The Inspector General’s Report on JPMorgan’s London Whale Is a Guide to What to Expect from Its Probe of the Fed’s Trading Scandal

By Pam Martens and Russ Martens: November 2, 2021 ~

Mark Bialek, Inspector General, Federal Reserve Board

Mark Bialek, Inspector General, Federal Reserve Board

The Office of Inspector General (OIG) for the Federal Reserve is conducting an investigation of the trading activities that led to the resignations of Dallas Fed President Robert Kaplan and Boston Fed President Eric Rosengren on September 27. The trading of other Fed officials may also be under the microscope.

The OIG investigations are conducted by federal criminal investigators who have the power to “carry firearms, seek and execute search and arrest warrants, and make arrests without a warrant in certain circumstances.” The investigative findings can be referred to the U.S. Department of Justice for criminal or civil prosecution, if warranted.

In the case of Kaplan, the matter belongs in the hands of the Department of Justice right now. Despite having ongoing access to market-moving information throughout 2020, Kaplan was trading in and out of S&P 500 futures in individual trades of “over $1 million.” S&P 500 futures are used to make market-timing bets, something that no official of the Federal Reserve should ever be doing. (See Kaplan’s 2015 through 2020 financial disclosure forms here.)

The U.S. stock market is open from 9:30 a.m. to 4:00 p.m. (ET) Monday through Friday. But S&P 500 futures trade around the clock during weekdays. The E-mini S&P 500 futures contract is the most popular and liquid S&P 500 futures contract. It can be leveraged by as much as 95 percent. The E-mini trades continuously from 6 p.m. Sunday night through 5 p.m. on Friday evening (EDT), allowing someone who might wish to trade on inside information a much larger window of opportunity to do so than stock trading.

Kaplan appeared to have a trading relationship with Goldman Sachs, an entity supervised by the Federal Reserve. Kaplan had previously worked at Goldman Sachs for 22 years, rising to the rank of Vice Chairman.

Wall Street On Parade emailed a total of five Goldman Sachs media relations staff inquiring as to whether Kaplan was conducting his S&P 500 trades and/or his individual stock trades of “over $1 million” at their firm. The company declined to answer our questions.

If the OIG investigators do their job properly, they will no doubt report that compliance officials at the brokerage firm Kaplan was using to place his trades raised red flags to superiors about the nature of his trading while being a Fed insider. It is also likely that the OIG will report that their complaints fell on deaf ears among their superiors.

Why do we suspect that this will be one outcome? Because that’s precisely what happened when the Federal Reserve’s OIG investigated JPMorgan Chase’s London Whale trading scandal.

On October 21, 2014 the OIG for the Federal Reserve released a report on the New York Fed’s supervision of JPMorgan Chase’s Chief Investment Office (CIO). That unit of the bank had used over $100 billion in deposits from the federally-insured bank to make exotic derivative trades in London. It had experienced at least $6.2 billion in trading losses as a result.

The OIG’s report in the London Whale case revealed that New York Fed staff had recommended three examinations of the Chief Investment Office – in 2008, 2009 and 2010. But, as is typical when powerful interests are involved, the examinations just never came to fruition.

The OIG report offers three cop-out explanations for why there was no comprehensive examination of what was going on in the Chief Investment Office by the New York Fed: “FRB New York did not conduct the planned or recommended examinations because (1) the Reserve Bank reassessed the prioritization of the initially planned activities related to the CIO due to many supervisory demands and a lack of supervisory resources, (2) weaknesses existed in controls surrounding the supervisory planning process, and (3) the 2011 reorganization of the supervisory team at JPMC [JPMorgan Chase] resulted in a significant loss of institutional knowledge regarding the CIO.”

We can think of a far more plausible explanation for why there was no examination conducted in 2008 through 2010: Jamie Dimon, the Chairman and CEO of JPMorgan Chase, sat on the Board of Directors of the New York Fed – his own bank’s supervisor – from 2007 through 2012.

How thorough was the OIG’s report on the London Whale matter? It measured 77 pages, which was 223 pages shorter than the investigative report of the same matter conducted by the Senate’s Permanent Subcommittee on Investigations. In addition, the OIG redacted significant parts of its report.

In November 2014, the Senate Subcommittee on Financial Institutions and Consumer Protection delved into the cronyism between the Federal Reserve Banks and the commercial banks they are supposed to be supervising. The hearing title said it all: “Examining and Addressing Regulatory Capture.”

One of the witnesses that testified was the late David O. Beim, then Professor of Professional Practice at Columbia Business School. Professor Beim was the author of a 2009 report, commissioned by the New York Fed, that was highly critical of how deferential the regulator was to the banks it was charged with supervising.

Beim testified as follows:

“In the late spring of 2009 I received a call from Bill Dudley, President of the NY Fed, inviting me to conduct a new consultancy project, this one about systemic risk. The United States, like all other countries, has had numerous banking failures over many years. But the events of 2008 were unlike ordinary bank failures – they represented a systemic financial collapse, in which the capital of almost all major financial institutions was exhausted simultaneously. We have not had a systemic financial collapse in the United States since 1931, and most people thought we would never have another…

“The Federal Reserve had not seen these events coming…

“We found that NY Fed officers were excessively deferential to their superiors and that the entire organization was excessively deferential to the banks being supervised. There was huge emphasis on consensus. This is in sharp contrast to academic culture, for example, where disagreement and vigorous debate are highly valued. Among our recommendations was one giving officers more incentives for disagreement and contrarian thinking.”

Rather than heeding this 2009 report, things actually got worse at the New York Fed. In September 2014 ProPublica and public radio’s This American Life released internal tape recordings made by Carmen Segarra, a former bank examiner at the New York Fed, who says she was fired in retaliation for refusing to change her negative examination of Goldman Sachs. The tape recordings revealed a lap dog regulator afraid to take on a powerful Wall Street firm.

The central bank of the United States has now lost credibility with other central banks around the world because of this trading scandal. But the trading scandal is just a symptom of a far more malignant disease – the structure of the Federal Reserve System.

All 12 of the regional Federal Reserve Banks are owned by the very banks that they supervise. These commercial banks elect two-thirds of the nine-member Board of Directors. The Federal Reserve Board of Governors in Washington, D.C. elect the other three members.

In the case of the New York Fed, the Federal Reserve Board of Governors in Washington has farmed out to it most of its money creation role; its supervision of the mega banks on Wall Street; and its lender of last resort role, which the captured New York Fed has reinterpreted to mean an open money spigot every time a speculating trading house blows up on Wall Street.

As a result of this hubris, the liabilities of the Federal Reserve now stand at $8.5 trillion – with the U.S. taxpayer on the hook for 98 percent of that amount.

Before the repeal of the Glass-Steagall Act in 1999, which allowed federally-insured banks to become trading casinos supervised by the Fed, liabilities at the Federal Reserve stood at just $534 billion on December 30, 1998.

Given this reality, the OIG report on this trading scandal will be little more than a band aide on a malignant cancer that is eating away at both financial stability and democracy in the U.S.

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