JPMorgan, Madoff, And Why No One Dared Ask "The Cult" Any "Serious Questions As Long As The Performance Is Good"
As was well-known in advance, today JPMorgan entered into a deferred prosecution agreement with the DOJ, whereby Jamie Dimon's enterprise, where legal fees and litigation charges are no longer "non-recurring" items but a cost of doing business, paid $1.7 billion (non tax-deductible) to settle all criminal charges that it was aware well in advance that Madoff was a ponzi scheme and did nothing to alert authorities or the general public. What was less known is just how acutely JPM was aware of the developments at Madoff's pyramid scheme, and that while apparently JPM was not convinced enough of Madoff's criminality to alert regulators using "Suspicious Activity Reports", it had seen enough to quietly reduce its exposure with the Ponzi from $369 million at the beginning of October 2008, or just after the Lehman collapse, to just $81 million at the time of Madoff's arrest.
There is much more on the sequence of events in JPM's realization that Madoff was a fraud (see filing below), but the punchline is the following extract from lengthy internal email in October 2008 by a JPM trading analyst that raised concerns about Madoff's investment returns, and which explains why frauds are never caught until it is too late: "The October 16 Memo ended with the observation that: "[t]here are various elements in the story that could make us nervous," including the fund managers "apparent fear of Madoff, where no one dares to ask any serious questions as long as the performance is good.... personnel at one feeder fund seem[ed] very defensive and almost scared of Madoff. They seem unwilling to ask him any difficult questions and seem to be considering his 'interests' before those of the investors. It's almost a cult he seems to have fostered."
And there you have the biggest failing of modern capital markets in a nutshell: nobody dares to ask any serious questions as long as the performance is good, and where there a cult-like following of the ringleader (see Central Banks). By the time the performance turns bad, and all the overdue questions are finally asked, it is always too late, and the cult blows up.
What is strangely missing in today's action by the DOJ, which slams JPM (rightfully), is any mention of the SEC, you know - the regulators - those people whose job it was to catch Madoff in the act. Because while pocketing $1.7 billion from JPM may be an enjoyable exercise in populist propaganda for an administration that suddenly realizes it has created an unprecedented social class hatred schism and needs to punish bankers on a recurring, monthly basis, where is there any mention of the SEC's fault for being completely oblivious to what JPM uncovered on its own? And yes, JPM did not alert the authorities, but at the end of the day its fiduciary obligations are first and foremost to its shareholders, which it executed, and not to a gullible public which opted for yet another "get rich quick" scheme, hoping foolishly that the SEC has some idea what it is doing.
Finally, we can't help but wonder: when the current bubble to end all bubbles implodes, who will be punished for failing to point out that the emperor is naked, and that it is the cult of the Federal Reserve and its central bank peers around the globe, that have created the biggest Ponzi scheme the world has ever seen?
For those curious about the details of how JPM succeeded in realizing what the SEC failed to grasp, despite numerous vocal warnings from Harry Markopolos, read on.
From U.S. v. JPMorgan Chase - Deferred Prosecution Agreement Packet, Exhibit C
October 2008: JPMC Concludes In A Report To U.K. Regulators That Madoff s Returns Are Probably Too Good To Be True
In mid-September 2008, following the collapse of Lehman Brothers and growing concerns about counter-party risk, JPMCs Head of Global Equities directed investment bank personnel to substantially reduce JPMC's exposure to hedge funds, which had increased following JPMCs March 2008 acquisition of Bear Stearns. This directive was reiterated by the Investment Bank Risk Committee on October 3, 2008. Acting at the direction of the Head of Global Equities, the Equity Exotics Desk began analyzing which hedge funds to reduce exposure to, including by directing the Desk's due diligence analyst (the "Equity Exotics Analyst") to scrutinize investments in various hedge funds, including the Madoff feeder funds. The Equity Exotics Analyst conducted this due diligence by, among other things, analyzing the reported strategy and returns of Madoff Securities, speaking to personnel at Madoff feeder funds and financial institutions administering Madoff feeder funds, and unsuccessfully seeking from the feeder funds and administrators documentary proof of the assets of Madoff Securities.
