Beware experts chasing leverage rather than profit

JP Morgan was in the news last week and, like most global investment banks these days, it was for the wrong reasons. The "experts", it emerged in a congressional hearing, once again got it wrong – proving that it is much easier than you think to manage your own money and beat the professionals.

Traders at JP Morgan in London went on a wild gambling spree in the London Whale affair and failed to tell their bosses of the risks involved. The bank was accused of surreptitiously increasing its exposure to the credit markets (a process known as leverage) and then concealing the losses that it suffered.

A question on everyone’s lips is when will all these financial scandals end?

Unfortunately, in the short term, the likelihood is that we will see more of them rather than fewer. Huge structural changes are needed before the dangers of powerful financial centres are contained.

Meanwhile, there are important lessons that individual investors who want to beat the experts can learn.

The antics at JP Morgan follow what are now similar characteristics appearing in almost every scandal; complex transactions that no one understands, huge leverage and hidden losses.

Apparently, one employee who should have overseen and stopped what some traders were doing, has had his salary halved from $11 million to $5.5 million. It clearly pays to be in investment banking, though as an employee and not a shareholder.

When investing other people's money, the temptation is to chase leverage and not profitability, leaving the private investor with potential lucrative opportunities.

To understand why the “expert” investors are continuously going off the rails and facing inquiries and negative publicity, the following example might help.

Volatile
Imagine you had a choice between two investments

(see table, right). Investment A costs €1 million and has three possible outcomes in a year’s time, each equally likely at the end of the year: €800,000, €1.1 million and €1.4 million.

Investment B also costs €1 million and it too has three possible outcomes: €300,000, €1.1 million and €1.6 million. As the table shows, the “expected profit” or average of A is greater than B but B is more volatile/leveraged.

A private investor who is exposed to losses will go for A but an “expert” investor, managing other peoples’ money, will find B more attractive because the expected bonus is higher.

This in a nutshell is why the “experts” prefer volatile leveraged investments.

There is a link between regulation and leverage which private shareholders need to be aware of, as the objective of any sensible investor is to avoid the overheated areas on which traders tend to concentrate.

It is no coincidence for instance that the property market, government bonds and securitisations are the three areas that brought international banks down. They are also the three areas that were lightly regulated by a set of banking rules known as the Basel Accords. In essence, regulators told bankers they could build up their exposure to these three areas without fear of too much regulatory intervention.

The result was that each of these sectors was overpriced and loss-making.

Bankers and other “experts” knew this but chasing leverage is more important for them than chasing profitability. Savvy private investors see regulation as a form of distortion where managed money flows to overpriced sectors.

The irony with JP Morgan was that it was supposed to enter the controversial transactions in order to reduce leverage, a process known as hedging. However, by using complex instruments, traders secretly increased leverage.

Had the markets gone as JP Morgan’s traders had hoped, they would have received higher bonuses.

Apart from fooling well-paid risk managers, complex trades have another advantage. It is very easy to hide losses.

In the case of JP Morgan, the valuation method which calculated losses was replaced with an alternative model, one that reduced losses considerably.

There are lessons for the private investor in all of this. Firstly, if there is a hint of an entity using complicated financial instruments, it is possibly because it can introduce concealed leverage and delay recognising losses. In other words steer clear of such a company.

Secondly, the study of regulation helps. An investor will most probably be reasonably rewarded for the risk he takes if he or she attempts to avoid overpriced sectors.

Regulation
Irish bankers failed to reveal how the Basel rules allowed them to overexpose themselves to the overpriced property market. Even today losses are concealed.

Regulation interferes with the laws of supply and demand. Far from reducing bubbles, it ends up creating bubbles. Think of the Irish hotel industry. Tax breaks offered by Irish governments produced an oversupply of hotels and, as a result, many casualties.

A long-term sensible investor will examine regulation and generally avoid those areas promoted by regulation such as Basel II or tax breaks, since these sectors are usually overpriced – though it doesn’t prevent traders chasing leverage. Often complicated deals are treated leniently by regulators, despite their high leverage.