JPMorgan Chase & Co. could have spotted trouble at its chiefinvestment office long before traders there racked up at least $2billion in losses. One reason it didn't: Chief Executive OfficerJamie Dimon.

Dimon treated the CIO differently from other JPMorgandepartments, exempting it from the rigorous scrutiny he applied torisk management in the investment bank, according to two people whohave worked at the highest executive levels of the firm and havedirect knowledge of the matter. When some of his most senioradvisers, including the heads of the investment bank, raisedconcerns about the lack of transparency and quality of internalcontrols in the CIO, Dimon brushed them off, said one of thepeople, who asked not to be identified because the discussions wereprivate.

Dimon's actions contrast with his reputation as a risk-aversemanager who demands regular and exhaustive reviews of every cornerof the bank. While Dimon has said he didn't know how dangerous betsinside the CIO had become, the loss on those trades calls intoquestion whether anyone can manage a financial empire as vast asJPMorgan, which became the biggest U.S. lender last year and nowhas more than $2.3 trillion in assets, larger than the economies ofBrazil or the U.K.

“These institutions are too big to manage because even the bankthat was considered to be the best-managed turns out to have had asignificant glitch,” said Gary Stern, a former president and CEO ofthe Federal Reserve Bank of Minneapolis and co-author of the 2004book “Too Big to Fail: The Hazards of Bank Bailouts.”

The trading breakdown has undermined Dimon's authority as acritic of regulatory efforts to curb speculation by deposit-takingbanks, and triggered government probes in the U.S. and the U.K. Italso cost Chief Investment Officer Ina R. Drew, one of the mostpowerful women on Wall Street, her job. JPMorgan shareholders haveseen about $30.1 billion of market value wiped out since Dimondisclosed the loss.

Dimon may have to account for his decisions as soon as tomorrow,when he's scheduled to testify about JPMorgan's trading loss beforea Senate committee in Washington. The senators, led by South DakotaDemocrat Tim Johnson, may ask Dimon why he didn't ensure that thechief investment office's risk managers kept pace with the natureof the unit's business.

Dimon, 56, declined to comment for this article.

The CIO's mission includes investing deposits the bank hasn'tloaned. Over the past four years, assets controlled by the unitballooned fivefold to $374.6 billion in the first quarter, makingit one of the largest money managers on Wall Street. Yet the unitwas ill-equipped to handle the size and complexity of itscredit-derivative portfolio, according to two former CIO executivesand one current executive.

L imits Ignored

As Dimon encouraged the CIO to take more risk in search ofprofits, the unit raised limits on positions and sometimes ignoredthem, the former executives said.

At the same time, the position of chief risk officer inside theCIO was a revolving door, with at least five executives holding thejob in six years, according to people familiar with the matter.Irvin Goldman, appointed in February and replaced in May, had beenfired in 2007 by brokerage Cantor Fitzgerald LP for money-losingbets that led to a regulatory sanction of the firm, said threepeople with knowledge of the matter. Goldman, 51, wasn't directlyaccused of wrongdoing.

The division's London team built up a book of credit derivativesbeginning in 2008 that became so large by late 2010 that employeescouldn't unwind it without roiling the markets or incurring largelosses, according to current and former executives.

Risk management at the CIO was a world of its own: This year itstraders valued some of their positions at prices that differed fromthe investment bank, people familiar with the situation have said.One trader built up positions in credit derivatives so large andmarket-moving he became known as the London Whale. It was thosebets on credit-default swaps known as the Markit CDX North AmericaInvestment Grade Series 9 that backfired and forced JPMorgan todisclose the trading loss.

While Dimon allowed risks inside the CIO to mount, members ofhis board lacked the experience to police it. None of the threepeople on the board's risk-policy committee has worked as a bankeror had any experience on Wall Street in the past 25 years, and oneis a museum director.

Dimon's push to take greater risks in the chief investmentoffice, first reported by Bloomberg News on April 13, began in2005, not long after New York-based JPMorgan completed itsacquisition of Bank One Corp. and he became CEO.

He created the CIO, elevated Drew from treasurer to chiefinvestment officer, had her report directly to him and encouragedher department, which had invested mostly in government-backedsecurities, to seek profit by speculating on higher-yielding assetssuch as credit derivatives, according to more than half a dozenformer executives. Sometimes Dimon suggested positions, such asdirectional bets on economic trends or asset classes, one currentexecutive said.

