Friday, February 22, 2013


Posted: 22 Feb 2013 03:30 AM PST

It’s really easy to have a fortress balance sheet if you can get other people to eat your losses.  It’s also how some scandals are picked up and amplified by the media while others lie fallow. The London Whale scandal, which was never going to rise to the level of bank-threatening losses, did reveal JP Morgan to have grossly deficient risk controls and Dimon to be arrogant, lackadaisical, and dishonest in dealing with the problem. Predictably, regulators have refused to acknowledge serious Sarbanes-Oxley violations. And Dimon, who loves to take personal responsibility for JP Morgan’s successes, rapidly threw members of his laxly-managed Chief Investment Office under the bus to salvage his reputation.

We’ll go into more details on JP Morgan’s WaMu machinations below. The very short version is this story came to the fore last year, when Deutsche Bank filed a putback suit against both JP Morgan and the FDIC for dud loans in 99 WaMu mortgage securitizations (recall that when a mortgage backed bond is found to have worse merchandise in it than than the investors were promised, the trustee is supposed to put the bad loans back to the originator and have them replaced with good loans or get cash compensation. The Deustche Bank suit was noteworthy because trustees normally do nothing). The FDIC has made a compelling case that WaMu is no longer its problem and JP Morgan assumed the relevant liabilities.

Yet we’ve been told that in the next few weeks, JP Morgan is about to enter into a settlement with Deutsche Bank regarding…hold your breath….the liabilities it insists sit with the FDIC. I’m not making this up (the source is legally savvy). I’m not even sure how you paper up something which is so clearly nonsensical.

This looks to be a larger scale version of the strategy it entered into with billionaire Len Blavatnik. Blavatnik’s operating business Access Industries hired JP Morgan to manage the cash it had sitting around among its various entities, which was roughly a billion dollars. The agreement called for it to be conservative, remain very liquid, and it also limited the amount that could be invested in any asset type. In 2007, JP Morgan quit sending timely account statements and quit providing straight answers on what was happening with the cash management account. It turns out it stuffed it full of toxic mortgage dreck. Blavatnik lost $100 million, which is just unheard of for that sort of vehicle. If JP Morgan had apologized and written a $20 million check, I suspect Blavatnik would have been satisfied. Instead, the bank continued to be uncooperative and Blavitnik sued, and he is not the litigious type.

At least on the surface, the bank’s strategy isn’t even remotely economically rational. Blavatnik is one of the 100 richest men in the world and had been a JPM private banking client, plus he does lots of deal and hence also generates a lot in the way of transaction fees. The bank simply tried to make the litigation as protracted and costly for him as possible: it put three costly lawfirms against Blavatnik’s one. I met with Blavatnik and his general counsel early on in the discovery process (Blavatnik had been a client roughly 20 years ago on an oddball acquisition he made in the US) and they made it clear then that even with the bank stonewalling on delivering information, what they had gotten so far was so damaging that they were unlikely to settle for much less than the amount they were seeking at trial. And they’ve just concluded trial.

Blavatnik spent $10 million on the lawsuit. JP Morgan has to have spent more given how many big ticket law firms it threw at the case. And it will still probably have to write a very large check. The bank increased its ultimate losses considerably. Settling after things got ugly but before Blavatnik felt he had to sue would still have been vastly cheaper for the bank. And for what purpose? To defer recognizing the losses by eighteen or twenty-four months? Is JP Morgan that desperate to manage earnings that it will engage in patently lousy “investments” (investing in litigating) to delay recognizing losses?

With the WaMu matter, we again have what looks to be a desperate attempt to delay loss recognition. It is hard to see how Slimin’ Dimon has a leg to stand on. Senator Levin, are you paying attention? The $6.2 billion in London Whale losses are similar in size to the range of likely losses that JP Morgan is trying to dump on the FDIC.

Now the background. Remember, JP Morgan bought WaMu from the FDIC in 2008 after the bank failed. The receivership wiped out the equity; the FDIC also, controversially, wiped out the subordinated debt as well (John Hempton has railed that this was unfair and unwarranted; Dimon’s desire to retrade the deal even with that concession should lead him to rethink that assessment).

