Executives, past and present, of JPMorgan Chase were grilled at a Senate hearing on Friday morning that followed up on a scathing report detailing the events leading up to a more than $6 billion loss in its derivatives portfolio.

The 300-page report delivered to the U.S. Senate Permanent Subcommittee on Investigations was the result of a nine-month investigation that included a review of nearly 90,000 documents, including internal bank records, emails, and telephone call transcripts.

The so-called “whale trades” were conducted by traders in the London office of JPMorgan Chase's chief investment office (CIO). According to the report, over the course of the first quarter of 2012, the CIO used the company's Synthetic Credit Portfolio (SCP) to engage in high risk derivatives trading; mis-marked the trading book to hide losses; disregarded multiple indicators of increasing risk; manipulated risk models; dodged regulatory oversight; and misinformed investors, regulators, and the public about the nature of its risky derivatives trading.

In an opening statement at Friday's hearing, Sen. Carl Levin (D-Mich.) chairman of the subcommittee, said the investigation demonstrates how credit derivatives, when purchased in massive quantities with complex components, “can become a runaway train barreling through every risk limit.”

The report alleges that JPMorgan traders, who were required to book the value of their derivative holdings every business day, used internal profit-loss reports to hide millions of dollars of losses. Eventually, those misreported values forced the bank to restate its earnings for the first quarter of 2012, spurred after an internal investigation uncovered phone conversations in which traders mocked their own valuation practices. The bank has maintained that the mis-marked values did not violate bank policy or generally accepted accounting principles. 

Not only were warnings ignored, “rather than ratchet back risk, personnel challenged and re-engineered the risk controls to silence the alarms,” Levin said. 

Among the allegations contained in the report:

In the first quarter of 2012, without alerting regulators, JPMorgan Chase's Chief Investment Office used bank deposits, including some that were federally insured, to construct a $157 billion portfolio of synthetic credit derivatives, engaged in high-risk, complex, short-term trading strategies, and disclosed the extent and high-risk nature of the portfolio to its regulators only after it attracted media attention.

The bank mis-characterized high-risk trading as hedging.

The bank, through the CIO, hid over $660 million in losses in the SCP by overstating the value of its credit derivatives.

In the first three months of 2012, when the CIO breached all five of the major risk limits on the SCP, rather than divest itself of risky positions, bank officials disregarded the warning signals and changed its risk evaluation models in order to continue trading despite the red flags.

The bank dodged oversight by the Office of the Comptroller of the Currency by not alerting it to the nature and extent of the portfolio; failing to inform the regulator when the SCP grew tenfold in 2011 and tripled in 2012; omitting portfolio specific data from routine reports; and omitting mentions of its complexity, risk profile, and losses. Instead, the bank responded to information requests "with blanket assurances and unhelpful aggregate portfolio data” and initially denying portfolio valuation problems.

After the whale trades became public, the bank misinformed investors, regulators, policymakers and the public by downplaying the portfolio's size, risk profile, and losses; describing it as the product of long-term investment decision-making to reduce risk and produce stress loss protection, and claiming it was vetted by the bank's risk managers and was transparent to regulators, none of which was true.

While conducting its review of the SCP, some OCC examiners expressed skepticism that it functioned as a hedge at all. In a May 2012 internal email, for example, one of them referred to it as a “make believe voodoo magic composite hedge."

Despite such concerns, the regulator ultimately failed to rein in risky trading, the report said. The OCC, it found, failed to fully investigate CIO trading activity that triggered multiple risk limit breaches, and tolerated reports that omitted portfolio-specific performance data. Staff also failed to take action when required monthly reports stopped arriving.

“At the same time the portfolio was losing money and breaching risk limits, JPMorgan dodged the oversight of the OCC” and “delayed or tinkered with requests for information by giving regulators inaccurate or unresponsive information,” Levin said. The failure of regulators to act sooner cannot be excused by the bank's behavior, however, and “the OCC also fell down on the job” by failing to investigate “multiple, sustained risk limit breaches.”

“It is deeply worrisome that a major bank should seek to cloak its risky trading activities from regulators, and doubly worrisome that it was able to succeed so easily for so long,” he added.

Sen. Ron Johnson (R-WI) said the investigation shows that JPMorgan “built its business model around ‘too big to fail.'”

“I've always said that the fact we have institutions that are ‘too big to fail' shows how regulation already failed us,” he said. “We had regulation in place that probably should have prevented this years ago. Regulators in general seem incapable of vetting all these things.”

Among the five JPMorgan witnesses called upon to testify, there were repeated refrains of “I don't recall” and “to the best of my knowledge,” interspersed with occasional finger-pointing.

Ina Drew, the former chief investment officer, defended her oversight of the synthetic credit portfolio, as “reasonable and diligent.” She said her work was “undermined” by a “flawed” VaR (Value at Risk) model and “deceptive conduct” by members of her London team who “failed to value positions properly and in good faith” and hid from her important information regarding the true risks of the book.

Sen. John McCain, the top Republican on the panel, wasn't swayed by that argument, and said the investigation revealed a lack of proper and necessary management. "It seemed that the traders seemed to have more responsibility and authority than the higher-up executives," he said.

McCain also criticized Drew for having once responded to an inquiry that all she could offer was a “guesstimate” of what the portfolio was supposed to hedge for.

Peter Weiland, former head of market risk for the chief investment office was similarly called out by McCain for telling the subcommittee, in previous testimony, that “it was not his job” to enforce the risk limits, despite serving as senior risk manager for the portfolio. Weiland responded that it he did not recall making such a claim.

The report suggests a variety of steps regulators should take to curb future derivative risks and abuses.

Requiring banks to identify all internal investment portfolios containing derivatives over a specified notional size, and require periodic reports with detailed performance data. There should be an annual review to detect undisclosed derivatives trading.

Mandating detailed documentation from banks when they establish a hedge, including identifying the assets being hedged, how it lowers the risk associated with those assets, how and when it will be tested for effectiveness, and how it will be unwound and by whom.

Requiring banks to provide periodic testing results on the effectiveness of any hedge over a specified size, and periodic profit and loss reports on hedging activities.

Strengthening credit derivative valuation procedures by encouraging banks to use independent pricing services or, in the alternative, prices reflecting actual, executed trades. Disclosure should be required of counterparty valuation disputes over a specified level.

Regulators, the report recommends, should immediately issue a final rule implementing the “Volcker Rule” provisions of the Dodd-Frank Act, a prohibition on proprietary trading by federally insured commercial banks. Regulators should also impose additional capital charges for derivatives trading characterized as “permitted activities."