“We want to ramp up the ability to generate profit for thefirm,” David Olson, a former head of credit trading for the CIO inNorth America, recalled being told by two executives when he washired in 2006. “This is Jamie's new vision for the company.”

Bank of America Corp., Citigroup Inc. and Wells Fargo & Co.,the next three largest U.S. banks, say their corporate investmentoffices follow more conservative strategies and don't tradecredit-default swaps or indexes linked to the health of companies,as JPMorgan is said to have done.

Surging Profits

In 2006, Drew hired Achilles Macris, 50, a former co-head ofcapital markets at Dresdner Kleinwort Wasserstein, to overseetrading in London and carry out Dimon's mandate to generate greaterprofits, three former employees said. When JPMorgan acquired BearStearns Cos. and Washington Mutual Inc. at fire-sale prices in 2008and with government support, the CIO's portfolio more than doubledto $166.7 billion from $76.2 billion the previous year.

Profits surged as assets swelled. The group started making moreexotic trades, betting against an index of subprime mortgage bondsin 2007 that resulted in a roughly $1 billion profit that year,according to one former CIO executive and another person briefed onthe trade. The following year, the corporate division, whichincludes CIO and treasury results, earned $1.5 billion, comparedwith a net loss of $150 million in 2007. Net income for thedivision was $3.7 billion in 2009.

As large as those numbers were, they understated the CIO's realprofitability. Because Drew, 55, and her traders invested on behalfof JPMorgan's deposit-taking businesses, some of the income theygenerated flowed to other departments, such as the retail bank.Macris's team in London, running a portfolio of as much as $200billion in trades, had a profit of $5 billion in 2010 alone, morethan a quarter of JPMorgan's net income that year, one formerexecutive said.

The CIO may have contributed as much as 80 cents a share to thecompany's earnings, according to estimates by Charles Peabody, ananalyst at Portales Partners LLC in New York.

“The issue that is still being underestimated is how much oftheir core earnings power is going to be reduced by restructuringand reining in that CIO office,” he said in a June 4 interview on“Bloomberg Surveillance.”

In addition to making speculative bets, the CIO took on a biggerrole after the financial crisis, hedging JPMorgan's potentiallosses on loans and corporate bonds by taking positions in creditderivatives.

CIO Oversight

The question of CIO oversight arose in the months after thecrisis, when top JPMorgan executives heard what Macris and hisfellow traders in the London office were doing and raised concernsto Dimon that the unit's risk management was inadequate, accordingto the two executives familiar with the conversations.

William Winters and Steven Black, co-heads of JPMorgan'sinvestment bank at the time, were among those who sought moreinformation about the CIO's changing risk profile, according topeople who participated in or witnessed the conversations.

James “Jes” Staley, 55, who ran asset management at the time andnow heads the investment bank, and John Hogan, then the investmentbank's chief risk officer, also questioned why risk controls insidethe CIO weren't as extensive or robust as in other departments.

“That's absurd,” said Kristin Lemkau, a spokeswoman forthe bank. Winters, Black and Staley never complained about aspecific risk in the CIO's office, she said. If they had, Dimon'sprotocol would have been to gather the relevant data, let them talkto Drew and return to him if they weren't satisfied with herresponse, a bank executive said. The operating committee, on whichthey all sat, also could have reviewed the matter if they still hadconcerns, the person said.

It's also “totally untrue” that Hogan questioned why the CIOdidn't have as effective or robust risk controls as otherdivisions, Lemkau said.

One sore spot for executives inside the investment bank was thelack of visibility into CIO positions, according to two people withdirect knowledge of the matter. While the weekly risk-committeemeetings held by the investment bank were open to members of seniormanagement and were attended regularly by Macris and occasionallyby Drew, parallel sessions run by the CIO were closed to anyoneoutside the unit, these people said.

Chinese Wall

Among the explanations offered for Drew's autonomy: There was aso-called Chinese wall between the CIO and investment bank becauseDrew's unit was also a client, according to one current and twoformer executives. The CIO used the investment bank to place andprocess trades. Drew didn't trust that division to refrain fromusing the data to its advantage by offering non-competitive pricesor by trading against her, according to a former executive whoparticipated in those talks.

It also was widely known within the bank that Winters, 50, andBlack, 60, didn't get along with Drew, according to a current and aformer executive.

