Ask an Ex-Banker: What Are Discretionary Accounts?

NOTE: A version of this post appeared earlier in the San Antonio Express News

Happy_Rich_Man

Dear Mike,

I wanted to report on my meeting with JPMorgan today. They were very nice, very polished. They handle private accounts and were confident that we could easily transfer my money over to them. They told me that they have analysts all over the world working on this, but they are personally watching the money to insure we get the best deals.

Then I started asking questions and found out a key point: All JPMorgan accounts are “discretionary accounts” (actively managed) and they explained why that was really important and helpful.

So my question is this: What is a discretionary investment account? What are the other alternatives? And what would you recommend a novice investor use? I think I remember my old banker advising me to stay away from discretionary account management, but I am not sure.

Thanks,

Sophie in Boulder, Colorado

————-

Dear Sophie,

“Discretionary” means someone else — not you, someone at the bank — makes decisions about your money. That works for people who totally trust their banker, I guess.

Personally, I would never do that, but probably not for the reasons you would think. Let me define a few terms to explain my thoughts.

As so often happens with money management, the way you pay fees determines everything.

A discretionary “brokerage” relationship is probably what your old banker advised you against. That kind of relationship is one in which the firm and your main advisor make money only when you buy or sell a product, basically from brokerage commissions. This has the pernicious effect of encouraging your broker — because they have discretion or control over your account — to trade more often than might be prudent. That’s how a discretionary brokerage account works, and that’s something to avoid.

A discretionary “fiduciary” account, by contrast, is one in which the bank and your financial advisor get paid through regular quarterly or annual fees, usually as a percentage of your money that they manage. This has at least three advantages:

  1. The broker does not make more money by trading frequently, which can be deathly to a person’s net worth;
  2. If you as the client have more money, the advisor gets paid more, so in general the broker’s incentives line up a bit better with your best financial interests; and
  3. A discretionary fiduciary relationship typically carries with it an expectation that the broker must act in the client’s best interest, and a regulatory regime exists to try to punish bad actors who fail to act as prudent fiduciaries.

Now, there’s no guarantee that the broker with discretion will always do that.

I say that not particularly because I think JPMorgan Chase will rip you off. While that’s possible, I would consider it highly unlikely to happen with JPMorgan Chase — or any other giant brokerage firm. I’m not naïve about the possibility of bad apples at JP Morgan Chase, but I trust in the power of lawyers going after big Wall Street firms. JPMorgan Chase and other huge brokerages are big fat targets in a highly litigious world. Many class-action or investor-protection lawyers would like nothing better than to take you on as a client if you got treated badly by a big brokerage company. That’s a massive payday all around for you and your attorney.

So I’m not primarily worried about fraud per se with your discretionary fiduciary account.

What I am more worried about with a discretionary account is the likelihood that JPMorgan Chase will provide higher-cost solutions than you really need.

I worked on Wall Street, and we always got paid better for putting clients into higher-cost, rather than lower-cost, solutions. Since that’s how we got paid, that’s where the conversations tended to turn. It’s really hard to avoid. When you give your broker discretionary power, mostly you run that risk. Since you are a novice investor, this is a particularly important risk to think about.

As for whether a discretionary account is standard at JPMorgan, as your prospective brokers claimed: It seems impossible to me that “everyone” has that kind of account. Those two brokers in Boulder, Colorado, may have every one of their clients with that deal, but I have no doubt that JPMorgan allows some clients to control their own money.

How do I know that? Here’s how I know. Many, many, many rich people want to control their own money, and JPMorgan Chase wants to make rich people happy. Therefore, JPMorgan Chase must open non-discretionary accounts.

A buddy of mine in San Antonio who works for a competitor of JPMorgan explained to me that he and his colleagues often prefer to set up clients with a discretionary fiduciary account. But the choice ultimately rests with the client.

Now, those JPMorgan financial advisors — or any other brokerage firm — may not want your account if they can’t have discretion over it, which is their own choice. But the JPMorgan investment advisors’ claim that “everybody” has that type of account is really a description of their own particular business model of those investment advisors within their office, rather than a universal rule of JPMorgan.

My buddy the investment advisor and I respectfully disagree somewhat on the issue of whether your discretionary fiduciary account will lead to higher cost solutions. He argues that because he makes more money when his clients make more money, he has both a fiduciary duty as well as a financial incentive to make his clients more money. For that reason, he argues, he will certainly choose a lower-cost investment product if that’s better for his client, or he will consider other options if that’s better for his client. Since he has set up his financial advisor practice so that he cannot benefit directly from higher-cost products, he feels confident he will protect clients from high-cost products that don’t serve them best.

I remain skeptical, and we’ve talked about this difference, because my experience tells me that investment advisors have a wide variety of incentives, and some of them go beyond the purely fiduciary. What if financial advisors get treated to a delightful luncheon at the best restaurant in town by the fund manager and their analysts? What about access, and information? What about a sense of belonging? Or brand loyalty — that goes beyond the precise “best practice” for the client?

My buddy says good investment advisors set themselves up to be client-oriented and safe from these competing incentives. I say that even with the best of intentions we’re all human and we have mixed motives. The more discretion you give your advisor, the less you can control those motives.

As for JPMorgan Chase’s claim that they are “watching your money to make sure you get the best deal,” I guess this is the kind of thing one says these days to justify higher fees.

