Last week the U.S Senate conducted hearings on JPMorgan’s $6.2 billion 2012 trading loss in its London office. This was the amount of a trading loss attributed to the “London Whale,” an individual trader in the bank’s Chief Investment Office (CIO), an office whose responsibility is risk management. That individual and the executive in charge of the CIO were let go and the damage now seems to be contained. So why should the Senate be investigating? Why should we care?

Critics might argue that this is the business loss of a defined corporate entity, JPMorgan Chase, and therefore a matter for the company and its shareholders, not the general public and the Congress. In most cases I would agree.

However, this is not just any company and the causes of the loss have significance beyond its corporate and national bounds. An important point to make here is that while the bank was successful in holding the loss at $ 6 billion, it could have been more extensive and had greater consequences.  More importantly, the nature of the loss is indicative of a systemic problem that continues to threaten the nation’s economy, which is the reason it is definitely the public’s business.

When the Banks Fall It Hurts Us All

JPMorgan Chase is a global financial entity, the largest global bank according to an editorial in Bloomberg. As the editorial points out, the bank’s equity is only between 3 and 4 percent of its total value. A sufficient drop in stock price could potentially wipe out that underlying equity and set events in motion that would cause the American taxpayer to bail them out.

How much would that bail out be? JPMorgan has a total value of around $4 trillion.   As someone argued soon after the first bail out, “too big to fail will one day be too big to save.”

The area that should be our greatest concern is this: if Mr. Dimon is the best risk manager in the industry, then can the industry as a whole really be counted on to be a partner with the people (via regulation) in ensuring we do not have another global calamity? The Bloomberg editorial re-opens the discussion on capping the size of the largest banks.

It’s Not Their Money

There are people who believe the $6 billion loss is an issue for JPMorgan management and its shareholders and should be left there. But it is not just the bank’s direct shareholders that may be hurt in these situations. This bank’s stock prices impact many other investors and non-investors. Indirect investors in JPMorgan include those who buy ETFs including ETFs that track the S&P, the Dow and other metrics. People who do not directly invest but have pension and other retirement plans can be affected. A major bank failure, as we saw in 2008 and 2009 can impact the economy as a whole costing the jobs of people who have no investments of any kind.

We need to address bank size to protect us all. We need to understand that complex investments aimed at managing risk can introduce new risks. And we need to realize that the importance of fiduciary responsibility must be re-established in the industry.

Each of these firms had achieved the highest reputation for integrity and quality by placing their responsibility to the investing public ahead of all else. Then their corporate cultures changed.

For those of us who were a part of Arthur Andersen in the 1960s and 1970s, there was no question that the firm considered its reputation to be its principal asset. An asset to be safeguarded at all cost. Reputation was everything and reputation brought in the revenue. The foundations of that reputation were competence, independence and objectivity, all found by no coincidence in the ethical standards for CPAs. The people we served were not our clients; they were the investing public who relied upon competent and independent audit opinions; opinions that were signed “Arthur Andersen & Company.”

The firm invested greatly in achieving and maintaining those qualities throughout its organization. We were masters at training our personnel, developing and enforcing firm wide standards of practice across the globe and maintaining discipline in the use of those standards through a mechanism of internal quality assurance reviews of every audit, tax and consulting engagement combined with frequent and specific personnel reviews at all levels.

But we overlooked one key and fundamental element of maintaining a corporate culture that applies to all organizations, one that Standard & Poor’s may also have missed. We altered the values that generated real rewards and recognition for upward movement in the organization. Over time we collectively allowed the importance of independence and objectivity to slip and the importance of revenue generation by individuals to rise. Serving the investing public remained in our literature, but generating more revenue for the partners became the most important value within the partnership.

Had the partners ever sat down at an annual meeting and openly proposed that this be done it most likely would have been booed down. It was not really a conscious decision, nor do I believe that we ever actually viewed rewarding individual revenue production as something likely to be in conflict with our reputation and our integrity. (A prior generation of partners most definitely did.) But slowly over time the focus on admission to and advancement within the partnership shifted. Reputation did not drive revenue; individuals did. Service to investors was not the primary overriding importance; renewing audit contracts and deriving consulting and tax opportunities was.

So when a Chicago Headquarters partner with a well established reputation for audit and accounting expertise came down to Houston to provide the quality assurance review for the Enron audit, his disagreements with the treatment of certain off balance sheet partnerships resulted in his quick dismissal by the firm’s client. The client had no say in the selection of quality assurance partners in the old days. The firm’s top management would not have acquiesced to a clean opinion after such client actions. The threat of loss of consulting revenue from the client would not have swayed the objections presented in the audit opinion. This time they did.