A person close to the bank offered a different description ofthe circumstances: While Dimon didn't adopt a double standard forDrew, he and other senior executives became complacent toward theCIO over time as a result of her track record as a consistent moneymaker, this person said.

Winters and Black proposed redefining the role of Ashley Bacon,then head of market risk for the investment bank, to extend hisoversight to the CIO, a former bank official said. The executivesalso asked that CIO risks be disclosed in greater detail at reviewmeetings and that other members of the bank's operating committeebe involved in assessing them.

Dimon's response, one of the people said, was that the situationwas under control. It was an answer that one former executive saidhe got from Dimon again and again, as risks in the CIO grew topotentially perilous levels.

“You really need people who have a very broad view of thingsboth quantitatively and with market knowledge and have the cloutwithin the firm to actually be heard,” said Emanuel Derman, aformer head of quantitative risk strategies at Goldman Sachs GroupInc., a professor at Columbia University and author of “My Life asa Quant” and “Models Behaving Badly.” “To say that it's OK with thedesk is not the right thing to do.”

In 2009, Dimon fired Winters and relieved Black of operatingresponsibility. Staley took over as head of the investment bank,and Mary Erdoes, 44, succeeded him at asset management. Winters,Staley and Hogan declined to comment on the discussions. Blackdidn't return phone calls seeking comment.

'Structural Deficiencies'

Dimon and what he called his “fortress balance sheet” meanwhilewere being lauded by politicians and the media. He steered JPMorganthrough the 2008 financial crisis without a single quarterly loss.New York magazine dubbed him “Good King Jamie,” while a biographyby Duff McDonald was titled “Last Man Standing: The Ascent of JamieDimon and JPMorgan Chase.”

“In the wake of the financial crisis, he came to represent thisnotion that, if well-managed, a bank didn't need to be regulatedall that heavily,” said Rakesh Khurana, a management professor atHarvard Business School in Cambridge, Massachusetts, and author of“Searching for a Corporate Savior: The Irrational Quest forCharismatic CEOs.” “That may have contributed to some structuraldeficiencies in governance and risk management. It probably createdthe benefit of the doubt to his direction in the board room andprobably a lot of deference to his authority in day-to-dayoperations.”

Drew spent three decades at the firm and its predecessors,helping steer it through the Russian debt crisis and the collapseof hedge fund Long-Term Capital Management in 1998.

At first, she maintained tight control over the CIO's trades,former colleagues and employees said. She ran the group's daily 7a.m. meetings in a seventh-floor conference room at JPMorgan'sheadquarters at 270 Park Ave. in Manhattan, according to formertraders. She placed strict limits on how much an investment couldlose or gain, and traders were required to exit positions if lossesexceeded a certain amount, according to one former manager inLondon and several former traders.

Macris gave traders a longer leash and imposed fewer controls,according to three former executives. So-called stop-loss limits,which were supposed to trigger an internal review or require atrader to immediately exit a position if losses grew too large,weren't always enforced, the executives said. Macris didn't respondto e-mails or phone calls seeking comment.

The shift in risk appetite led to the departures in 2008 of sometraders who specialized in more-liquid markets where risk waseasier to measure, such as interest-rate products and foreignexchange, three other former CIO executives said. Under Macris, theCIO's London office bought European mortgage-backed securities,structured credit and other assets that brought higher yields andmore risks than the safest short-term Treasury bonds.

Peter Weiland, who graduated from Princeton University with adegree in chemistry and had been overseeing risk for JPMorgan'sproprietary-trading group, was transferred in 2008 into the samerole at the CIO. He immediately saw faults in the division'srisk-management system, said two former executives who worked withhim.

While Drew hired traders and quantitative analysts needed fortrading, she failed to add the staff, computer models or technologynecessary to evaluate the new risks, a former and a currentexecutive said. The risk-management systems and framework designedto spot potential pitfalls, especially in credit derivatives,didn't keep pace with the portfolio's expansion, the peoplesaid.

Changing VaR

Weiland became concerned that Bruno Iksil, the trader inMacris's office now known as the London Whale, had amassed acomplex and illiquid position, according to two former executives.Weiland, who declined to comment, warned Macris and Drew about thetrades on numerous occasions beginning in 2010, the people said. Itwas a topic of frequent discussions in the CIO's global weeklymeetings, they said.

