After producing positive revenues each year from 2008 through 2011, the JPMorgan Chase

& Company (JPM) traders in charge of the banks Synthetic Credit Portfolio grew alarmed

when they consistently lost money beginning in January 2012. Disbelieving the quotes they

saw for the credit derivatives they traded, and wanting to minimize the losses they reported

to their superiors until such time that market prices turned in their favor, Javier Martin

Artajo, Bruno Iksil, and Julien Grout began to value their largest derivative positions in a

manner that did not comply with United States (US) Generally Accepted Accounting

Principles (GAAP) and bank policy.

JPM was the largest US bank holding company in December 2011, with almost $2.3 trillion

in total assets. The banks Chief Investment Office (CIO) had as its primary function to

profitably and safely invest a $350 billion pool of the banks excess deposits, which exceeded

its loan balances. One of CIOs secondary functions was to partially offset the credit risk, also

known as default risk, to which JPM was exposed as part of its core lending activities. This

risk was to be partially hedged by CIOs Synthetic Credit Portfolio (SCP), which was run out

of London by senior trader Iksil, junior trader Grout, and their supervisor Martin-Artajo. The

SCP, which ultimately became the source of JPMs $6 billion London Whale loss in 2012,

consisted of long and short positions in various credit default swaps and other credit

derivatives.

GAAP requires that credit derivatives and certain other financial instruments be adjusted to

fair value every day, with the resulting profit and loss also being recorded on a daily basis,

known as mark to market accounting. However, unlike exchange-traded securities (for

example, common stock of companies in the Dow Jones Industrial Average), credit

derivatives trade in a much smaller, less liquid dealer market, introducing greater

uncertainty and discretion into the valuation process.

After losing money on 17 of 21 business days in January 2012, Martin-Artajo started to think

that the market had become irrational and that the dealer quotes used by his traders to set

fair values were not reliable. In response, Iksil informed Martin-Artajo on January 31 that

one of their largest positions was being marked to market value at a realistic level instead

of at the midpoint price that was standard JPM policy. Grout, who was responsible for

marking the fair value of the SCP book each day, was valuing the derivative positions using

whichever side of the bid-ask spread was more favorable to SCP. As the strategy that the SCP

traders pursued proved increasingly unsuccessful, losing money on 15 of 21 business days

in February and 16 of 22 business days in March, the traders likewise continued their

aggressive marking of the credit derivatives, hoping for markets to become rational and

waiting for prices to move in their favor.

As required by banking regulators, the internally estimated SCP fair values were reviewed

monthly by CIOs Valuation Control Group (CIO VCG). Though evidence later showed that the

SCP traders had understated their losses at the March 31 quarter-end by upwards of $500

million, CIO VCG only called for a $17 million adjustment. However, a March 30 analysis by

JPM Internal Audit concluded that CIO VCG itself need[ed] improvement in several areas,

considered an adverse rating.

JPM uncovered the mismarking when CIO began having disputes with several counterparties

in March and April. CIO and some of the firms with which it traded could not agree on the

amount of collateral required by certain credit derivative contracts, because the parties were

valuing the same derivatives at different amounts. These collateral disputes came to the

attention of JPM senior management, which ordered CIO to resume marking the SCP book at

midpoint prices, which in turn quickly resolved the collateral disputes by the end of May.

After the Internal Audit report and the collateral disputes cast doubt on the quality of CIO

VCGs monthly reviews of the fair values assigned to the SCP positions, JPM senior

management asked the Controllers office to undertake an additional special assessment. The

Controller concluded on May 10 that CIO valuations were consistent with industry practice,

and that CIO properly reported $719 million in year-to-date SCP losses at March 31, instead

of the $1.2 billion that would have been reported if midpoint pricing had been used. JPM

provided the Controllers report to its external audit firm, PricewaterhouseCoopers, who in

turn concurred with this determination.

At this point, JPM senior management concluded that the fair values included in the firms

publicly reported financial results as of March 31 were acceptable. However, the

management task force conducting an internal investigation of the trading losses uncovered

evidence in June that the SCP traders did not provide good-faith estimates of the exit prices

for all the positions in the Synthetic Credit Portfolio as required by GAAP (JPM Task Force).

As a result, JPM suspended Grout (who later resigned) and terminated the employment of

Iksil, Martin-Artajo, and his superior Achilles Macris. JPM announced July 13 that it was

restating its first-quarter 2012 earnings, reducing consolidated total net revenue by $660

million, which in turn reduced after-tax net income by $459 million.

The remainder of the case is organized as follows. Section 2 explains GAAP requirements and

JPM procedures for valuing derivative securities. Section 3 details the motivation for and

manner of mismarking the SCP book, including specific instances. Section 4 discusses CIO

VCGs regular review of the traders fair value calculations and Internal Audits criticism of

this review. Section 5 describes how collateral disputes brought the mismarking to the

attention of JPM senior management. Section 6 summarizes additional reviews of the SCP

values that were undertaken as the result of Internal Audits critical report and the collateral

disputes. Section 7 concludes with a discussion of the aftermath of the mismarking, including

changes made to the CIO valuation review procedure, as well as legal and regulatory action

against JPM and certain of the traders. See Appendix 1 for a timeline of key events pertinent

to this case.

Questions

1. Why are credit default swaps and other derivatives difficult to value precisely?

2. Why were the SCP traders motivated to mismark their positions, and how did they

accomplish this?

3. Why did an external control (collateral disputes with counterparties) prove more

reliable in uncovering and halting the mismarking than internal procedures

(recurring and special audits of fair values)?

4. Could marking financial instruments at an amount that is different than their

economic value have systemic risk implications?