Floyd Norris’s story in The New York Times draws potential parallels between the corporate culture issues underlying Andersen’s demise and those that are appearing to surface as the government brings its civil case against Standard & Poor’s. In the case of Andersen, damage to our economy was contained. In the case of the CDO s of the type that S&P and others rated, the damage was global and a near worldwide meltdown.

Corporate culture is the key to ethical behavior in any organization. But can a company of such importance police itself? Enron led to the Sarbanes-Oxley Act, which among other things established a new oversight agency, the Public Company Accounting Oversight Board (PCAOB), for a profession that had previously been proudly self-regulating. It is time to do the same for the ratings industry.  They are there to serve the public and the public should have the oversight.

As I read John Carney’s piece on CNBC.com (“In Defense of Morgan Stanley’s ‘Nuclear Holocaust'”) I decided a rebuttal of his opinion should be a post on this blog.

Among the news items this week was the release, in a civil trial, of the text of certain emails that were sent among staff at Morgan Stanley pertaining to the internally perceived quality of a mortgage backed CDO that they were preparing for the market. The emails speculated on an appropriate name for the CDO and included such labels as “Subprime Meltdown.” The emails were brought to light in a lawsuit by a Taiwanese bank that had invested in part of that CDO.

The original story was written by Jesse Eisinger in ProPublica on January 23rd and was also published by the New York Times’ DealBook that same day.

While there is a lot to ‘bite’ on, ethically speaking, in the story itself, I was particularly amazed by the defense of Morgan Stanley written by John Carney, Senior Editor at CNBC.com. Mr. Carney’s article attempts to defend Morgan Stanley from having done anything wrong. The core of his argument can be found in this statement: “There’s a big difference between selling a product to a retail investor and a bank, even a Taiwanese bank.”

Setting aside the obvious disrespectful phrase “even a Taiwanese bank” (implying that a Taiwanese bank is inherently not as competent as its Western counterparts), I find it incredible that anyone could hold out a distinction of this sort as a basis of a defense. At its foundation, this defense is the inevitable result of the caveat emptor (“buyer beware”) attitude that has permeated the financial industry for so long.

Carney goes on to say that it was no secret in the industry that Morgan Stanley was bearish on mortgage debt and that the bank had published articles on the approaching bubble as early as August of 2006. Evidently none of those articles reached the desk of then Federal Reserve chief Alan Greenspan. We all know that there were many contrary opinions within expert economic circles at that time.

Carney then points out that it is common practice, even today, for a bank to sell products to its customers that it does not itself believe to be good investments. In other words, everyone does this so therefore it is OK.

This defense of the bank’s actions is filled with flaws. I want to discuss those using my model for ethical standards, the Seven Layers of Integrity®. Quotations below are from his article, referenced above, and I encourage you to read his entire article.

The Law and Contracts and Agreements

We have laws and regulations governing the selling of securities to investors. A key focus of those rules is the attempt to ensure that the buyer is fully aware of the risks of the securities. That risk discussion is to be found in the prospectus or offering documents, not in “notes” from one of the company’s analysts appearing in an overall market assessment or industry hearsay that the bank was a bear on mortgages in general. The risks of the specific security being offered, not just the broad market or industry risks, should have been highlighted. The fact that fully $415 million of the $500 million package ended up being worthless and that this apparently came as a surprise to the buyer would raise the question of what was and was not revealed. The fact, via the emails in question, that the bank’s own staff who were putting the offering together believed it to be highly likely to default is tantamount to the bank itself knowing that the product being offered on the market was completely speculative and extremely risky. Is that how they categorized it?

The argument that these securities were not being sold to retail investors implies that for “sophisticated financial institutions” an investment bank can be less scrupulous, less transparent, in presenting the risks involved. I am not a registered financial broker or the like, and would invite the perspective of someone who is, but I am highly skeptical that an appropriate discussion of risk can be bypassed when the bank presenting the offering believes the securities to be highly risky. If that is actually acceptable, it should not be.

Professional Standards

I would like to think that people in the banking industry who hold certain securities licenses have professional ethical standards that they should adhere to just as CPA s and attorneys do. I would like to think that independence and objectivity would be part of those standards, along with placing your clients’ interests above your own. I don’t see any of that being observed in this case, nor does Mr. Carney’s defense even attempt to address those issues, other than pointing to an industry standard.