Weiland compared efforts to reduce Iksil's outsized position tothe difficulty of trying to safely land a Boeing 747 without flyinglessons, one executive said. The position was so large andilliquid, Weiland said he couldn't get the plane below 35,000 feet,the executive said.

By 2010 Iksil's value-at-risk, or VaR — a formula used by banksto assess how much traders might lose in a day — already was $30million to $40 million, a person with knowledge of the matter said.At times the figure surpassed $60 million, the person said, aboutas high as the level for the firm's entire investment bank, whichemploys 26,000 people.

Drew, who resigned last month after the CIO losses wereannounced, was on sick leave for about six months in 2010, duringwhich time Macris and Althea Duersten, head of the CIO for NorthAmerica, ran the division. The daily meetings were moved to alarger conference room near their new offices on the 10th floor toaccommodate about 40 people in attendance. Drew relocated to theexecutive suites, more than 30 floors higher, to be closer toDimon.

Drew and Macris agreed to reduce Iksil's positions and tried todo so beginning in early 2011, according to a current and twoformer executives. The plan was to work down the book gradually asthey found opportunities to sell the assets, these people said. Theproblem: No one was buying. The position was too large and illiquidand couldn't be reduced without a loss. Drew and Macris decided thebank could hold the trades to maturity and that the risk of beingforced to liquidate them under duress was low, according to theformer executives.

'Risk 101'

Early this year, as the size and volatility of its trades weregrowing, the bank changed the computer-based mathematical formulasfor calculating the chief investment office's VaR. The new modelhad the effect of understating the risk of losses from Iksil'strades: It showed an average daily VaR within the CIO of $67million, about where it stood in the fourth quarter of 2011.

On May 10, when JPMorgan announced the loss, Dimon said the bankhad reviewed the effectiveness of the new model, deemed it“inadequate” and decided to go back to the original model. On thatbasis, VaR doubled to $129 million. So far, the bank hasn'tdisclosed how or when VaR for the CIO unit was changed while themodel for the rest of the firm remained untouched. Nor has itexplained who sought the change and who approved it.

Unable to unwind Iksil's bets, the bank tried to hedge them thisyear with other trades, exacerbating the losses, Dimon said on May10. Iksil had amassed positions in securities linked to thefinancial health of corporations that were so large he was drivingprice moves in the $10 trillion market.

Dimon later called it “a Risk 101 mistake.” Shares of thecompany have dropped 19 percent through yesterday since the losseswere announced, and at least half a dozen agencies, including theU.S. Department of Justice and the Securities and ExchangeCommission, are investigating.

While Dimon hasn't faced the same public scrutiny that rivals atGoldman Sachs and Bank of America endured after the 2008 creditcrunch, the attention surrounding his testimony has echoes with thebank's own history. In 1933, after Congress was shaken by anotherfinancial crisis, J.P. “Jack” Morgan, then CEO of the company, wassummoned to testify about preferential treatment that JPMorgan gavecertain clients.

The public reaction was “extreme disillusionment: the brightestangel on Wall Street had fallen,” Ron Chernow wrote in his 1990book, “The House of Morgan.” The scandal “cast it in the mud withother banks.”

The embarrassing disclosures in those hearings led to theGlass-Steagall Act, which forced JPMorgan to split off itsinvestment-banking business from its deposit-taking arm. Dimon'stestimony tomorrow may have a similar effect: Giving ammunition tothose who would enforce stricter regulation of banks, includingadvocates of the Volcker rule, which would bar most proprietarytrading by deposit-taking institutions and that the JPMorgan CEOhas fought vociferously.

Psychiatrists

He has said former Fed Chairman Paul Volcker, for whom the ruleis named, doesn't understand capital markets. He quipped thatbankers will need psychiatrists to evaluate whether their tradesqualify as hedges. Last year he took on Fed Chairman Ben S.Bernanke in a public forum, blaming excessive regulation forslowing a U.S. economic recovery and asking whether anyone has“bothered to study the cumulative effect of all these things.”

Now, his own lapses may come back to haunt him.

“The risk management is as amateurish as you can get on WallStreet,” Nassim Taleb, a professor of risk engineering at New YorkUniversity and author of “The Black Swan: The Impact of the HighlyImprobable,” said in a telephone interview about the bank's loss.“JPMorgan is vastly more fragile today than it was five years ago,and the system is more fragile today with more too-big-to-failbanks with proven incompetence at their management level.”

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