JP Morgan Chase financial crisis

JP Morgan Chase financial crisis is a subsection of the main SourceWatch article JP Morgan Chase.

Role in crisis & financial innovation
In her book Fool's Gold, Financial Times columnist Gillian Tett focuses on the “innovation evangelists” in the firm. A team within JP Morgan developed many of the financial products like credit derivative, which almost brought down the financial system in 2008. The long subtitle of the book sums up her research: How the Bold Dream of a Small Tribe at J.P. Morgan was Corrupted by Wall Street Greed and Unleashed a Financial Catastrophe. A JP Morgan executive told Tett, that the idea of creating markets for credit derivatives was first developed at a 1994 company retreat in Boca Raton (Florida):


 * “It was in Boca where we started talking seriously about credit derivatives. That was where the idea really took off, where we really had a vision of how big it could be.”

Credit derivatives are a type of insurance that allows lenders to off load risks of default on the loans they have made. In 1986, the Federal Reserve, chaired by Alan Greenspan, a former director of JP Morgan; suggested credit derivatives would allow banks to lower capital requirements. Credit derivatives pair those who want to take on risks, with those who want to be hedged against it. While JP Morgan did not invent credit derivatives, it was the first to “industrialize” them; mass producing derivative deals which could cover large numbers of loans at once.

The purpose behind credit derivatives was to enable JP Morgan to circumvent regulatory capital requirements. The company successfully convinced regulators that it could use credit derivatives to shift risk associated with the loans it made. Therefore, it did not need to set aside capital to cover losses in the event that borrowers defaulted. With credit derivatives, JP Morgan not only succeeded in shifting risks off its own books, but created a rapidly expanding market which raked in billions in fees for financial institutions. A journalist covering JP Morgan in the 1990’s commented:


 * “They thought they were the smartest guys on the planet. They had found this brilliant way to get around the rules, to play around with all this risk.  And they were just so proud of what they had done.”

Bill Winters, CEO of JP Morgan Chase’s investment bank until 2009 and a leader in the drive to innovate; denies that credit derivatives had anything to do with the 2008 financial crisis. He points instead to “bad mortgage lending, bad risk management practices, how the innovation was used”. Winters also has blamed the crisis on “greedy bankers, investors and borrowers”, as well as “inept risk managers who relied on the rating agencies”.

However, Frank Partnoy, a former trader with Morgan Stanley, has argued that the crisis would have been much less extreme without derivatives:


 * “Without derivatives, the total losses from the spike in subprime mortgage defaults would have been relatively small and easily contained. ...Instead, derivatives multiplied the losses from subprime mortgage loans, through side bets based on credit default swaps." .  Still more credit default swaps, based on defaults by banks and insurance companies themselves, magnified losses on the subprime side bets.”

Opposition to regulation: Lobbying against Glass-Steagall Act
JP Morgan has campaigned for the repeal of the Glass-Steagall Act, since it was first introduced in 1933. From the company’s founding in the 1860’s until the Depression, JP Morgan grew into a major financial powerhouse, by combining the commercial and investment sides of banking. According to Ron Chernow, author of The House of Morgan:


 * “The Glass-Steagall Act took dead aim at the House of Morgan. After all, it was the bank that had most spectacularly fused the two forms of banking.” According to Chernow, the Morgan financial empire:


 * “was shattered by the Glass-Steagall Act of 1933, which erected a high wall between commercial banking (making loans and accepting deposits) and investment banking (issuing stocks and bonds).”

To conform with Glass-Steagall, J.P. Morgan became a commercial bank and established Morgan Stanley as a separate investment bank. JP Morgan was accused of keeping to the letter, but not the spirit of the Glass-Steagall Act, because of the close ties it initially maintained with Morgan Stanley. Most of Morgan Stanley’s preferred stock was owned by JP Morgan executives; JP Morgan referred clients to Morgan Stanley and Morgan Stanley trades were cleared at JP Morgan. A lawyer for the U.S. Securities and Exchange Commission (SEC) accused JP Morgan of creating a “legal fiction” in Morgan Stanley, in order to maintain its investment banking business. However, by the 1980’s, Morgan Stanley was breaking away from traditional, conservative JP Morgan culture to engage in riskier activities.

