JP Morgan Fined For Shorting Madoff

7 comments Written on January 8th, 2014 by
Categories: General

JP Morgan has just been fined $ [heck of a lot] of money for shorting Madoff without telling anyone.

How the heck do you short a guy? I mean, do you buy insurance on him? Do you find out what he’s bought and short that? Yes, I hear you think. But wait, wait. Madoff didn’t buy anything. That was the scam! He just spent the money or used it to pay off exiting investors. So what did JP Morgan short?

Turns out they had an “exotics equity desk”. This is for those people who make too much money and can’t snort enough cocaine, I suppose. This desk sold investors structured notes, linked to Madoff’s performance, and to hedge, bought into the Madoff feeder funds themselves. So JPM had to pay investors whatever returns Madoff made, and they would in turn get those returns from Madoff.

But someone within JPM smelt a rat and they did an internal investigation. The result of what happened after that was: They didn’t buy as much into the Madoff funds as they started out with (exposure went from $349 million to $81 million).

And then when it was time to unwind, they left their “short” positions open - effectively, the notes which the investors had bought - while getting out of Madoff’s funds with what they could. The clients who bought the notes would eventually see zero returns when the fund went bust.

Apart from fidiciary duty (which hasn’t yet figured here), the deal was that suspicious activity was not reported to the US.

The fine is $2.6 billion, which they can rustle out of their left pocket on any given afternoon. They’ve already been fined $13 billion in November.

The bank will pay $1.7 billion to settle the government’s charges, $350 million in a related case by the Office of the Comptroller of the Currency and $543 million to cover private claims, the firm said in a filing.

Side Note: If JP Morgan was fined that much in India, the government would have a lot less problems with its fiscal deficit.

The stock’s up 30% in 2013, but might announced a 20% drop in earnings later this month. But if there’s one thing the story tells you it’s this: Too Big to Fail has become Too Big To Hurt, Too Big to Touch and Too Big to Even Expect To Bother.

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The man behind Capital Mind. Deepak is a co-founder at MarketVision, a financial knowledge company. Deepak also provides data research and consulting services, and now lives in Bangalore. Connect with him at deepakshenoy@gmail.com.

7 comments “JP Morgan Fined For Shorting Madoff”

Huh? I don’t see a problem with JPM’s behavior here. They saw a scam and profited from it by being smarter than the morons who continued to invest with him. The only wrongdoers here are the investors and Madoff. How can someone who shorted Madoff be bad or wrong? And, I’ll never understand why the investors who were so dumb to invest with Madoff are considered “victims”. They fully deserved it and should take responsibility for their bad decisions.

And, if JPM wasn’t selling exposure to Madoff, the buyers would have gotten it some other way. Why blame the broker? Brokers don’t always have fiduciary duty and only offer products. As far as fiduciary duty is concerned, it depends on what type of desk it was. If it was a sales desk then they behaved no better or worse than any salesman peddling any product anywhere in the world.

This product would not have been created if there wasn’t demand for it. The way such products come about is that people must have been clamoring to “get in” to Madoff’s hedge fund but they weren’t able to. So, a sales desk obviously dreamt up a way to provide exposure synthetically. Snide remarks about “exotics” etc are meaningless as its not the mechanism to blame here. The thing is a broker will create products for whatever is in demand. Can’t blame them.

But, yeah, TBTF is a huge problem. Poor regulation is a problem. I just don’t think this particular event is a problem though. And, I don’t think it has much to do with TBTF. In fact, maybe the opposite. In the US, the govt and regulators also wait for when they can spot some weakness and they can then extract something from big companies. So, there are no holier than thou entities here. Wall Street or Govt, pick your poison. Who was asleep in the Madoff case? SEC or JPM? Fine SEC first.

I think the only reason JPM should have been fined would’ve been breach of fiduciary duty (i.e. not telling customers to get out, because they have a fiduciary duty to do so) By the way brokers do have fiduciary duty. It’s agents that don’t. (Banks sell insurance as agents not brokers, which is why the fiduciary duty does not apply)

Exotics are typically lipsticks on pigs, sold to unsuspecting fools who think they know better. Hedge funds should do that, not banks. In India too this is a problem, and RBI is very lax on banks, something I’ve railed about for a long time. My concept is to fine them so much that their capital ratios become 6%. And that close to finishes them off unless they raise new capital and so on.

In this case, the first link I gave argues that it was TBTF that screwed things up for JPM because its left hand didn’t know what its right hand was doing. Well, the fines should fix that.

Well, I’m still unclear about fiduciary duty in this particular case. Me buying RIL stock from my broker does not mean that the broker needs to advise me about whether buying RIL stock is a good idea or not. And, most times the broker won’t even know or will feign to not know. And, even if he knows, he won’t know the timing, etc. Usually the broker only cares about selling volumes – good or bad is irrelevant. And, more times than not, my mind is usually made up on buying RIL stock, so the broker merely satisfies the demand. Its not clear without going into details whether JPM has fiduciary duty in this case. There are branches of business in banks where fiduciary duty clearly applies like investment management (which this isn’t) and then there are branches where it doesn’t. This looks more likes sales, where the customer has to be wary like with any sales department of any product.

By the way, this is different from the problem of information asymmetry. I don’t know what the proper way to handle information asymmetry is or if there even is a good way to do it. I mean, if someone has better information, you can argue that he should share it with the world, but that is almost never likely to happen in any industry. Usually information asymmetry is something to take advantage of, unless there is a very clear fiduciary role, which as I pointed out is unclear in the world of market making and brokerage.

And, I don’t fully agree about exotics. Sometimes exotics can create liquidity in something decent that is hard to get exposed to. And, on the long or short side, that is irrelevant. And, yeah, if someone buys an “exotic” he better know what he’s doing. I don’t think the existence of unsuspecting fools should lead to criticism of any or all “exotics”. There are also plenty of suspecting smart people like Michael Burrys who were able to use the “exotic” subprime products to create profitable trades. And, these products hasten transparent price discovery, although the unsuspecting fools may not like it.

My main irritation is that what I’ve found in real life is that the unsuspecting fools usually get enough notice, enough red flags thrown their way to get out of the trade. But, they don’t. And, then they cry that they are the victims. Oh please, cry me a river. The world strangely bends to the fools rather than the smart ones.

Oh, and where are the fines on Indian banks for misrepresenting ULIPs? And, that’s just one of many products that banks mis-sell here.

Whats TBTF ?? in the first two comments.

Too Big To Fail….

DJ does have a point – investors can be greedy despite knowing the risk of things going wrong.

And this can also apply to the NSEL situation. NSEL investors knew they were doing two-way trades. They knew or ought to have known that no commodity exchange can honestly guarantee an assured return. They would find it hard to prove they were not one of the two: greedy or dumb.

Having an exchange like the NSEL operate for the many years that it did is the major issue here, and regulators should be jailed for this along with the exchange promoters, for violating the trade mandate that NSEL had. But investors don’t have a strong case to be compensated, because they knew the risks and still participated.