When Genius Failed... Again

The following commentary was originally posted on FoolFunds.com, the website of Motley Fool Asset Management, LLC, on April 4, 2013. With permission, we're reproducing it here in slightly edited form.

"If you're the first to do something, you don't have to read about it." -- Jack Horner

By now you know about the "London Whale," the JPMorgan Chase credit trader whose investing decisions cost that storied bank some $6 billion. You might think that losing $6 billion is kind of easy, but a recent Senate report and testimony about this ordeal suggest that lots of things went wrong at JPMorgan on the way to losing such an eye-popping amount of money. The lesson from the London Whale debacle is a simple one: The smarter you think you are, the less likely you are to use common sense. This might seem counterintuitive. Don't smart people tend to make better decisions?

It's pretty easy to grasp what caused JPMorgan to lose $6 billion. You don't need to know the details of the London Whale trades or even understand the mechanics of derivatives and complicated risk models. You just have to be able to recognize the hallmarks of a very bad decision.

Faced with certain capital adequacy requirements, JPMorgan, according to the Senate report on this matter, "instructed the CIO [Chief Investment Office] to reduce its Risk Weighted Assets (RWA)." While this sounds complicated, it just means that regulators require banks to have sufficient assets (like loans) to offset liabilities (like retail deposits) and that regulators don't view all assets equally, even if they are theoretically valued the same. For example, a book of distressed illiquid derivatives is worth far less in the eyes of regulators than is a book of short-term government bonds.

Where JPMorgan went wrong
Rather than sell risky and/or volatile assets and put that capital into safer instruments, the CIO instead "launched a trading strategy that called for purchasing additional long credit derivatives to offset its short derivative positions and lower the CIO's RWA that way." I hope you read that correctly. To lower the risk of the bank's investment portfolio, the CIO did not trade higher-risk assets for lower ones, but rather bought more higher-risk assets and decided that higher risk plus higher risk equals lower risk -- a strategy that gained tacit approval from a risk group "staffed by well-trained and educated PhDs." Fare thee well, Common Sense.

People who think they are extremely intelligent will still defend this as hedging. In fact, it is just egoism. In a Motley Fool editorial a few years ago, Bill Mann described this kind of thinking as "Harvard stupid." It's the kind of trouble people get into when they're absolutely convinced they're far more clever than everyone else.

Recommended reading
Two fantastic books are germane to this discussion. The first is the wonderfully titled Deep Survival: Who Lives, Who Dies, and Why. On its face, it's not an investing book, but its careful study of good and bad decisions in high-stress scenarios is certainly applicable to the world of finance. You should read all of the case studies for yourself, but the takeaways boil down to simple common-sense lessons: It's better to be prepared than be unprepared, for one example. The known is far superior to the unknown, for another. Pro tip: If you find yourself lost in the wilderness or hiking into a blizzard, turn back the way you came. Your salvation is unlikely to be around that next bend, or even the one after that.

This month's letter borrows its title from the second book, When Genius Failed: The Rise and Fall of Long-Term Capital Management. Long-Term Capital Management was a hedge fund set up by, among others, two Nobel Prize winners to execute on ostensibly low-risk, high-reward arbitrage strategies. It attracted huge amounts of assets because it, as BusinessWeek eulogized after its collapse, "was considered too clever to get caught in a market downdraft." Yet none of the very smart people at LTCM ever asked the obvious question about what fueled their trading gains: Should we be worried about our 25-to-1 leverage?

See the pattern?

If you're stupid, you're not alone
But JPMorgan and LTCM are not alone this century in believing that the best way to get out of a hole is to dig deeper. For example, when faced with riskier and riskier loan profiles, the mortgage industry chose to make more loans and believe that diversification took away all the risk. Or there are the daily deals sites such as Groupon and LivingSocial that seemingly came to believe that the solution to unprofitable growth was faster growth.

It's for this reason that the highlight of our recent research trip to India was a simple line uttered by HDFC Bank executive Paresh Sukthankar. Challenged by an analyst about why HDFC Bank wouldn't grow faster if public sector banks in India started going bust and giving up business, Sukthankar simply replied: "We're not that smart. If we tried to grow too fast, we would make mistakes."

That type of self-awareness, consideration, and common sense is one reason we have a great deal of respect for HDFC management. It's probably why HDFC (both the shares and the company) has so outperformed the rest of the Indian banking space for so long. And it's certainly why HDFC finds itself in our portfolio. In fact, we strive to collect managers in our portfolios who admit they aren't as smart as their results make them look -- people like Warren Buffett at Berkshire Hathaway or Tom Gayner at Markel.

Paradoxically, these are some of the most brilliant people in the world precisely because they recognize that they are more than capable of making catastrophic mistakes. Buffett always talks about staying within his circle of confidence. This is a man who, in the words of legendary coach Bum Phillips, "can take his'n and beat your'n and take your'n and beat his'n." He's smart. Reaaaaalllly smart. And he doesn't stray from his areas of expertise specifically because these are places where he is least likely to outsmart himself.

Editor's note: Tim Hanson is not able to engage in discussion on the boards or in the comments section below. He owns shares of HDFC Bank and Berkshire Hathaway.

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