In the 1980’s, JP Morgan spearheaded an attempt to repeal Glass-Steagall, but failed to convince the then chair of the Federal Reserve, Paul Volcker. Volcker was concerned about banks getting into risky activities, then having to be bailed out by the government. Alan Greenspan, who was a Morgan director at the time, promoted the bank’s case against Glass-Steagall. According to Chernow:


 * “The House of Morgan led the fight to repeal Glass-Steagall. Like other banks, it tried to scramble into so many investment bank activities that congress would have to rubber-stamp the marketplace reality.  Lew Preston (JP Morgan’s president and CEO) also believed in making an intellectual case for change.  In 1984, the bank produced a treatise called "Rethinking Glass-Steagall."  One patron was Alan Greenspan, then a Morgan director, who followed Paul Volcker as Fed chairman.  According to a JP Morgan Insider:


 * "Greenspan was very instrumental in getting that document out."

Charles Geisst, a Professor of Finance at Manhattan College, recounts how Greenspan undermined the Glass-Steagall Act, first as a JP Morgan director and then as Chair of the Federal Reserve:


 * “When (Greenspan) was a director of J.P. Morgan & Company in the 1980s, Morgan produced a pamphlet called "Rethinking Glass-Steagall," in 1984, which he was obviously privy to and had contributed to…The pamphlet was advocating getting rid of the Glass-Steagall Act and the separation between commercial and investment banking, so that commercial bankers particularly could begin to underwrite corporate securities again, as they hadn't done since before 1933.”

During the 1990’s as Chair of the Fed, Greenspan effectively gutted the Glass-Steagall Act by using loopholes in the Bank Holding Company Act. These loopholes enabled him to allow commercial banks like JP Morgan, to earn a percentage of their total revenues from investment bank types of activities. Professor Geisst explains that :


 * “Single-handedly, the Fed got rid of the Glass-Steagall Act over a period of about six or seven years. That preceded the actual change in the law, which came eventually, after the fact, in 1999.” Subsequent to the repeal of Glass-Steagall, JP Morgan rapidly entered the investment banking field, so that by the first quarter of 2010, three quarters of the bank’s profits came from investment operations.

Robert Weissman and Harry Rosenfeld identified the repeal of the Glass-Steagall Act, as one of the main causes of the 2008 financial crisis. According to Weissman and Rosenfeld:


 * “The 1999 repeal of Glass-Steagall helped create the conditions in which banks invested monies from checking and savings accounts into creative financial instruments such as mortgage-backed securities and credit default swaps, investment gambles that rocked the financial markets in 2008.”

Lobbying against regulation of derivatives
JP Morgan was a founding member of the International Swaps and Derivatives Association, established in 1985. One of the early successes of this industry lobby was to block a Commodities Futures Trading Commission proposal to require all derivative trading be done on its exchange. In the early 1990’s, when the New York Federal Reserve was proposing regulation of derivatives, JP Morgan assigned Mark Brickell to lobby against it. Brickell became JP Morgan’s and the industry’s “Rottweiler in fending off regulatory concerns.” Brickell is a libertarian and an admirer of economist Frederich von Hayek. Arguing that markets are inherently efficient, Brickell said government regulation of derivatives should be opposed because:


 * “Markets can correct excess far better than any government. Market discipline is the best form of discipline there is.”

Despite complaints about the aggressiveness of the Brickell's Washington anti-regulation campaign, Alan Greenspan and others in the Clinton Administration were open to his arguments. By the end of 1994, all four bills to regulate derivatives had been dropped. In a 1998 statement submitted on behalf of JP Morgan to the House of Representatives Committee on Banking and Financial Services, Brickell argued against a renewed effort by the Commodities Futures Trading Commission to regulate derivatives. Brooksley Born, the chair of the Commission from 1996 to 1999, became concerned over the deregulated status of derivatives after their roles in other financial disasters, such as the bankruptcy of Orange County. However, her agency was not even able to exercise its responsibility to prevent fraud, due to the complete lack of transparency in derivatives trading.

