Madoff's Legacy: How the JPMorgan Chase Suit Relates to the Financial Crisis

Last Updated Feb 4, 2011 2:13 PM EST

To observe the financial crisis in microcosm, see the allegations that J.P. Morgan Chase (JPM) kept Bernie Madoff as a banking customer despite suspecting for years that he was crooked. It's all there: Wall Street duplicity and greed; managerial negligence; financial hocus pocus; indifference to risk. And hovering in the background, bumbling securities regulators watching this tragicomedy unfold. As the Financial Crisis Inquiry Commission might have it, this man-made catastrophe was avoidable.

Not by coincidence, that pattern is visible in all of the era's defining scandals. Banks knew that the mortgage loans they were stuffing into CDOs were worthless, for instance. That's because their own bankers and risk managers told them so. Financial firms knew that the sterling credit ratings bestowed on securities were fictional. And why not -- they'd ordered up those AAAs themselves. Bankers knew they were breaking the law in "robo-signing" homeowners out of their houses, since their own legal departments were involved in the racket.

JPMorgan, which was Madoff's main banker for more than 20 years, says it's innocent. Perhaps. What remains to be seen is whether Irving Picard, the court-appointed trustee in charge of recovering money for Madoff's victims, can prove that the company was "complicit" in the fraud or merely incompetent. The charges parallel a suit Picard filed in November against Swiss bank UBS. In both cases, the financial firms are said to have been instrumental in helping Madoff perpetrate fraud.

Red flags, black box
According to the lawsuit, internal JPMorgan emails dating back to 2006 -- more than two years before Madoff's Ponzi scheme was revealed -- raised concerns about his accounts. By then, suspicions on Wall Street were growing that he was engaged in illegal activity. Certainly, there were numerous signs that something was amiss, including that Madoff's investment strategy was a "black box" even to his own customers. The major red flags:

  • Madoff's investment returns were too consistently good to be true, even in a down market
  • His firm refused to disclose any information about its trading techniques or investment strategy
  • Madoff also would not provide any information on his purported over-the-counter counterparties
  • The auditor for Madoff's investment firm was a small, unknown firm
  • Administrators for the "feeder" funds that invested money with Madoff couldn't independently confirm their account information
  • Feeder funds refused to cooperate with JPMorgan efforts to perform due diligence on Madoff's firm
What was in it for JPMorgan? One guess. Picard says the company earned more than $500 million in fees and profits from handling Madoff's business. Along with serving as his banker, JPMorgan sold structured financial products linked to the feeder funds that invested with his firm. That business, it's worth noting, appears to have led other investors to sink money into Madoff's fund. Even after bank personnel had raised concerns about Madoff, the company in 2007 planned to greatly expand this business, according to the suit.

When JPMorgan bailed
As the NYT describes the situation within JPMorgan at the time:

What emerges is a sketch of an internal tug of war. One group of senior Chase bankers was pursuing profitable credit and derivatives deals with Mr. Madoff and his big feeder-fund investors, the hedge funds that invested their clients' money exclusively with him. Another group was arguing against doing any more big-ticket "trust me" deals with a man whose business was too opaque and whose investment returns were too implausible.
"Tug of war" may be too generous in characterizing what the suit alleges was going on within JPMorgan. Because if Picard is right, the company repeatedly turned a blind eye to the suspicious activity. It wasn't until the fall of 2008 that JPMorgan, by then coping with the effects of the housing crash, took action -- not by contacting the authorities, but by withdrawing most of the $276 million the bank had invested in Madoff's funds. As for the JPMorgan clients who bought structured investments tied to Madoff, they seem to have been left high and dry.

After Madoff's arrest in December of that year, one undisclosed JPMorgan employee wrote:

We've got a lot wrong this year but we got this one right at least -- I said it looked too good to be true on that call with you in Sep. Despite suspecting it was dodgy I am still shocked to see this happen so suddenly. I guess it's true that when the tide goes out you see who is swimming naked.
That doesn't look good. JPMorgan's strongest defense, as is common in complex cases of financial fraud, may be that it's hard to prove intent. That can be the difference between conceding the company should've known that Madoff was dirty and admitting that it was complicit in fraud. Not surprisingly, that's also Wall Street's broader defense against charges it helped engineer the financial crisis.

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    Alain Sherter covers business and economic affairs for