The purchase and sale agreement is below.
Note Section 2.1:
Liabilities Assumed by Assuming Bank. Subject to Sections 2.5 and 4.8, the Assuming Bank expressly assumes at Book Value (subject to adjustment pursuant to Article VIII) and agrees to pay, perform, and discharge, all of the liabilities of the Failed Bank which are reflected on the Books and Records of the Failed Bank as of Bank Closing, including the Assumed Deposits and all liabilities associated with any and all employee benefit plans, except as listed on the attached Schedule 2.1, and as otherwise provided in this Agreement (such liabilities referred to as “Liabilities Assumed”). Notwithstanding Section 4.8, the Assuming Bank specifically assumes all mortgage servicing rights and obligations of the Failed Bank.
A colleague of mine took a look at the P&S agreement and some of the filings last summer. He’s normally understated, so for him to get this exercised is a sign of how barmy the JP Morgan argument is. From his e-mail (and note that the indents in his message is where he is citing the FDIC’s filing. Emphasis his):
I went to dinner with some Wall Street lawyers last week and they talked at length about how the new regulations create so much uncertainty in the mortgage market (such as the “qualified mortgage” definition) and this is preventing the mortgage and securitization markets from recovering. In reality, the biggest obstacle to the mortgage securitization market recovering is the tremendous uncertainty created for investors by MBS litigation – investors have no idea what they are on the hook for and how much it will cost to enforce their rights. BS litigation like what JPM is arguing in this WaMu case is a big cause of this litigation uncertainty. WaMu signed up for a bunch of deals and JPM signed up to succeed them, and now JPM is trying to weasel out of it with stupid legal arguments (though argued by expensive attorneys) whose only purpose seems to be to delay the obligation that is clearly JPM’s.

In my view, this case is another piece of evidence that bitching and moaning about onerous regulations by the banks is just a smokescreen to cover their own damaging and irresponsible behavior.

It’s really outrageous that JPM is arguing, on one hand, that it is entitled to a one-sided sweetheart deal from the FDIC with WaMu, while complaining, on the other hand, that government regulations are strangling the mortgage market.
The arguments made by both Deutsche Bank and the FDIC in this case are straightforward and sensible enough. JPM’s position, however, makes little sense. I’m inclined to think they are just trying to waste time (and kick the can down the road) without any actual hope of winning. It is fairly ironic that in one of the few cases where the trustee has been willing to act on behalf of investors, JPM has managed to successfully muddy the waters for 4 years and avoid any liability.

The FDIC is quite clear that JPM purchased the rights and liabilities of WaMu in the transaction. They argue JPM is being disingenuous (ie lying) by claiming that the rep repurchase obligations were not mature (technically, the did not represent any “Book Value”) at the time of the WaMu sale and so they shouldn’t be JPM’s problem. This seems like a pretty strange defense by JPM. (To be clear, Deutsche Bank brought the claims against the FDIC because JPM argued that the FDIC was entirely on the hook for the rep and warrant obligations).
DBNTC’s claims against FDIC Receiver should be dismissed in their entirety, because FDIC Receiver transferred all of WaMu’s liabilities and obligations under the Governing Agreements to JPMC. Under the Purchase and Assumption (“P&A”) Agreement1 that JPMC and FDIC Receiver entered into when the Office of Thrift Supervision (“OTS”) closed WaMu on September 25, 2008, JPMC acquired WaMu’s ongoing banking operations in a “whole bank” transaction, “purchas[ing] substantially all of the assets and assum[ing] all deposit and substantially all other liabilities” of WaMu, for a purchase price of $1.9 billion. P&A Agreement at 1, Art. VI. JPMC expressly agreed to “pay, perform, and discharge” all liabilities reflected on WaMu’s books and records as of September 25, 2008, including specifically “all mortgage servicing rights and obligations.” Id. § 2.1. JPMC purchased “all” the assets of WaMu, including specifically “all the mortgage servicing rights and obligations,” id. § 3.1, and “all rights of [WaMu] to provide mortgage servicing for others . . . and related contracts,” id. Schedule 3.2. Further, the assets were purchased subject to “all liabilities” affecting those assets, as provided in Section 2.1. Without question, JPMC succeeded to all of WaMu’s interests, rights, obligations, and liabilities under the Governing Agreements, which, according to DBNTC, are for each Trust an integrated set of agreements governing the transfer of loans into the Trust, the securitization of the loans in the Trust, the servicing of the loans, and the rights and obligations of all the parties to the transaction.

