'London whale' fiasco begs question: When do investments become bets and approach fraud borders?

"Call me Ishmael." That's the identifiable opening line for Herman Melville's 1851 novel "Moby Dick." In fact, the American Book Review listed it as No. 1 in its list of 100 best first lines from a novel. Flash forward about 160 years, and you have a French-born trader named Bruno Michel Iksil trying to harpoon one more whale of a trading deal for his firm, JPMorgan Chase & Co.

Gregory Zuckerman in The Wall Street Journal May 17 article, "From 'Caveman' to 'Whale,' " writes that Iksil, a London-based trader in the chief investment office of JPMorgan Chase & Co., had bet $1 billion that companies like Eastman Kodak, Dynegy and American Airlines would default on their debts.

Supposedly, Iksil gained the "caveman" moniker because of his steadfast belief that his overly aggressive and risky trades would reap financial benefits. Dynegy filed bankruptcy on Nov. 7, and, shockingly, only a few weeks before the trades were set to expire AMR Corp. (American Airlines' parent company) filed bankruptcy on Nov. 29.¹  

To the dismay of his rivals who took the opposite positions, "Mr. Iskil's positions brought a windfall of about $450 million to J.P. Morgan, saddling hedge funds and other rivals with similar-size losses," according to Zuckerman. Millions of dollars in success sometimes bring riskier investments, higher dollar amounts and lesser oversights. Zuckerman reported that J.P. Morgan's Chief Investment Office was "part of a group that posted net income of $5.09 billion over the past three years, according to regulatory filings, over 10% of J.P. Morgan's $48.08 billion of profits over that period."

One has to wonder if Iksil was given greater longitude and latitude in navigating the high seas of investing or betting. In 2012, he took a large position for JPMorgan Chase on credit default swaps. From the view of opposing traders, the position was so massive that they knew Iskil as "the London Whale." The trouble is when you're the largest mammal in the ocean you might have a hard time unloading your position to minimize your losses.

As the European bank worries subsided, Iskil's large position in the credit default swaps lost value. Total losses aren't official but the majority of news releases indicate they're in excess of $2 billion. The Wall Street Journal May 21 article, "Rivals Go to Lunch on J.P. Morgan's Losses," also written by Gregory Zuckerman with Liz Rapport, reveal that while losses mounted at JPMorgan Chase, "A group of about a dozen banks, including Goldman Sachs Group Inc. and Bank of America Corp., have scored profits that collectively could total $500 million to $1 billion on trades that sometimes pit them directly against" the London Whale.

The Financial Times on May 16 reported in the article, "How JPMorgan's storm in a teapot grew," by Tracy Alloway and Sam Jones that during a first-quarter results conference call, Jamie Dimon, chief executive of JPMorgan Chase & Co., told listeners that the trade was "a complete tempest in a teapot." Talk about a captain not being able to gauge the magnitude of the impending storm brewing in the financial ocean. Speaking of oceans, The Financial Times reported that one trader said, "It wasn't just a giant whale. It was the size of the Atlantic Ocean." The Atlantic Ocean is some teapot. So what we have is a trade position where one side wins and one side loses. Sounds like betting on football matches (or soccer, if you're in the states) — not investing in business plans.

Have you noticed the financial press using the words bet or betting instead of invest or investing in describing business ventures or investment activities? Example in point is a headline, "Hedge or Bet? Parsing the J.P. Morgan Trade," by Katy Burne, Aaron Lucchetti and Zuckerman in the May 16 edition of The Wall Street Journal. The article highlights the questionable strategies of JPMorgan Chase & Co. and its trading losses in excess of $2 billion. Was it a hedging strategy to manage risk, or as the article implies, a banking bet to earn revenue?

Look at the headline, "Citi Bets That Proofs Lead to Profits," on the June 5 article in The Wall Street Journal, by Suzanne Kapner, that describes Citigroup's expansion "into a little-known but fast-growing field known as identity proofing — the tedious and time-consuming task of proving people are who they say they are." Is the word bet in the headline an attempt to get investors accustomed to associating new business ventures as gambles?

The Wall Street Journal article reports this identity-proofing business could reach into the billions. The U.S. government granted clearance to only one financial institution, Citigroup, to issue digital-identity badges to employees of U.S. Department of Defense contractors. The headline, "MF Global chiefs shuffled bets before fall," introduced a June 5 Financial Times article by Tracy Alloway about MF Global's use of repo trades to make bets on the creditworthiness of European bonds.

