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Why JPMorgan's 'London Whale' was set free

The most fascinating thing about the government's charge that JPMorgan Chase employees committed fraud in connection with the bank's $6 billion trading loss, and the one that will have the largest reverberations for Wall Street, is not who is being charged, but who isn't.

Ina Drew, the long-time head of the chief investment office and the person who pushed the bank to take on more risk and was well aware of the trades, does not stand accused of any wrongdoing. (Why not charge her with failure to supervise?) Nor is JPMorgan's CEO Jamie Dimon, who told investors the issue of the London Whale was "a tempest in a teapot" even after he was alerted to the size of trade, if not an accurate picture of the losses. Dimon also signed off on JPMorgan's faulty books, which eventually had to be restated, something Sarbanes Oxley was supposed to hold executives accountable for. Nor are any of the bank's multiple risk officers who signed off on the change in the risk model that allowed the London Whale's ill-fated trade to get bigger, even as the bank's books appeared to show that JPMorgan was reducing its trading risks.

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Also getting off mostly scot-free is JPMorgan (JPM). The SEC says its investigation is continuing. And regulators have already ordered the bank to improve its risk controls. But it appears JPMorgan is looking at a minor slap on the wrist.

And remember the London Whale himself, Bruno Iksil, the actual architect of the ill-fated trades? Yeah, he's off the hook as well.

The Justice Department and the SEC's cases against Javier Martin-Artajo and Julien Grout, the two who are being charged, give an amazing window into what it's like to be a trader these days on Wall Street, especially the ones who are responsible for multi-billion dollar portfolios of the market's riskiest stuff. Martin-Artajo was Iksil's direct boss. Grout worked under Iksil and was responsible for valuing Iksil's portfolio, computing the gains or losses.

The conversations detailed in the government's complaints are not what you would expect from three guys in the heat of the market, facing the most difficult trade of their careers. In early 2012, when the losses appeared to be mounting, there was no discussion by any of the three about what bonds or derivatives they might sell or buy to minimize their losses -- also known as trading. In fact, Martin-Artajo seems to be driven by a desire to keep the synthetic portfolio, which had grown by this time to have a notional value of $157 billion, as is for as long as possible. That is not a trade.

Instead, according to the court filings, the three traders spend a lot of time (all of their time?) talking about valuations and marks. What are the trades they have worth, and how can they make the losses they've got look as small as possible. It starts off as minor tweaking. By the end, Grout is maintaining a spreadsheet showing the traders' actual losses are as much as $800 million more than what they are reporting up the chain. In one telling moment, on the last day of the first quarter, Martin-Artajo tells Grout that he wants to show a daily loss of just $200 million, even though it's likely the portfolio had sunk that day alone much more than that. When Grout does this, Martin-Artajo goes back and asks whether they can get the loss number down to $150 million. The daily loss they end up reporting: $138 million.

Late in the game a JPMorgan risk officer does catch up with Martin-Artajo and asks him to explain the way the portfolio is marked, to which Artajo responds basically, "Hey, I ain't no accountant." And that you know is a pretty funny excuse because all these guys seem to be doing is accounting, but not actually a legal one.

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At some point along the way, Iksil jumps ship. According to the government's case, Iksil breaks with Martin-Artajo and starts reporting larger losses than Martin-Artajo wants to acknowledge to others at the bank. And he tells the other two traders that it's time to come clean. That, along with the fact that Iksil is cooperating with the government, appears to be why Iksil is not being charged.

Ironically, Grout was the first of the three to warn that Iksil's derivative trades could produce huge losses. In early January, Grout drew up a plan for the bank to get out of the trades, but it would end up creating a $500 million loss. Iksil and Martin-Artajo told him no thanks.

At the heart of it, the government's case is about traders hiding their losses. And back in late 2011, that's exactly what Iksil did. He had a portfolio of bets, meant at least in name to protect the bank's loan book, that would pay off if a bunch of companies defaulted. But the U.S. economy was improving and that wasn't happening. So Iksil's trades were becoming costly for the bank.

So Iksil came up with a way to keep the trade on, but magically make it profitable. He did that by taking on a massive amount of offsetting bets on a slightly different index to make his slowly losing trading into one that was cashflow positive, but also likely pay off if suddenly companies stopped paying their loans and the economy blew up. For all the bashing Iksil has taken in the past year and a half for the $6 billion blunder, the trade itself was in a way brilliant, but it also opened the bank up to a lot more risk.

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And it shouldn't have been allowed. But Iksil's superiors -- including Drew, and in part Dimon -- signed off on new risk models that not only made the vastly larger portfolio not acceptable, but appear like it was actually a smaller bet, at least risk-wise. The Senate's investigation into the trading loss criticized JPMorgan for not telling investors that it changed its risk model, not actually for changing its model. JPMorgan and other banks change their models all the time. It's allowed.

The difference here is that Iksil and Drew and the others at JPMorgan not facing charges hid the losses in the bank's portfolio in a regulatory compliant kind of way. Martin-Artajo and Grout, on the other hand, did it in a lying kind of way. The end result of both techniques were the same: Investors and regulators were misled as to the size of JPMorgan's potential losses.

There will be some griping as to why Iksil and others weren't charged as well. But that's not the fault of the Justice Department or the SEC. Or really Iksil's either. He knew when his colleagues had crossed over from bending the rules of the market to breaking the laws of the land, and he wasn't willing to follow. That's not quite righteous, but it isn't wrong either.

What's really at fault is our still overly complicated, loophole-ridden financial regulations that allow banks to hide the huge risks they take all the time that are subsidized by the government and that taxpayers would have to pay for if they go colossally bad. In the end, the message to Wall Street of Jamie and the Whale could be, unfortunately, that you can still do that and stay out of jail, as long as you are clever about it.