Now, JPMC is attempting to rewrite history. The unambiguous terms of the P&A Agreement, which the Court may construe as a matter of law, demonstrate that any and all of WaMu’s rights, obligations, and liabilities under the Governing Agreements were transferred to and assumed by JPMC. Accordingly, FDIC Receiver can have no liability to DBNTC for any obligation owed under the Governing Agreements, whether arising before or after WaMu’s closure, and all claims against FDIC Receiver should be dismissed under Rule 12(b)(6).
The FDIC helpfully points out to the court that JPM has told its shareholders, repeatedly, that it was assuming WaMu’s liabilities, including rep and warrant liabilities, in the transaction.
Notwithstanding the plain terms of the P&A Agreement and the many benefits that JPMC has received from the acquisition of WaMu’s assets, JPMC has denied assuming any of WaMu’s liabilities under the Governing Agreements.25See Am. Compl. ¶ 91 (“JPMC further contends that ‘all other liabilities of [WaMu], including the DBNTC liabilities, remain with [FDIC Receiver].’”) (quoting 8/25/10 letter from JPMC counsel to DBNTC counsel) (emphasis in original). JPMC’s public statements both before and after the WaMu transaction, however, belie this denial, and instead evince a clear awareness that those liabilities were reflected on WaMu’s books and records prior to its closure and transferred to JPMC along with all of WaMu’s rights, interests, and obligations under the Governing Agreements.
JPMC’s public filings after the P&A Agreement make repeated reference to its assumption of WaMu’s rights and responsibilities under the Governing Agreements. When discussing its accounting for the WaMu transaction in its 2008 Form 10-K, for example, JPMC noted that the liabilities it had assumed include WaMu’s “executory contracts and other commitments.” Elsewhere in that Form 10-K, in presenting data about its residential mortgage securitization activities, JPMC included the principal balances of the loans in securitizations sponsored by WaMu in a table displaying “the total unpaid principal amount of assets held in JPMorgan Chase-sponsored securitization entities . . . to which the Firm has continuing involvement” such as ongoing repurchase or indemnification obligations.

Indeed, in the “Risk Factors” section of a December 2009 prospectus supplement, JPMC forthrightly discussed its potential exposure resulting from its assumption of WaMu’s repurchase and indemnification obligations. Under the heading “Defective and repurchased loans may harm our business and financial condition,” JPMC stated:
In connection with the sale and securitization of loans (whether with or without recourse), the originator is generally required to make a variety of customary representations and warranties regarding both the originator and the loans being sold or securitized. We and certain of our subsidiaries, as well as entities acquired by us as part of the Bear Stearns, Washington Mutual and other transactions, have made such representations and warranties in connection with the sale and securitization of loans (whether with or without recourse), and we will continue to do so as part of our normal Consumer Lending business. Our obligations with respect to these representations and warranties are generally outstanding for the life of the loan, and relate to, among other things, compliance with laws and regulations; underwriting standards; the accuracy of information in the loan documents and loan file; and the characteristics and enforceability of the loan… Accordingly, such repurchase and/or indemnity obligations arising in connection with the sale and securitization of loans (whether with or without recourse) by us and certain of our subsidiaries, as well as entities acquired by us as part of the Bear Stearns, Washington Mutual and other transactions, could materially increase our costs and lower our profitability, and could materially and adversely impact our results of operations and financial condition.
This is a pretty amazing “gotcha”. Not only does the Purchase & Sale agreement pretty unambiguously leave JP Morgan on the hook for the representation and warranty liabilities, JP Morgan clearly told shareholders it was assuming representation and warranty liability with respect to WaMu.

It made more statements to that effect. For instance, in SEC reports discussing 2010 earnings:
….we and certain of our subsidiaries, as well as entities acquired by us as part of the Bear Stearns, Washington Mutual and other transactions, have made such representations and warranties in connection with the sale and securitization of loans (whether with or without recourse… Our obligations with respect to these representations and warranties are generally outstanding for the life of the loan, and relate to, among other things, compliance with laws and regulations; underwriting standards; the accuracy of information in the loan documents and loan file; and the characteristics and enforceability of the loan…. if a loan that does not comply with such representations and warranties is sold, we may be obligated to repurchase the loan and bear any associated loss directly, or we may be obligated to indemnify the purchaser against any such loss.
It again acknowledged its responsibility for the WaMu reps and warranties in a February 28, 2011 SEC filing for all of 2010. It wasn’t until 2012 that it tried backpedalling from this position, as even Deutsche Bank noted in court filings:
JPMC, by its own post-acquisition actions, evidenced an understanding that it is liable for all other liabilities reflected on WaMu’s books and records….JPMC’s own statements and actions were inconsistent with its current position, but very much consistent with the plain reading of the PAA advanced by the FDIC and the Trustee.
The reason to go into this case at such length is to puncture the myth that Dimon has managed to perpetuate. In a more sober time, the astonishing qualifications that JP Morgan’s auditors issued to its financial statements in the wake of the London Whale trading debacle would have finished most CEOs. But this is also a time in which people like Angelo Mozilo and Jon Corzine not only have not been prosecuted, but have most of the money they earned while driving their enterprises into the ditch intact. I strongly suspect that the reason Dimon has gotten away with so much is that he is running the ultimate too big to fail institution. JP Morgan’s standing as one of the biggest derivatives clearing shops makes it too critical to allow it to even wobble. But the fact that JP Morgan has wound up at such a critical financial nexus is not excuse to allow Dimon to remain so firmly attached to its helm.

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