Finally, Carol Lee and Damian Palette in the May 17 article in The Wall Street Journal, "White House Steps Up Push to Toughen Rules on Banks," write, "In the wake of losses at J.P. Morgan Chase & Co., the White House is seeking to ensure a tough interpretation of a regulation designed to prevent banks from making bets with their own money. …"

Maybe the increased use of betting concepts provides a way for business to create a new norm in peoples' minds.

Is a financial institution making an investment hedge or wager bet when engaging in certain trading practices? When do these bets border on fraud? In the case of JP Morgan Chase its previous "bet" (CEO James Dimon is quoted in The Wall Street Journal as telling Congress "We don't gamble.") might be closer to a fraud when it stated in a SEC 8-K filing that "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." The losses for the second quarter alone were reported in a media release from JP Morgan Chase at $4.4 billion. 

Investors should be leery of bets masquerading as investments. If institutions are too big to fail do government and taxpayers bail out the losing sides? But if it's a true betting position then there will be winners and losers with every gamble. The certain losers are the taxpayers who pay the bill to bail out the losing side and get little in return from the winning side. Not a very good arbitrage position. In this environment, traders/bettors will more than likely engage in excessive scamming and gambling behavior.

Melville's last novel, "The Confidence-Man: His Masquerade," was published on April Fool's Day of 1857. It's only fitting that that was the publishing date of a novel about people sailing down the Mississippi River on a riverboat loaded with con men who are either selling stock in failing companies or herbal "medicine" that can cure all ailments, raising funds for fictitious widows and orphanages, or simply convincing people to give them money outright as a sign that they have "confidence" in their fellow man. Perhaps Melville's view of the world's investment banking and human behavior hasn't changed much since 1857. We're still living in a world of confidence characters and individual fools.

So, whom do we trust? If it's Captain Ahab, we'll go down with the ship. If it's the London Whale, our investments will sink to the bottom of the ocean. Ponder the last lines of "Moby Dick":

"On the second day, a sail drew near, nearer, and picked me up at last. It was the devious-cruising Rachel that in her retracing search after her missing children, only found another orphan." In place of Melville's orphan, today we might think we just found another fool.

Sidebar:

Is an investment really a bet that could become a fraud?  

The media appear to be substituting the word bet for investment, but all good investment managers should hedge their investments to minimize loss. So are banks hedging or betting? Let's talk about the difference between a bet and a hedge. 

A hedge isn't necessarily a means of making money but a way to reduce losses if things go wrong. Consider ABC Inc. — a coffee importer. You're a large shareholder because you're convinced of the worth of the company and its future. Media reports suggest the coming coffee harvest may be poor, which could lead to a sharp rise in the price of coffee. You could now hedge by using a futures or a forward contract in which you agree to buy coffee at a specific price by a specific date. If coffee prices rise sharply you'll still be able to buy at the agreed price, but if they don't reach the agreed price you'll still be obligated to buy.

Further media reports suggest that a new major importer is starting to directly compete with ABC. To protect yourself from a fall in share prices you could purchase a put option, which gives you the option to sell your shares at a specific price. If the share price tumbles, your loss will be offset by the gains on your put option.

You may chose to invest all your allocated capital in ABC shares with no hedging; if it's unaffected by new competition and prices don't surge, your return on investment will be greater than if you had hedged. However, if you invested 50 percent of your allotted capital in ABC with 25 percent each in forward contracts and put options, the share price dramatically dropped due to new competition, and the harvest failed, which caused prices to soar, your losses would be less than they would if you hadn't hedged.

This is a simplified example; investors can use a variety of financial instruments and strategies in numerous complicated ways, which can be dependent on such combined factors as stability of nations, variations in currency and changing weather.

A bet is to risk something — usually on the outcome of a future event. So while this simple example demonstrates that a hedge should act as a means of reducing loss in the worst-case scenario, the multifaceted, complex strategies in today's markets could be likened to bets because the outcomes rely so much on outcomes of future events. The question again is: When do the bets morph into improper risk for investors and creep over the boundaries of fraud?

If we get back to our whaling metaphor: Was the crew of the Pequod betting they could kill Moby Dick or making an investment in the future? Either way, they should have hedged!

— Tim Harvey, CFE, JP

Richard Hurley, Ph.D., J.D., CFE, CPA, is a professor at the University of Connecticut (Stamford) School of Business.  

Tim Harvey, CFE, JP, is director of the ACFE's UK Operations and a member of Transparency International and the British Society of Criminology. 

¹Kodak filed bankruptcy on Jan. 19 but this was after the expiration of the trades.

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