Sunday, July 15, 2012

Risk Controls Hurt Investment Profits

Investors are giving up too much on the upside

The financial world is being buffeted by credit risks. To protect investors from large unexpected credit failures, various risk control approaches are being used. A look at financial history suggests that hiding a problem only makes it worse when it is revealed. In the meantime, by hedging the risks, money is taken away from more productive investing at today’s low prices. Those that are doing the hiding, hedging and manipulating of the markets are concerned about career risk for themselves or their leaders.  I believe we should deal with the present unpleasant problems,  re-set our levels, and unencumber the potential upside.   

Questions for Jamie Dimon

I was one of the analysts and portfolio managers that attended the early morning analyst meeting masterfully presided over by JPMorgan Chase* CEO Jamie Dimon. Both in his presentation and the two accompanying presentations, attention as well as most of the analysts’ questions were focused on the CIO (Chief Investment Office) and the “London Whale” losses. Many who know me either directly or through reading this blog may recognize that when all or almost all attention is focused narrowly on one topic, I try to explore other areas that I believe can be more fruitful. Thus I asked two somewhat related questions about derivative exposure. The first was, “With some $86 billion in derivative assets and $76 billion in liabilities, how much was netted with the same counterparty?" The second question was how much of the June 30 statement included the CIO debacle?  The answer to my first question was that the subject was covered in a previous presentation to analysts as to the complexities of its management of derivatives. My second question was answered with the statement “very little.” The answers delivered were not satisfying.

What was the JPM CIO designed to do?
Purportedly the office, among other tasks, was meant to hedge some of the loans made by the bank. These loans of various maturities were with governments, central banks, commercial customers, and other banks. A bank can only stay in business by accepting some of the risks of making loans. JP Morgan does some of the best credit work of any large bank, thus it had to have some inkling as to the type of credit losses it was exposed to through its loan portfolio. Considering what has been going on in Europe for the last year, one would assume that JPM had some worries as to its loans to various European financial institutions. (Reportedly the large loss was in a derivative that tracked the credit of large US commercial entities. However this does not totally eliminate a concern about some large European Banks.) I do not know whether there were additional concerns about prompt payment from certain derivative counterparties, particularly if the originating derivative transaction was not executed through an exchange with a strong clearing house behind it.
*For many years I have owned shares in JP Morgan, but they are not currently owned in the private financial services fund that I manage.

JPM and Libor

Somewhat more understandable was Jamie’s ducking questions as to the ongoing Libor investigations. (Wouldn’t it have been interesting to hear his views from his place on the board of the New York Fed?) Some may not see the connection to the two probes, but I believe that they are getting to the crux of the overriding problem facing investors and financial consumers.

Too much fudge can make one sick 

As kids we all liked sweet things, I was particularly enthralled with brown sugar fudge. After a while it became clear to me that eating too much fudge made me sick.  As an adult, I find the “fudging” of data makes me equally unwell.
Since probably sometime in 2007 there was an attempt by some to manipulate the Libor rate. One of the repeated mistakes of the financial community is to use a particular metric designed for a specific purpose for other uses. (My favorite misapplication is the use of price/earnings ratios to identify cheap or expensive, growth or value stocks.) The original purpose for the daily setting of a US dollar Libor rate, was to estimate the rate that banks would pay for US dollar loans from other banks  on days when there were no known transactions. The methodology used was for sixteen specified banks with operations in London to indicate what it would pay for money. Reuters, now Thomson Reuters**, would collect the data, then drop the four highest and the four lowest samples and take the inter-quartile mean of the eight central results and report that calculation to the British Banking Association which authorized its publication as an estimate. 

The rate was never designed to be an interest rate arbiter for non-banking loans. When floating rate paper was being developed first at the wholesale level and then on the retail level, some “bright person” at a law firm or an investment bank grabbed Libor as a well-known daily fluctuating interest rate that the London market controlled rather than a US Treasury rate. Starting in 2008 some in the marketplace were getting concerned that the interest rate estimates were being influenced by traders for the benefit of their trading positions. At any rate the British government used its knowledge of the individual bank submissions as a possible indicator that a bank with a high rate needed to use the high rate to attract capital, for it was perceived to be having problems. It is alleged that the Bank of England, the central bank, did not want to have to rescue another failing bank, suggested to at least one bank that it need not always be the highest bidder for money. No one is publicly discussing that banks that submitted lower rates did not expect to get additional loans or equity through the marketplace and thus following a US Marine Corps tradition, “kept off the skyline.”  The rumors of these concerns probably entered the hedging practices in JP Morgan’s CIO as well as others who were in the business of making loans to banks. (Confirming this assumption would have helped in understanding what the CIO was doing in its proper hedging activities.)
** In 1998 Reuters bought the operating assets of my old firm, Lipper Analytical Services for cash. While currently a user of the firm’s data and an occasional columnist for Reuters, I have no contractual relationship with the company. Both the fund I supervise and personally I own shares in Thomson Reuters.

The Third Aberration To Sound Investing

In addition to the CIO errors and Libor manipulation, the very same concern for the safety and soundness of banks in major countries of the world has led to various central banks rescuing specific banks and banks in general by flooding their economies with cash as well as driving down interest rates. These low interest rates do not recognize the credit risks in the marketplace which has two impacts:  the first is to dry up the lenders’ willingness to lend to the borrowers, which slows the economy. The second and more insidious is that individual and institutional investors that we serve cannot meet their ongoing income needs in high quality investments. Thus they seek other investments with enlarged credit risks so that they can pay for people’s retirements, pay reasonable wages to those devoted to the non-profit areas and provide capital for future expansion of facilities and employment. 

What do you think?
Did you miss Mike Lipper’s blog last week?  Click here to read. 
Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of

No comments: