'CIO Was a Mistake and We Are Sorry': JPMorgan's Dimon (Update 1)

Updated to reflect NY City Comptroller comment on clawbacks.

NEW YORK ( TheStreet) -- After reporting mixed, but generally better than expected second quarter earnings, JPMorgan Chase ( JPM) and its chief executive Jamie Dimon are trying to distance themselves from the reputational and trading disaster that was its Chief Investment Office, a unit created before the financial crisis to hedge the bank's risk and invest excess deposits.

"CIO was a mistake and we are sorry," Dimon told investors in a special two-hour call held to disclose what now stands as a $5.8 billion CIO unit trading loss.

On Friday, Dimon said that the unit will no longer invest in complicated credit derivatives, which precipitated the loss, and that the bank will clawback two years of pay for three London-based executives who are leaving the bank.

Dimon refuted the notion that he was instrumental in building the CIO unit. "I knew about it, but I had no role in creating it," Dimon said in a call with the media. JPMorgan said in multiple disclosures that the unit was created as a macroeconomic hedge to the firm's various credit risks.

Fielding a flurry of concerns on the trading loss, and even questions about whether JPMorgan would consider a separation of its investment banking unit from lending business, Dimon emphasized that the CIO unit failed in its execution, noting that its ability to trade in illiquid and risky credit products was a mistake from its start in 2007.

Just how big of a mistake remains to be seen, even after JPMorgan disclosed that losses at the unit have grown to $5.8 billion in total, clouding the bank's 2012 earnings.

The nation's largest bank by assets said on Friday that it would restate first quarter earnings by $459 million, according to a filing with the Securities and Exchange Commission, as a result of a what it characterized as an attempt to hide losses at its CIO unit. The decision to restate earnings was made on Thursday, said chief financial officer Douglas Braunstein, on a media call.

"The firm has recently discovered information that raises questions about the integrity of the trader marks and suggests that certain individuals may have been seeking to avoid showing the full amount of the losses in the portfolio during the first quarter," JPMorgan said in its restatement filing on Friday.

While the prospect that intentional loss avoidance looms as a potential ongoing reputational risk, JPMorgan is taking steps to essentially disband the unit.

JPMorgan said that its CIO unit will no longer trade credit products and will focus on investing excess deposits in safer assets, it also said it will clawback two years of pay for three London-based executives from the unit who are leaving the bank. Dimon said that the CIO's former head Ina Drew voluntarily withdrew most of her compensation over two years, and added that he had "enormous respect" for the longtime executive, who resigned in May.

According to the 2010 Dodd Frank Wall Street Reform and Consumer Protection Act, banks are now required to recover current and former executive bonuses, in the event of an earnings restatement that would have impacted discretionary pay. Clawback provisions can be triggered for up to three years after a restatement.

"As long-term shareowners, we are pleased by JPMorgan's commitment to aggressively exercise its clawback policy," said New York City Comptroller John Liu in a statement. "On the other hand, it is disheartening that the bank now states its losses are much higher than the $2 billion it first reported, leaving shareowners to wonder how deep this hole will turn out to be." The New York State Common Retirement Fund holds over 14.6 million JPMorgan shares, according to filings with the Securities and Exchange Commission as of March 31.

Going forward, the remaining position known as the 'London Whale' will be maintained at JPMorgan's investment bank and won't be disclosed unless they have a material impact on earnings, the company said in a media call.

Year-to-date, JPMorgan has lost $5.8 billion from its CIO unit, with $4.4 billion in pre-tax losses coming in the second quarter and another $1.4 billion in the first. CEO Dimon said that future losses could be between $800 million to $1.7 billion, while noting that such calculations aren't a forecast.

"Since the end of the first quarter, we have significantly reduced the total synthetic credit risk in CIO - whether measured by notional amounts, stress testing or other statistical methods," said Dimon of the CIO unit's size in a statement. "Importantly, we have put most of this problem behind us and we can now focus our full energy on what we do best - serving our clients and communities around the world."

" It is a sign that the situation is under control and they believe that they can manage the business through the ordinary course of business," says Peter Tchir, founder of TF Market Advisors and a former credit derivative trader for Deutsche Bank, UBS and RBS.

On a call with the media, Mike Cavanagh -- an executive charged with leading an investigation of the CIO unit as its losses were recognized by JPMorgan in May -- said that the bank has investigated tens of thousands of hours of voice records and millions of emails regarding the CIO's operations. After that review, Cavanagh said, "we decided to take a conservative step and restate earnings," although he said trader marks were within bid/ask spreads.

Cavanagh said the restatement was an accounting decision and not one based on revelations of fraud.

Part of the losses in the bank's CIO unit also were a result from traders and executives dismissing risk limits as a position in illiquid credit products soured, Cavanagh noted in his review.

After taking a large long position in investment grade credit, JPMorgan said that its risk management failures stemmed from a subsequent short trade in structured credit tranches -- now known as the 'London Whale.' As the position soured, the CIO unit changed its risk assesment models and underestimated potential losses, JPMorgan said.

An April review made by the CIO unit on its position ahead of JPMorgan first quarter earnings showed quarterly loss expectations of just $250 million and actually a 'bias' toward a $350 million gain, said Cavanagh. Actual losses that JPMorgan says may reach $7.5 billion show that the assesment was misleading. After losses escalated in April, JPMorgan launched a 'bottom-up' review of the position, which uncovered flawed risk models and precipitated the banks' disclosure of a loss in May.

The accounting review, "left us with questions regarding the traders' intent,' said CFO Braunstein a the media call, of JPMorgan's decision to restate earnings. Braunstein noted that JPMorgan's restatement does not impact year-to-date revenue, net income or capital.

JPMorgan shares rallied over 5% in early trading to $36.04, stemming a 15% plus share loss since the bank first disclosed its CIO loss in May.

-- Written by Antoine Gara in New York

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