manipulate the P&L your bosses would see.

Now imagine that you’re a trader and your bonus/review is based on end of quarter or yearly numbers? Or the market value of your stock in the company might be altered significantly based on the publicly reported number? Do you attempt to mark your trades by a slight amount? The incentive is surely not high enough for all traders and other traders may try to mark positions in the opposite direction, but clearly some percentage of traders will attempt to play this game. Now, on an individual basis it might not make much difference, but if the percentage at a firm is high enough or the positions large enough, this game could have a meaningful effect. In the case of JPMorgan, it appears that the latter was the case this time, but we should not write off the possibility of the former (at JPMorgan or any other large financial institution).

This disclosure adds another tally to the list of areas that regulations are clearly not being enforced. After paying billions to cover up the mortgage fraud debacle, the largest banks now face billions more in charges related to LIBORgate. One should expect that many more financial restatements and disclosures of bad practices will be revealed in time.