JP Morgan, Enron & Gold

Januray 6, 2003 – I have today mailed the following letter to the Enforcement Division of the Securities & Exchange Commission. It’s about time that we learn the truth regarding JP Morgan Chase’s activity in the gold market, the full extent of its gold exposure, and whether it used gold loans to fund the so-called “disguised loans” that it arranged for Enron. Perhaps the SEC will help us learn the truth by investigating these matters and reporting the results.

Dear Sir/Madam:

I am writing in regard to recent statements made by the management of JP Morgan Chase (“JPM”) relating to its activity in the gold market. This is to ask for your determination whether their statements are false or misleading.

On January 2nd JPM announced that it had reached an out-of-court settlement with several insurance companies regarding JPM’s involvement with Enron. You will recall that these insurance companies had initiated this litigation, alleging in their lawsuit brought in New York federal court that certain trading transactions between JPM and Enron were shams, thereby negating the insurance contracts covering these transactions.

In a press conference subsequent to their January 2nd announcement, JPM management commented on rumors relating to its activity in the gold market. I refer to the following CBS.MarketWatch.com report by Luisa Beltran and Greg Morcroft published on January 2, 2003:

“…[JP Morgan Chase] executives said that, despite persistent rumors to the contrary, it has no exposure to the recent run-up in gold prices. “We don’t have any real exposure to gold. I don’t know where that rumor keeps coming from, but it’s not true,” CEO Harrison said. “We have seen this rumor pop up again and again,” added chief counsel McDavid, “and we have asked the SEC to look into it.“

I have no specific knowledge about these rumors, other than what I have learned from the media. But I am very pleased to hear that the SEC has been asked to investigate them. In this regard, I am writing to bring the following matters to your attention.

Given that these so-called rumors “pop up again and again” as Mr. McDavid states, perhaps they have some basis in fact. It is a well-established truth that ‘buzz’ about a company will often circulate before an event.

For example, rumors about derivative problems in Long Term Capital Management circulated well before that company’s collapse. More recently, word of potential problems in Enron circulated freely, much of which was reported in the media. The protracted drop in Enron’s share price for several months before the resignation of its CEO, which itself occurred three months before that company’s bankruptcy, was an indication that the market believed (as evidenced by that company’s declining share price) the rumors about Enron’s problems had some basis in fact.

In both of these instances, company management denied that there was any substance to the so-called ‘rumors’ that were circulating, as JPM management has now also similarly done. I also bring to your attention the decline in JPM’s share price that occurred last year while these rumors about its gold exposure circulated.

Thus, your investigation into the rumors about JPM’s activity in the gold market is timely, but the focus of your investigation should not be, as JPM management implies, how these so-called “rumors” started. Rather, your investigation should determine whether these rumors have any basis in fact. If they do, then this is to also ask for your determination whether the statements above by Messrs. Harrison and McDavid are false or misleading.

To assist you, I would like to bring the following matters to your attention:

1) The Wall Street Journal published an insightful article about JPM and Enron on January 25, 2002 (“Insurers Balk at Paying Bank Up to $1 Billion in Claims On Complex Transactions”). That article provides an overview about the financing provided by JPM to Enron, through Mahonia Ltd., a company Chase Manhattan (one of JPM’s predecessor companies) established in the Channel Islands. The article states: “Prepaying for future delivery of a commodity is known as a “gold trade,” because it is the way gold bullion has been trading for centuries. In recent years, trading companies, whether from Houston or Wall Street, have been making more use of this structure to buy and sell oil, natural gas and other commodities. Some commercial banks, including Chase Manhattan…had to set up part of these trades overseas because their banking charters wouldn’t allow them to take delivery of commodities.” The article describes what is generally known as a commodity swap, and gold is frequently used in one side of the transaction. As an ex-banker (1969 to 1980), I have some knowledge about how these transactions work, as banks are a facilitator for them. When gold is used to finance a commodity swap, bullion is borrowed from a central bank, and sold to raise dollars, which are then used to purchase the commodity on the other side of the transaction (oil and gas in the case of Enron). It is noteworthy that the WSJ article specifically mentions a “gold trade”; given this remark, anyone knowledgeable about commodity swaps might naturally assume that JPM/Mahonia was arranging gold-for-energy swaps for Enron. Thus, this WSJ article may be the original source of the so-called “rumors” referred to by JPM management. But importantly, this WSJ article also suggests that these rumors may have some basis in fact. The article did not specifically state from where Mahonia was obtaining the funding needed to purchase the commodity contracts it acquired from Enron (the so-called “disguised loans” which the insurance companies contended were shams). Nor did a WSJ article published August 13, 2002 (“Enron Probe Shines Harsh Light on Financiers“) disclose the nature or the original source of the funding needed to complete these commodity swaps, but this later article does provide more information about potential gold activities by JPM in its dealings with Enron: “In the world of commodities, particularly gold trading, the 50-year-old Mr. Mehta [Chase’s and then JPM’s head gold trader] was well known. His successful marketing of derivatives, and his enthusiasm for the use of these instruments, helped the gold-hedging business take off in the 1990s. Mr. Mehta and his team executed…[deals which]…allowed Enron to use an offshore vehicle known as Mahonia to raise hundreds of millions of dollars from J.P. Morgan.” Taken together, there are enough facts disclosed in these two WSJ articles to suggest that gold loans could be one possible source of funding for Mahonia’s commodity swaps with Enron, and if so, these gold loans could lead to the “gold exposure” denied by JPM management.

