By BRETT ARENDS
The drama unfolding at J.P. Morgan Chase is stunning.
And oh so predictable.
If you think this is just a story about Wall Street greed and folly, and has nothing to do with you, think again. We are all J.P. Morgan (JPM)
To recap: The bank just lost $2 billion in something called its "synthetic credit portfolio" by taking big bets on European bonds. The trader involved, Bruno Iksil, was known as "the London Whale" and "Lord Voldemort" for his big trades. Heads are now rolling. CEO Jamie Dimon is under pressure.
The details, of course, are fascinating -- "the London Whale," the legendary Dimon and his "Dimon principle," and so on.
But those mask the real story. The entire world of investing -- including your 401(k) -- is now being operated on pretty much the same lines as JP Morgan's "synthetic credit portfolio." And everyone is making the same mistakes, even if for most, it's on a smaller scale.
Not to alarm you. But I thought you should know.
James Montier put it best. Last week the GMO senior strategist was in Chicago talking to the CFA Institute annual conference. Montier explained how little the finance industry has actually learned from the global crisis four years ago. Almost everyone, it seems -- from the regulators to the big banks to your financial adviser -- is still making the same mistakes.
A few days after he spoke, J.P. Morgan dropped its bombshell.
What are these mistakes? Montier doesn't put it quite like this, but as far as I can see there are at least five.
- Too many people still don't understand what "risk" really is.
- They rely far too much on dangerous computer models.
- They aren't prepared for the unexpected.
- They put too much faith in "experts."
- People have all the wrong incentives.
These were all major factors in the J.P. Morgan blow-up. They are all endemic. And no one seems to notice! Every time something blows up, people run around asking questions like, "How could this happen?" "Where were the regulators?" and, "Who should get fired?" They are all pointless questions. As long as all the players keep operating under the same flawed theories, these things are inevitable.
Risk? Wall Street thinks it's "volatility." No, really. You and I know it's the likelihood of losing money. Ask the average person what the "risk" of investing in the Facebook IPO would be, and she'd tell you it's the risk you'll lose money. Ask Wall Street and they'll tell you it's "beta." (Don't ask).
Computer models? I am still amazed at the quasi-religious worship accorded these things. I used to build computer models, back when I was an analyst. Even the best models rely on dubious assumptions that put the conclusions at risk. All financial models are basically contraptions put together with Airfix and balsa wood. Would you fly to Peru in a plane built by a hobbyist? That's what you're doing when you invest based on a "model."
The unexpected? Apparently the people at J.P. Morgan were just amazed that things in the bond market didn't go quite their way. The same way Ben Bernanke and Alan Greenspan and Wall Street were just shocked that house prices could go down. How could this happen? It's not in our model! When Wall Street banks try to work out how prepared they are, they use a flawed calculation called "Value at Risk." Montier says it's like buying a car with an airbag that is guaranteed to fail just when you need it, or relying on body armor that will only keep out 95% of bullets.
The experts? What suckers most people are for letters after the name, technical jargon and all that jazz. Two thirds of finance is a snow job. Montier, an expert in behavioral finance, cites some fascinating experiments that psychologists have done to show just how we are wired for this. MRI scans have found that listening to expert advice can actually override the independent judgment parts of our brain. They've done studies where they found people were willing to take stupid bets just because an expert told them it was okay.
As for the incentives, this is always my favorite. Most people don't realize just how perverse the incentives system is on Wall Street. This ignorance is, I feel, one reason why so many perfectly smart conservatives continue to misunderstand the issue of banking regulation, and think somehow that "the market" will sort things out on its own. It doesn't. Only abolishing limited liability, and enabling vicious clawbacks of past salary and bonuses, could do that. Ina Drew, the J.P. Morgan Chief Investment Office, resigned Monday as a result of the scandal. But last year alone she pocketed about $15 million in pay and bonuses, reports say. Presumably she made similar amounts in previous years. None of that can be clawed back. On Wall Street, taking the big risks -- even crazy risks -- is good business sense. Heads you win, tails somebody else loses.
Do you think this affair will change anything? Hardly. Not so long as we think "Jamie Dimon" is the problem.