The Price Of Wall Street’s Black Box

By John Gapper

  • 24 Jun 2011

JPMorgan Chase this week became the second Wall Street bank after Goldman Sachs to face a large fine and a stiff warning over its sales of mortgage-backed bonds in the last days of the housing bubble in spring 2007. Others are to come, perhaps including Merrill Lynch, Deutsche Bank and Citigroup.

It is no coincidence that the Wall Street banks have lobbied with such energy against efforts to force trading of more derivatives on to exchanges and through clearing houses. They do not want the black box of fixed income and derivatives trading, which has provided so much of their profits for so long, to be exposed to plain view.

The failure of US prosecutors to secure criminal convictions against any senior bankers or hedge fund managers apart from Raj Rajaratnam is a let-down. They have been defeated by the difficulty of proving fraudulent intent in the deceptions that flourished as banks struggled with mortgage losses.


Yet JPMorgan’s battle with the Securities and Exchange Commission, in which it paid $153m to settle civil fraud charges, carries an important lesson. The behaviour revealed in the JPMorgan and Goldman cases is a product of the conflicts of interest embedded in how integrated Wall Street banks work. As they say in Silicon Valley, it’s not a bug – it’s a feature.

That feature is inherent in most of what banks do, but the opacity and complexity of credit derivatives – especially mortgage-related securities such as collateralised debt obligations – let deception, overpricing and ultimately fraud flourish. From this black box came the bulk of revenues and bonuses.

In some ways, JPMorgan’s case is less serious than that of Goldman. It has been wilier in keeping its head down, its fine was lower ($133m versus $300m) and the SEC did not impose such serious conditions on the settlement. There was no equivalent of Goldman’s “Fabulous Fab” Tourre and his lurid e-mails.


But the difference is a matter of degree. In other ways, the case against JPMorgan is a carbon copy of the Goldman one. The SEC caught both of them failing to be honest with the investors to which they were selling securities about the involvement of a hedge fund in designing the instruments.

That was the alleged fraud (neither bank conceded it) but, to my mind, JPMorgan and Goldman’s most egregious behaviour came when they found themselves stuck with the flawed securities in spring 2007. Both scrambled to find gullible investors on whom to dump the problem.

In JPMorgan’s case, that meant passing on $150m of mezzanine securities (soon to become worthless) to, among others, Thrivent Financial for Lutherans, a faith-based life insurer from Minneapolis; two Taiwanese life insurance companies, Far Glory Life and Taiwan Life; and Security Benefit Corporation, a life and pensions company from Topeka, Kansas, which woke up to find it wasn’t in Kansas any more.


The internal e-mails urging the JPMorgan sales team to pass along its securities (“We are sooo pregnant with this deal, we need a wheel-barrel [sic] to move around”) are like those at Goldman at the same time. “Things we need to do ... Get out of everything,” Dan Sparks, Goldman’s former mortgage head, noted after a call with another executive.

The Wall Street defence for this kind of behaviour is that these were sophisticated investors that were qualified to make up their own mind about mortgage securities – even immensely complex ones. JPMorgan has been told to pay the money back not because it was inherently wrong to sell securities it no longer trusted but because it did not make the right disclosures.

Even if the securities had been labelled correctly, however, there was something wrong about the entire way that Wall Street behaved. These institutions were not widows and orphans themselves but they represented ordinary people’s retirement funds and the losses they suffered would, had the financial crisis not occurred and investigations been made, ended up as a levy on annuities and pensions.


The synthetic CDOs that caused the trouble were expensive bespoke instruments that were very profitable for the banks involved – JPMorgan was paid $19m to structure and market the Squared CDO alone before it got stuck with $880m in unanticipated losses. Their complexity meant that only a few professionals could grasp them – most “sophisticated” investors went by credit ratings.

For investors, it was akin to being informed by a mechanic at the local garage that your vehicle needs expensive new parts and servicing. The garage has an incentive to charge you as much as possible and the information asymmetry between professional and customer makes it easy to pad the bill.

As long as the structure encourages it, investment banks will place their interests above those of their clients, no matter what they say. That is one reason why the US and European reforms to push as much of the derivatives market on to to exchanges and clearing houses – and into sight – are vital.


It also reminds me of the way the City of London was organised before the Big Bang deregulation in 1986, when stock brokers were separated from stock jobbers (what would now be known as marketmakers). That was partly to ensure that brokers did not pass on shares to customers to avoid losses themselves.

It seems old fashioned, and was ended by the Thatcher government in an effort to make the City competitive with Wall Street. But it had virtues that, reading the SEC’s settlements with JPMorgan and Goldman, make me nostalgic.

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