On October 16, 2008, the Equity Exotics Analyst wrote a lengthy e-mail to the head of the Equity Exotics Desk and others summarizing his conclusions (the "October 16 Memo"), The October 16 Memo described the inability of JPMC or the feeder funds to validate Madoff s trading activity or custody of assets. The October 16 Memo noted that the feeder funds were audited by major accounting firms, which had issued unqualified opinions for 2007, but questioned Madoff s "odd choice" of a small, unknown accounting firm. The October 16, 2008 Memo reported that personnel from one of the feeder funds "said they were reassured by the claim that FINRA and the SEC performed occasional audits of Madoff," but that they "appear not to have seen any evidence of the reviews or findings," The October 16 Memo also questioned the reliability of information provided by the feeder funds and the willingness of the feeder funds to obtain verifying information from Madoff. For example, the memo reported that personnel at one feeder fund "seem[ed] very defensive and almost scared of Madoff. They seem unwilling to ask him any difficult questions and seem to be considering his 'interests' before those of the investors. It's almost a cult he seems to have fostered." The Equity Exotics Analyst further wrote that there was both a "lack of transparency" into Madoff Securities and "a resistance on the part of Madoff to provide meaningful disclosure."
The October 16 Memo ended with the observation that: "[t]here are various elements in the story that could make us nervous," including the fund managers "apparent fear of Madoff, where no one dares to ask any serious questions as long as the performance is good." The October 16 Memo concluded: "I could go on but we seem to be relying on Madoff s integrity (or the [feeder funds'] belief in Madoff s integrity) and the quality of the due diligence work (initial and ongoing) done by the custodians . . . to ensure that the assets actually exist and are properly custodied, If some[thing] were to happen with the funds, our recourse would be to the custodians and whether they had been negligent or grossly negligent."
The Head of Due Diligence responded by complimenting the Equity Exotics Analyst on the October 16 Memo, making reference to other long-running fraud schemes, and suggesting in a joking manner that they should visit the Madoff Securities accountant's office in New City, New York to make sure it was not a "car wash."
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JPMC's Redemptions From Madoff Feeder Funds
On October 16, 2008 — the day of the October 16 Memo — an Equity Exotics employee requested by e-mail a "list of all external trades and the exact counterparty trade" for each of the Madoff-related feeder funds, noting that "[t]le list needs to be exhaustive as we may be terminating all of these trades and we cannot afford missing any." The Equity Exotics Desk, which had already placed redemption orders for approximately $78 million from the Madoff feeder funds between October 1 and October 15, thereafter sought to redeem almost all of its remaining money in the Madoff feeder funds.
In addition to redeeming its positions in the Madoff feeder funds, JPMC sought, with the assistance of legal counsel, to cancel or otherwise unwind certain of the structured products issued related to the performance of the Madoff feeder funds. In an attempt to unwind these transactions, JPMC told the distributors of the Madoff notes that it was invoking a provision of the derivatives contract that enabled it to de-link the notes from the performance of the Madoff feeder funds if JPMC could not obtain satisfactory information about its investment. For example, in a letter dated October 27, 2008, JPMC warned that it would declare a "Lock-In Event" under the terms of the contract unless the recipient — a distributor that the Equity Exotics Analyst had spoken to as part of his due diligence underlying the October 16 Memo — could provide the identity of all of Madoff Securities' options counterparties by 5:00 PM the following day.
In the Fall of 2008, the amount of JPMC's position in Madoff feeder funds fell from approximately $369 million at the beginning of October 2008 (which was down slightly from its high-water mark of $379 million, in July 2008) to approximately $81 million at the time of Madoff s arrest, on December 11, 2008 — a reduction of approximately $288 million, or approximately 80% of JPMC's proprietary capital invested as a hedge in Madoff feeder funds. During the same period, JPMC spent approximately $19 million buying back Madoff-linked notes and approximately $55 million to unwind a swap transaction with a Madoff feeder fund that eliminated JPMC's contractual obligation with respect to those structured products. When Madoff was arrested, JIPMC booked a loss of approximately $40 million, substantially less than the approximately $250 million it would have lost but for these transactions.
At the same time, the Equity Exotics Desk also held through the time of Madoff s arrest a gap note providing JPMC with $5 million in protection if the value of a Madoff feeder fund collapsed completely. In a November 28, 2008 e-mail, an Equity Exotics banker declined a third party's request to buy this protective gap note from JPMC, and described the gap note as being "as of today. . . very valuable" to JPMC.
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