Industry Standards

The argument that “the investment banks have typically allowed clients to take the opposite sides of trades, even when they regard one side of the trade as misguided” states a current industry standard of expected behavior.  As I point out in our book, industry standards can and do violate the standards found in the Law, Contracts, Professional Standards and the other layers in my model. When they do, and this is one case where I believe strongly that they are in conflict, the industry standard will ultimately be changed.  I look forward to that day.

Community Standards – The Investing Public

Neither Mr. Carney nor anyone else can state without qualification that there were no retail investors involved. The odds are high that some were involved, albeit indirectly. For example, there could well have been retail investors holding shares of the purchasing bank that saw their investment in those shares hit when this CDO and others like it proved to be worth so much less on the bank’s books. And in general the losses on mortgage backed CDOs that were bought by municipalities, pension funds and other entities have affected retail investors and the non-investing public alike.

Interpersonal Standards and Spiritual Values

Not even raised by Mr. Carney as something to be defended, so the only flaw is that he doesn’t even mention them. Interpersonally, no one buys a second time from someone they had to sue. Spiritually, as I have said before, there is no spiritual value I am aware of that justifies what the banking industry has done to the global economy and millions of individuals in the name of greater profits for its own pockets.


Mr. Carney’s defense makes it clear that in his mind Morgan Stanley did little wrong, save for failing to teach their staff to not send emails of this sort. I don’t consider hiding bad actions to be a virtue.

For my part, and likely a large percentage of the retail investor market, the revelations coming from this lawsuit are of little surprise and may simply confirm our worst suspicions. There are so many instances of ethical failures and deception in this real world example that a reasonable person can only conclude that what the bank did in this case was simply wrong.  It is one more reason why so many of us are reluctant to return to the market even now as it is clearing the decks for new highs.

Wall Street has tarnished itself mightily, doesn’t even realize it and most likely doesn’t even care.

Other Assessments

Two other interesting opinions on the ethics of the investment banking industry are

“Wall Street Ethics Codes Make Me Want to Inhale” by Susan Antilla of Bloomberg News

“The Market Has Spoken, and It Is Rigged” by Simon Johnson, Professor of Entrepreneurship, M.I.T. Sloan School

Yesterday’s Sunday New York Times’ business section featured a lengthy article on the proposed takeover of the New York Stock Exchange by an Atlanta based company with the unfortunate three letter acronym of ICE. Here are parts of this story that caught my attention.

ICE, the IntercontinentalExchange, is located in a modest, nondescript office building in Atlanta. There are not enough employees working there to fill the building – at least two other companies have marquees out front. ICE personnel eat their lunch in the same cafeteria with those other companies’ employees. The small personnel footprint is a direct result of the computer based management of the exchanges that ICE already has. This fact has caused anxiety among the traders on the floor of the NYSE who still handle the orders.

While ICE founder and CEO Jeffrey Sprecher maintains that he knows investors will still want a human being on the other end of the phone overseeing the trading, I doubt that he will need as many such people physically present on the pricey NYSE trading floor as opposed to sitting at computers in Atlanta or anywhere else. In short the computer leverage that is already a powerful force in the trading process is likely to increase.

At the same time, Sprecher recognizes that the flash crashes that occasionally occur with individual stocks and less frequently with an entire market, are not a good thing for the long haul. According to the Times’ story, ICE “has been praised as one of the first exchanges to put limits on lightning-quick, high-frequency trading.” Having that mind-set at the helm should be welcomed by investors, and would lend some hope to addressing the ethical issues of high-frequency trading that we have discussed in a prior post.

The Wrapper On 2012

What a year it was. I started this blog and its associated Twitter account, @ethicsbite, in March and since that time have covered and commented on an amazing number of stories. When I scroll down the list of tweets I realize first hand the extent of ethically questionable (and many times illegal) corporate behavior in our country. Ponzi schemes, insider trading, money laundering and (in the UK) phone hacking are among the illegal. Providing financial advice to clients while your own firm profits by the reverse position is unprofessional. Manipulating the rate determination for an international banking benchmark is likely a violation of regulations. I’ll stop there as the full list would no doubt cause my readers to move on. So we’ll switch to sex.

The Petraeus sex scandal seemed to dominate the corporate ethics news at the end of the year. The New York Times story regarding Walmart’s Mexico operations was more significant in scale.  But all of that was eclipsed by juicy, titillating tales from Washington, Tampa and Afghanistan.

2012 Awards

In addition to being amazed at the plethora of unethical activity, I have marveled at the crassness of the people involved. One has to wonder how they would explain their actions to Mom.

