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JPMorgan Goes Rogue

NEW YORK ( TheStreet) -- JPMorgan Chase's (JPM - Get Report) $6.2 billion "London Whale" trading loss is looking more like a rogue trade, after the Department of Justice on Wednesday filed criminal charges against two former traders for allegedly fraudulently mis-marking a portfolio the bank said was intended to hedge its credit risk.

The DoJ's new scrutiny into the trading loss and two criminal indictments filed against former traders Javier Martin-Artajo and Julien Grout reveal activity that casts the bank's overall risk management capabilities in doubt. What once looked like a backfired hedging strategy involving complex credit derivatives and structured products now looks more like a rogue trade that went unreported by risk management staff and upper management.

Beyond the criminal complaints, which raise the prospect of significant prison time for Artajo and Grout, the DoJ's indictment brings to light new concern about the management of America's largest bank by assets and about the transparency of Wall Street financial reporting.

As was the case in other large rogue trades such as Jerome Kerviel's 4.9 billion euro trading loss at Societe Generale (SCGLY) or Kweku Adoboli's trading loss of 2.3 billion pounds at UBS (UBS), JPMorgan's independent risk management staff was unable to curtail allegedly fraudulent profit and loss reporting on a trading position that, at times, exceeded $100 billion.

JPMorgan's 'London Whale' loss, like those created by Kerviel and Adoboli's rogue trades, reintroduces the prospect that investment banks on Wall Street are unable to account accurately to investors the risks that their trading staff are taking.

In all three instances, indictments show that key risk management personnel in each firm's product control, accounting and operations units did not spot or report large trading discrepancies that were material to ordinary shareholders.

SocGen's Kerviel argued fruitlessly that the bank's management knew of what prosecutors said was a $100 billion rogue Exchange Traded Fund (ETF) trade. Adoboli said UBS fostered a culture of irresponsible risk taking that birthed his concealed trades. It is unclear how either of JPMorgan's traders will respond to the DoJ's charges, or if they will claim JPMorgan management instructed or knew about their alleged manipulated marking of a trading position that peaked at $157 billion in size.

The bigger issue is the extent to which financial statements coming from the trading operations of America's largest banks are subject to unreported trading and the obfuscation of losses. The DoJ's complaint raises very large red flags for JPMorgan, once thought of as a top risk manager of Wall Street after it survived the financial crisis without reporting major losses.

The U.S. Attorney's office said in a criminal indictment Wednesday that as a portfolio of structured credit instruments held in JPMorgan's so-called Chief Investment Office soured, Artajo and Grout attempted to conceal losses by fraudulently marking their trading positions.

At the portfolio's largest size in March of 2012, an independent review made by JPMorgan's investment bank indicated that profit and loss statements had been misstated by about $767 million. When the extent of JPMorgan's trading issues were finally revealed, the bank was forced to restate its first-quarter 2012 results to show net income of $4.924 billion, declining from the previously reported from $5.383 billion. Revenue, the bank said, was overstated by $660 million.

The DoJ's indictment provides some new color into the trading loss and communications between Artajo, Grout and the London Whale, after a Senate Subcommittee on Investigations report detailed the loss in March of this year.

Most importantly, the indictment indicates that JPMorgan's Valuation Control Group (VCG), a team designated to independently verify the profit and loss statements of the bank's trading operations, had failed to rectify Artajo and Grout's alleged manipulation.

In February of 2012, the DoJ's complaint states that there was discrepancy of about $95 million between Artajo and Grout's trading marks and those independently arrived at by the one-person VCG team. Instead of reporting the pricing difference to JPMorgan's CIO head or the bank's overall management, the VCG staff was influenced by Artajo to report no discrepancy or accounting adjustment whatsoever, according to the DoJ's complaint.

A near-$100 million adjustment likely would have garnered the attention of the bank's upper management.

It is also unclear whether other communications such as an email chain in which the CIO's head trader voiced concerns about the portfolio's profit and loss reporting was seen by upper management.

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