2) An article about Enron in The New York Times published on February 17, 2002, was important for the following statement [note the emphasis added by me]: “Partly because of the way the loans [by JPM/Mahonia to Enron] were accounted for, the company [i.e., Enron] reported a surge in its hedging activity, accomplished using financial contracts called derivatives, during its last few years. When pressed about the increase by skeptical analysts, Enron officials said the numbers reflected hedges for commodity trades, not new financing, the analysts said.” The key point here is the “surge” in derivative contracts entered into by Enron “during its last few years”. Each derivative has two-parties to the contract. It has not been disclosed to my knowledge who took the other side of the Enron contracts, but the following information from the Office of the Comptroller of the Currency offers one possible answer. According to its website, the OCC “charters, regulates, and supervises national banks to ensure a safe, sound, and competitive banking system that supports the citizens, communities, and economy of the United States.” As part of this responsibility it collects derivative exposure of the nation’s banks. The disclosure by Chase Manhattan Bank (before its merger with Morgan Bank) is telling. In three years from December 31, 1997 to December 31, 2000, there was a surge in Chase’s gold derivative contracts from $11.8 billion to $29.8 billion. Because of the merger, it is not possible to determine from the OCC reports Chase’s derivative activity for 2001. But looking at the derivative exposure of JPM on a combined basis subsequent to its merger, it is noteworthy that after the Enron bankruptcy at the end of 2001, the gold derivative activity of JPM was unchanged at $41.0 billion reported at December 31, 2001 and $41.0 billion as of September 30, 2002, the latest reporting period available. Thus, Chase’s derivative contracts in gold surged while Enron’s derivative contracts surged, and then remained unchanged after Enron collapsed. This pattern suggests that it is possible Chase (and JPM as its successor) was the counter-party to Enron’s derivative contracts. Further, this growth in gold derivative contracts provides further evidence to the possibility I note above that gold was used by Mahonia to fund the commodity swaps (the so-called “disguised loans”) that it entered into with Enron. The August 13, 2002 Wall Street Journal article states: “Mr. Mehta has had other high-profile scrapes with controversy while at the bank. For instance, Mr. Mehta came under fire for the bank’s earlier arrangements with Sumitomo Corp., the Japanese trading company and the employer of a copper rogue trader named Yasuo Hamanaka who lost $2.6 billion in copper trades. Mr. Mehta’s team structured a number of derivatives transactions that allowed Mr. Hamanaka to raise money that didn’t appear to senior Sumitomo executives as debt, said people familiar with the deals.”

Thus, perhaps the rumors circulating about JPM’s gold exposure have some basis in fact. In any case, the above material does highlight the importance of your investigation.

I note again Mr. Harrison’s statement: “We don’t have any real exposure to gold.” Perhaps in your investigation you can ask him to define the term “real”. That JPM has exposure to gold is undeniable from the OCC reports. There are different kinds of exposure from derivatives – price risk and counter-party risk.

It may be that through its derivative contracts, JPM believes that it does not have any price exposure to gold. However, while the gold market has been generally quiescent and its price relatively stable the past few years, gold has in recent weeks become very active. As we have learned from the collapse of Long Term Capital Management, volatility undermines what otherwise may appear to be a safe derivatives position. So we will see in the weeks and months ahead whether JPM’s derivative exposure to the gold price is indeed under control. Given the size of its position, it may be difficult for JPM to keep its price risk controlled. JPM’s gold derivative exposure of $41 billion of notional value represents 117 million ounces of gold – a number that is nearly 50% greater than all the gold produced worldwide in a year. Thus, it seems likely that the gold market may not be able to provide the liquidity JPM will need to keep its gold derivative position in balance in a period of increased gold price volatility, which is a result that would clearly negate Mr. Harrison’s contention that JPM does not have “any real exposure to gold.”

Then there is counter-party risk, which is always present because the financial position of companies changes. Counter-parties deemed creditworthy when JPM entered into derivative contracts may no longer be financially as strong as before. Further, if in fact the simultaneous surge in Enron’s and JPM’s derivative contracts was not just coincidental and that they were counter-parties to each other, one has to wonder whether JPM has any ongoing exposure to Enron in these derivative contracts. It is noteworthy that JPM’s most recent 10-Q shows that derivative receivables rose $16.4 billion, or 23.0%, in the nine months from December 31, 2001 to $87.5 billion as of September 30, 2002. The net change is actually 25.0% when adjusting derivative receivables as of December 31, 2001 to reclassify to Other Assets the Enron-related surety receivables from the insurance companies in the case now settled. Does this glaring (and potentially alarming) surge in derivative receivables reported by JPM reflect an inability of JPM’s counter-parties to deliver under their derivative contract commitments? And perhaps more importantly to help evaluate the accuracy and therefore reliability of Mr. Harrison’s statement, what portion of this derivative receivable relates to gold?

The point is that certain aspects of JPM’s derivative disclosure appear to be inadequate. Thus, this is to ask that you make a determination in your investigation whether JPM’s disclosure about its gold derivatives has been sufficient, and indeed, whether the statements by its management about JPM’s gold exposure are not false or misleading.

Lastly, your website states: “The laws and rules that govern the securities industry in the United States derive from a simple and straightforward concept: all investors, whether large institutions or private individuals, should have access to certain basic facts about an investment prior to buying it. To achieve this, the SEC requires public companies to disclose meaningful financial and other information to the public, which provides a common pool of knowledge for all investors to use to judge for themselves if a company’s securities are a good investment.” To achieve this objective, the SEC must investigate JPM in order to determine whether it is providing the investing public with sufficient disclosure on its gold exposure, which from the OCC reports is undeniable. Further, the SEC must determine whether the statements above by JPM management are false or misleading. I look forward to reading and learning the results of your investigation.

For the sake of disclosure, I do not have any position in the stock of JPM.

Yours truly,
James Turk