JP Morgan’s position, as advocated by Brickell, was that Brooksley Born’s suggestions that derivatives might be regulated:


 * “undermined the carefully crafted legal certainty that these instruments currently enjoy” and represented “a troubling shift in CFTC policy that is contrary to the express intent of Congress...”

Brickell argued that the existing system, largely relying on market players to police themselves, worked best:


 * “Market discipline refers to a system in which market participants control their risks because it is in their own best interest to do so. It exists when participants know they will be forced to bear the costs of their mistakes because no one will assume these costs for them. It works because those who ignore it fail, while those who take it seriously are able to thrive. And it has the paradoxical effect of increasing the likelihood that individual firms will fail, while reducing the prospect of widespread difficulties in the financial system. Market discipline works largely through attempts by swap dealers to improve both their reputation and credit quality. These competitive advantages differentiate those who succeed from those who fail.”

By 2008, financial institutions made massive derivative bets on the US housing market, could not be “forced to bear the costs of their mistakes” because of the catastrophe their failure would have caused the US and the world economy. Alan Greenspan, testifying before the House Committee on Oversight and Government Reform, argued that the government bailout was necessary:


 * “to avoid severe retrenchment, banks and other financial intermediaries will need the support that only the substitution of sovereign credit for private credit can bestow.” He also retreated from his longstanding advocacy of the notion that markets would police themselves. Those of us who have looked to the self-interest of lending institutions to protect shareholder’s equity (myself especially) are in a state of shocked disbelief”.

Dealings with AIG
JP Morgan was the first institution to approach the insurance company, American International Group (AIG), to take over some of the risks associated with its CDO business. Joseph Cassano, an AIG executive in the company’s now infamous financial products unit, recounted:


 * “J.P. Morgan came to us, who were somebody we worked with a great deal, and asked us to participate in some of what were the precursors to what became the CDO market.”

In assuming the risk of banks’ CDO business, AIG had the advantage that it did not have the same capital requirements as banks and were lightly supervised by officials who had little expertise in financial innovation. Under Cassano, by 2008 AIG’s holdings in “super-senior” CDO’s had grown to $560 billion. Although these securities originally were considered very low risk, AIG had to write them down by $43 billion due to the dramatic downturn in the US housing market. AIG was in danger of default, so the US government stepped in with an $85 billion bailout that subsequently increased to $255 billion in commitments to provide loans and purchase AIG’s toxic assets.

Too big to fail
JP Morgan's strategy of growth, lead them to become a "too big to fail" bank, requiring government support during the financial crisis. In 2004, the bank agreed to buy Bank One, creating a $1.1 trillion bank holding company. JP Morgan Chase acquired Bear Stearns on March 18, 2008, for $2 per share. Six days later, the deal was revised upward to $10 a share, after Bear Sterns shareholders objected to the initial pricing. On September 25, 2008, the Federal Deposit Insurance Corporation (FDIC) closed Washington Mutual. The bank was purchased by JPMorgan Chase for $1.9 billion. Washington Mutual shareholders lost all of their equity.

Capital Purchase "Healthy Bank" Program (2008)
On October 28, 2008 the Treasury Department started the Capital Purchase Program. JP Morgan was among the eight large U.S. banks to receive the Treasury Department's initial round of capital investments and received $25 billion of Troubled Asset Relief Program (TARP) funds.

Impact of 2008 financial crisis on JP Morgan Chase
Fortunately for the bank, JP Morgan fell behind its competition in the hugely lucrative, but ultimately disastrous, business of selling subprime mortgage securities. Analysts within JP Morgan in the 1980’s identified key problems in applying financial innovation to the mortgage market. For example, unlike corporate loans, there was no long term data for the housing market allowing financial institutions to reliably quantify the risk associated with bundled mortgage securities. In addition, JP Morgan could not figure out what to do with the so called “super senior” portion of packaged mortgage securities, which were a problem if retained on a bank’s books; yet hard to off load. JP Morgan staff wondered how banks like Citigroup managed to deal with this fundamental flaw in the mortgage securitization market.

