c.2013 New York Times News Service

c.2013 New York Times News Service

To veterans of Wall Street, the details that emerged in last week’s criminal complaints against two former JPMorgan Chase traders didn’t exactly shock. Over the years, countless traders have misrepresented the values of the securities they hold, hoping that a market move will reverse a looming loss.

Still, the case against Javier Martin-Artajo and Julien Grout, two of the bank’s traders, has larger lessons for investors and regulators. One has to do with the risks inherent in opaque, over-the-counter markets, where securities’ prices can’t be seen and so can be easily manipulated. Another involves the fairly significant leeway that financial firms have in valuing the securities they trade and hold.

According to prosecutors in the Southern District of New York, Martin-Artajo and Grout hid or understated losses in credit derivatives trades held by JPMorgan Chase Inc.’s chief investment office during 2012.

Lawyers for both men say that they did nothing wrong and would be exonerated.

But the complaints against both men, laced with emails and transcripts of phone calls, indicate that the traders ignored the bank’s protocol for valuing the complex bets and chose instead to mark them in a way that would mask and minimize ballooning losses.

The bets were made on indexes that reflected the performance of a group of corporate debt obligations; the trader in charge of the portfolio had gambled that defaults among these debt issuers would rise. They did not.

It was an outsize bet. By the first quarter of 2012, the so-called synthetic credit portfolio had a total exposure of $157 billion, up from $51 billion in 2011. When the trade was finally and disastrously unwound, it cost the bank more than $6 billion in losses.

The exotic instruments that made up this portfolio did not trade on an exchange and so were harder to value than a stock, whose prices reflect actual market transactions. Because the credit derivatives traded privately, in a so-called dealer market, the traders had to get bids and offers from market participants to value the positions. Bids and offers are not the same as actual transaction prices, of course, but the standard procedure is to assign a value that is somewhere near the middle of the bids and offers.

When the trades went against them, the men deviated from that procedure to cover up some of the losses, prosecutors said.

“None of these trades were done on an exchange or exchangelike platform,” said Dennis Kelleher, president of Better Markets, a nonprofit organization that promotes the public’s interest in financial markets. “That’s how they were allowed to do two things — one, build up such a huge position with no one knowing and, two, misprice the securities.”

Indeed, Wall Street has fought to prevent the open trading of instruments like the ones at issue in the JPMorgan situation. Why? Profits are higher when instruments trade one-on-one rather than on an exchange. Customers who don’t know the price of a complex instrument can be easily overcharged.

Despite Wall Street’s objections, the Dodd-Frank law now requires many of these derivatives to be traded on exchanges or similar platforms. When the rules go into effect in coming months, prices and positions will be more apparent, reducing the possibility and surprise of a whalelike loss.

While the regulations have been written, there are still ways for Wall Street to water them down, like seeking certain exemptions, Kelleher said, And even the toughest laws and tightest rules can’t protect the financial system and taxpayers from risks posed by a major bank with lax internal controls.

One of the failures noted by prosecutors in the JPMorgan cases was the bank’s reliance on a single person in its valuation control group to serve as an independent check. That person was responsible for monitoring the values assigned to the chief investment office portfolio, which held tens of billions of dollars in positions.

“In practice,” the complaint said, the control group “was neither independent nor rigorous.”

The individual designated to police the portfolio valuations looked at them only once a month, for example. And those intermittent reviews relied heavily on the traders for information on the market and price quotations, prosecutors said. The impact: The valuation control group tolerated prices that were outside the bid-offer spreads.

In the aftermath of the mess, officials at JPMorgan say the bank has significantly ratcheted up its risk management. For example, it has created an oversight and control group whose staff reports to the company’s co-chief operating officers. Every one of the bank’s business lines will be represented in that group.

Mark Kornblau, a JPMorgan spokesman, also said the bank’s valuation control group had been completely revamped with additional staff members and a new governance structure that brings greater consistency and regimentation.

But these institutions and their exposures are so enormous and interconnected that even insiders apply guesswork when assessing exotic positions.

The most illiquid of these holdings, including the kinds of derivatives that wreaked havoc in the chief investment office, fall into a category known in industry parlance as Level 3 assets.

In the valuation hierarchy, Level 1 assets are easy to assess. They include U.S. Treasury securities and listed stocks. Level 2 is a bit trickier and includes mortgage-backed securities.

Level 3 securities trade infrequently and don’t have readily observable values, allowing bankers the most leeway in their valuations. Since the end of last year, JPMorgan has reduced its Level 3 assets by one-third. At the end of June, regulatory filings show, the net value of these assets was $65.7 billion, or 2.8 percent of the bank’s total assets.

JPMorgan has “well-documented processes for determining fair value,” its most recent quarterly filing notes. But it also says that such determinations require “the application of judgment.”

The bank and its executives have been deeply embarrassed by the trading fiasco and the internal failures of judgment it exposed. They have learned their lesson, they say.

Investors surely hope so. Because while it is possible to trust these mammoth institutions and what they say their holdings are worth, the verifying remains all too hard.