Tuesday, May 29, 2012

JP Morgan and The Whale

The ongoing saga about J.P. Morgan’s multi-billion trading loss involving the “London whale” reminds me of a timeless story – the parable of Jonah and another whale in about 750 B.C.

As the legend goes, Jonah found it difficult to convince people to live the virtuous life, despite being held up as an example.  To pay for his failure, he was tossed out of his boat one day and was swallowed by a whale. After spending three days in the belly of the beast, he repented and promised to try again. The whale then spit him out.

J.P. Morgan’s trading blunder involved a different kind of whale – the so-called London whale. Since then, the London whale’s mammoth trading loss has engulfed an institution previously thought to be exemplary in risk management. The fallout has reignited the debate about proprietary trading, the Volcker Rule and too-big-to-fail.

The modern and ancient storylines are similar, but it’s an open question how J.P. Morgan will re-emerge from the whale.

Were they lucky or good?

Post-crisis, J.P. Morgan found it difficult to live by the Dimon Principle, which is supposed to guard against stupidity born of hubris.

The Dimon Principle and advanced risk management techniques, such as value at risk (VaR), were a key reason J.P. Morgan was one of the most successful in protecting assets during the financial crisis. Unlike the reputation of other bankers, Jamie Dimon’s grew in stature after the crisis because the bank appeared to manage risk so well.

VaR was a core of the bank’s risk management strategy. This technique was supposed to help the bank quantify risk.  In the end, it didn’t work.  The VaR reported to Mr. Dimon showed the trade made by the London whale had a VaR of less than $100 million, not the reported loss of $2 billion that could possibly grow to over $5 billion.

This is not the first time risk management models have failed Wall Street.  The subprime mortgage debacle that triggered the financial crisis is a recent example of a sophisticated model that faltered badly. Mortgage lenders, aided by investment banks and ratings agencies, believed they had cracked the code and were able to properly measure the risk in lending to people previously considered too dodgy for a home loan. We know what happed next.

Is Redemption Next?

To redeem itself, J.P. Morgan has admirably tried to make amends.

Mr. Dimon has owned up to the problem and has admitted that avoidable mistakes were made. He held a conference call to discuss the loss, went on Sunday talk shows, and will testify before Congress.  Those responsible for the loss have resigned or been fired.

The real question is whether J.P. Morgan will renounce proprietary trading – the root cause of the problem.

It’s quite possible it won’t.

There is too much money to be made in proprietary trading. J.P. Morgan, like the rest of Wall Street, relies on “prop trading” to produce huge profits. In fact, big financial institutions still have as strong an incentive as ever to take the unrepentant risk to make up for falling earnings.

Given the pressure to deliver results, it will be interesting to see how J.P. Morgan responds. Until it figures out what to do, the bank will remain trapped inside the whale.

Sunday, May 27, 2012

Do You Just Love Me For My $?

Large Wall Street firms have tossed independent advisors yet another great opportunity.  Recently, management at many of the wirehouses informed their financial advisors that they wouldn’t get paid on accounts with a balance of less than $250,000. These clients are being shipped off to a call center because, in so many words, they can’t be profitably serviced by a “full service” financial advisor.  This decision is a frank admission that the cost structure at big firms is still too high. Large firms in the Dodd-Frank era are feeling the squeeze. The result is predictable: Wall Street again put self-preservation ahead of advisors and clients.  Is that any way to treat people, let alone someone who may become a worthy client one day? The opposite is also true: Aren’t these big firms really saying that if you have enough money, we will love you?

Short-Term Thinking
This bloodless view of the world is not particularly nice, nor is it necessarily good business practice.
The fact is not everyone is born a 1 percenter. Clients with smaller accounts often grow into much larger ones. Here in Northern California, engineers and many entrepreneurs are just one IPO away from fabulous wealth.
The problem with packing smaller accounts off to a Siberian call center is that you never know who becomes the next Mark Zuckerberg. If clients are mistreated before they hit the home run, there’s virtually no chance they’ll ever come back.

Opportunity For Independents
The good news is that a large firm’s cast-offs can be good business for independent advisors. Because independents have far less overhead, they have lower costs and can incubate smaller clients profitably. The key is having the right business model.
There’s another opportunity, too, for independents: The freedom to run a business as advisors see fit.
Most accomplished advisors don’t want corporate bureaucrats dictating how they serve clients or operate their business. A large firm’s management decisions are particularly irritating because they not only deprive advisors of income, but also create the embarrassment of having to tell clients that the firm believes they’re no longer worth the time.
Wealth management can’t be all about the money. Just like in any relationship, if someone happens to have money, that’s fine. But that’s not the reason you love someone.
As an independent advisor, you don’t have to be all about the money. One of the greatest advantages of being independent is the freedom to do the right thing by your business and your conscience. That always feels good.

The Best Buy Effect

It’s not easy being Best Buy these days.
Price competition is intense, and pressure is coming from all directions. Online competitors, without costly overhead, are selling the same products cheaper. Tech-savvy consumers are comparison shopping right on the showroom floor, using mobile phones and the RedLaser app to scan for the best price. Instantly, a consumer can get a list of better deals on a flat screen TV or Blu-ray player from online retailers and even nearby stores.
Wealth advisors are facing the same challenges from online “firms” like Wealthfront and from other advisors who are willing to cut their fees to win business.

The Opportunity in Solving Problems
But all is not lost for advisors or retailers if they heed the lesson from one of Best Buy’s more successful innovations: The Geek Squad.
The Geek Squad delivers what most low-priced product sellers don’t: Expertise to make everything work together. Anyone who has ever tried to create a home theater knows the frustration. Integrating sophisticated pieces of consumer electronics has almost become rocket science. Best Buy is keeping clients happy and loyal by providing a service that makes it easy to buy and then enjoy cool products.
Financial advisors have the same opportunity to attract and retain clients if they take the responsibility to simplify the many complex financial products and design a program that works.
In fact, anyone can open a discount brokerage account, do some online research and start buying investment products. However, buying and selling products doesn’t equate to comprehensive wealth management. There’s much more to this discipline than most recognize initially.

Watch Out For Cheap
An advisor who provides real value need not fear the cheap advice that can be obtained online or through cut-rate competitors.
Cheap online advice is nothing more than a computer algorithm. More often than not, human strategy trumps most computer driven decisions (Kasparov Wins). Only an experienced human advisor can provide that strategy and then recommend how to put together the complex investment solutions that meet each client’s needs. When you’re talking about your life savings and financial independence, what would you prefer, a cheap computer automated solution or a unique personalized plan?
Put another way, it might seem like a good idea to buy the bargain-priced flat screen TV and then read the directions to mount and connect the components. You can’t really appreciate the Geek Squad until the whole project has gone terribly awry. It’s one thing to mess up your home theater; it’s another when it’s your financial security.
That’s the good news for advisors. By providing understandable solutions, personalized service and delivering wise counsel – an advisor’s value proposition is as compelling as ever.