As it turns out, other banks were largely ignoring the problem. Robert Rubin, Secretary Treasurer and senior advisor to Citigroup in the time leading to the crisis, acknowledged to the Financial Crisis Inquiry Commission (FCIC), that Citigroup “suffered distinctively high losses” with its super-senior securities and had exposed itself to a $43 billion risk. He blamed the ratings agencies that had given the securities AAA ratings. He also said that there were “almost no financial models” which could have predicted the massive decline in the U.S. housing market. However, JP Morgan analysts had correctly identified the problems with quantifying risks in the mortgage security market. When he became CEO of JP Morgan in 2006, Jamie Dimon set the goal of diversifying its trading department into mortgage-backed securities, an area where his competitors were reaping huge profits. In his former position as bank president, he had:


 * “already revamped J.P. Morgan's retail-branch system to encourage greater selling of mortgages, credit cards, and other products.” JPMorgan Chase hired mortgage traders from other Wall Street firms to beef up this area of its operations. In a 2007 article titled “JP Morgan quietly climbs subprime ladder”, Reuters reported that the number of subprime mortgages that JP Morgan Chase had originated jumped by 11% in first quarter of the year.

The online journal ProPublica noted, that while the bank was originally cautious about getting involved in sub-prime mortgage securities:


 * “by mid-2006, JP Morgan joined the herd. It hired bankers to expand its CDO team and got to work.”

JP Morga worked on a deal with Magnetar, a hedge fund that specialized in betting against the US mortgage market. Magnetar bought the riskiest mortgage securities and hedged against them, reaping huge profits with the sharp housing downturn. JP Morgan created a CDO with an initial stake from Magnetar and turned it into a $1.1 billion investment, sold internationally to 17 institutional investors. This JPMorgan/ Magnetar deal was struck in 2007 after the housing market had already started to decline. Investors, including a Lutheran non-profit organization, saw 100% losses only eight months later. ProPublic reported:


 * “According to marketing material and prospectuses, the banks didn't disclose to CDO investors the role Magnetar played.”

By finding markets for risky assets, in spite of indications that there were problems in the housing market, Magnetar, JPMorgan Chase and other financial institutions enabled the housing crisis to grow into a full-blown financial crisis. CEO Jamie Dimon acknowledged in his 2009 letter to shareholders that JP Morgan had made its own mistakes during the lead-up to the crisis:


 * “Our two largest mistakes were making too many leveraged loans and lowering our mortgage underwriting standards. While our mortgage underwriting was considerably better than many others’, we did underwrite some high loan-to-value mortgages based on stated, not verified, income.”

However, he claimed that despite his bank’s CDO deal with Magnetar, “there also are many mistakes that we did not make, among them... collateralized debt obligations...”

JP Morgan’s profits fell from $15.4 billion in 2007 to $5.6 billion in 2008. However, it did well in comparison with its competitors. An article in Fortune magazine in September 2008 reported:


 * “Before the crisis J.P. Morgan was a middle-of-the-pack performer; today it leads in nearly every category, starting with its stock.”

The company’s investment banking division was called “king of the downturn” for the success it had in 2009. JP Morgan paid back the $25 billion it received in TARP funds in June, 2009. In his 2009 annual letter to shareholders, CEO Jamie Dimon wrote that the firm did not need these funds, but did so because


 * “we believed we were doing the right thing to help the country and the economy.”

He expressed surprise at the public anger the bailout had prompted. He also portrayed JP Morgan’s purchase of Bear Stearns and Washington Mutual as actions that contributed to “stabilization and recovery.” Dimon has been questioned, however, on the deal JP Morgan struck with the New York Fed over Bear Stearns. In order for JP Morgan to agree to buy the brokerage, the New York Fed paid $28.8 billion for Bear Stearns securities that since have fallen dramatically in value. In his testimony to Congress on the Bear Stearns deal, he stated:


 * “It would have been irresponsible for us to take on the full risk of all those assets at the time.”