In terms of sheer and utter crassness, the 2012 award truly has to go to the News of the World, whose employees allegedly hacked into the cell phone of a young British girl who had disappeared, then proceeded to delete some of the messages on her cell phone so they could capture potential new incoming messages. Her parents detected that something was going on and informed the police. That case led to the demise of one Rebekah Brooks, a Rupert Murdoch “protégé” and the editor of News of the World. Ms. Brooks and her husband’s relationship with David Cameron, the British Prime Minister, tainted 10 Downing Street and created a political situation that could not be ignored. As the investigation continued, Rupert found himself testifying at Parliament and Ms. Brooks was formally charged in May, together with her husband and four others, with conspiring to interfere with the investigation. She allegedly attempted to carry off the evidence in boxes she took out of News of the World’s offices. Moreover it has turned out that phone hacking may have been a relatively common tool at News of the World as close to 200 individuals, many of them celebrities and political figures, have filed suit over the hacking of their personal cell phones. News of the World was shut down by Mr. Murdoch and he subsequently re-organized the News Corp. entity.

A close second place in crassness would be Chesapeake Energy’s founder, Aubrey McClendon. Mr. McClendon showed little bounds in his use of the company’s money and making a name for himself with it. From such relatively small amounts as corporate payment of his personal staff (to be reimbursed at year end without interest on the amounts advanced) to the millions of dollars he authorized be invested in a local NBA team and the construction of a shopping mall that just happened to have eateries owned by Mr. McClendon, the CEO continually used corporate funds to “match” expenditures from his personal wealth to foster his interests. Chesapeake by this time was a publicly held company traded on the NASDAQ and the CEO’s use of money in this manner should have been overseen by the Board. But as is often the case, the Board was beholding to the CEO.  Chesapeake’s stock fell on bad times (from around $34 on 8/1/2011 to around $17 on 12/14/2012), four new independent board members were elected and McClendon was stripped of his Chairman title. But those who paid the cost were the shareholders, of course.

What Will We See In 2013?

Here are our predictions: Rebekah Brooks will go to trial. JPMorgan will further increase its reserve for bad trades by “The Whale.” No one in the investment banking industry will go to jail for anything other than insider trading. Goldman Sachs will continue to be bad. The global economy will continue to improve. Slowly. More dirt will come out regarding Walmart’s non-US operations. Somewhere in the US a bank will go under.

And there will be at least one big sex scandal.

As the French say, “the more things change, the more they stay the same.”

Today’s biggest news on the corporate ethics front was the federal government’s settlement with Bank of America and other large banks related in part to their foreclosure processes.

According the Reuters story:

  • “The [foreclosure] reviews had already cost more than $1.5 billion. They turned up evidence that around 6.5 percent of the loan files contained some error requiring compensation, but most of those errors involved payouts much less than $125,000.”
  • Under the settlement the banks will provide “up to $125,000 to homeowners whose homes were being foreclosed when the paperwork problems emerged.”
  • Bank of America “also announced about $11.6 billion of settlements with … Fannie Mae to end allegations the bank improperly sold mortgages that later soured, and to resolve questions about foreclosure delays.”
  • “The bank is moving closer to the day when it can stop worrying about mortgages and start focusing on growth, analysts and investors said.”

This is great news for BoA and the other banks involved and the investors who lost money on the mortgage backed CDOs and other vehicles. They can get back to growth.

As for the people, often “sub-prime” mortgagees, who went through the traumas of foreclosure – locked out of their homes, their furniture on the street or ruined, their credit destroyed – the most they can get is up to $125,000. And how were they foreclosed on? Illegally. Paperwork not processed properly. Mortgages that had been sold to investors without a legal trail of ownership of the collateral – the home. Unable to pay for lawyers and court fees to protect their rights. Being told to re-finance and then foreclosed on when they followed the bank’s directions. We all remember reading those stories in the paper don’t we? And let us not forget our soldiers in uniform overseas whose homes were foreclosed in spite of clear federal law prohibiting that from happening.

Yes this was a great settlement for some and a life altering event for others.

Friday’s tragedy in Connecticut made any problems I have seem miniscule. I almost typed “by comparison,” but there really is no comparison between the two. None. At the same time, we all seek to draw lessons from what has happened and wrestle with how to make sure this never happens again. One focal point of course is the second amendment, the right to bear arms. That is the law.

Then there is ethics. Ethics is doing what is “right” using whatever yardstick we measure our lives by. The Law allows us to bear arms. That doesn’t mean we have to, nor that we should. We still have a choice to make individually and as a nation.