The key to Wall Street — as always — is to convince clients that the broker or bank provides some extraordinary service to justify extraordinary costs, when in reality the service is typically very ordinary.

I know you are concerned about what to do next.

I’ve thrown a bunch of skeptical ideas at you that do not solve the problem for you.

The long run solution is to invest enough time in understanding your investments to the point where you will no longer see giving a bank or brokerage discretion as a good thing. The short run solution is to keep shopping around for a bank or brokerage that wants you to gain that understanding, rather than to make decisions for you.

Please see related post: Do You Need An Investment Advisor? If So, What For?

Please see related book review: Simple Wealth, Inevitable Wealth by Nick Murray

 

 

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I Disagree about JP Morgan But I’m Totally Entertained

A friend and I debated the merits yesterday of Alex Pareene’s recent article on Salon, in which Pareene praises the most recent $13 Billion fine against JP Morgan as justifiable punishment for greedy bankers and a morally-positive disincentive to the banking industry generally.

I totally disagree.

I happen to think, and I’ve written before, that the journalistic narrative demonizing bankers for the 2008 Crisis misleads us about the root causes of the financial crises.  I will argue vigorously for a more complex understanding of what went wrong.

Jon-Stewart-Bank-Yankers-screenshotOn the other hand, and despite my disagreement, Jon Stewart is better at what he does than anybody else is good at what they do (with the sole exception of Nate Silver).  So I’m still totally entertained by his characterization of the massive JP Morgan fine, the Alex Pareene article, and the response of financial journalists.

The first Daily Show video clip is here, in which he features Pareene, and Maria Bartiromo and Jim Cramer:

The second Daily Show clip is here, in which he satirizes the financial media’s “shakedown, jihad, gun-to-the-head” characterization of the JP Morgan $13 Billion fine.

 

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What The Dimon Hearings Today Are Really About

The Senate Banking Committee long-ago proved itself to be not a truth-seeking body, but more of a combination woodshed and green room, in which distinguished financial guests get paddled mercilessly by one Party, while coiffed and flattered by the other.  Senators play at Congressional inquiry in the interest of the public good, while keeping a keen eye on the opportunity for scoring points in their internecine battles.  Today’s distinguished guest Jamie Dimon, JP Morgan Chase’s chairman and chief executive, got his chance to receive the paddle and the flatter.

In a perfect world, it’s nobody’s business whether a bank makes a mistake in risk management and loses a nominally large, but clearly manageable, amount of money.  The JP Morgan losses from the London Whale, compared to the magnitude of its balance sheet[1] as well as the magnitude of 2008-era banking write-downs[2], amount to a tiny hiccup.  In a risk management sense nobody should care[3].  In a public welfare sense as well, regardless of what the Senators say, nobody should care about the London Whale losses.

We live in a far from perfect world, however, and recent history (i.e. 2008) teaches us that large, private banks’ losses can become massive public liabilities pretty quickly.  Nevertheless, the London Whale losses are largely irrelevant.

Do not be confused by the real issues at stake here.  Nominally, Dimon was invited to respond to his bank’s recent trading losses attributed to the London Whale, which he did.  In truth, the topic is to what extent the so-called Volcker Rule, intended to limit proprietary trading by regulated banks, will be put into effect.

That debate matters, and it harks back to the central issue facing bank regulators today.  Namely, should deposit-taking banks be in the business of securities trading?  It’s a front-burner, Top 3-most-pressing-financial-issues-of-the-day question.

In other words, can we return to a Glass-Steagall Act era, in which deposit-taking banks are not also acting like hedge funds?  Those are the stakes, and they deserve serious discussion, such as we did not get today from the Senate Banking Committee.  We got lecturing and posturing but we did not get serious discussion.

Two other thoughts.

As a betting man, and as one with a view on where Senators’ bread is buttered, I think there’s no chance they have the foresight, financial independence or cojones to really roll back the union of deposit taking banks and proprietary trading banks.  We’re just not returning to the regulatory environment of the mid-1990s.[4]  It wasn’t that long ago, but the Clinton-era unleashing of these Too Big To Fail behemoths has created too many deep-pocketed interest groups.  So don’t hold your breath on that one.

Second, while it may not be obvious to everyone, Congress has a funny way of rewarding relatively positive risk management.  I don’t know Jamie Dimon and I have no reason to flatter him[5], but the firm has performed far better than most.  The London Whale losses stand out precisely because JP Morgan navigated the Credit Crisis much better than almost anyone.

I know it’s hard to ask the public in this environment of “Banking CEO = Greedy Vampire Deserving of Public Stake-Burning” to distinguish between good and bad actors, but the Senators should at least make the attempt.  The Senators do, after all, accept their campaign contributions.

So many other CEOs besides Dimon deserve the woodshed treatment.  In my opinion the most reprehensible banking CEOs (or any financial executive for that matter) are the ones who receive extraordinary personal pay before leaving massive public liabilities in his wake.  Ken Lewis at Bank of America, Sandy Weill and Vikram Pandit at Citigroup, Stanley O’Neal at Merrill Lynch, Franklin Raines at Fannie Mae, Joe Cassano at AIG, and Angelo Mozilo at Countrywide are easy examples, although there are many more.

If you can wrap your mind around good guys in the banking world, compared to that rogue’s gallery, Jamie Dimon would be one of the good guys.



[1] To give an idea of size, the approximately $2Billion loss from the London Whale trades represent less than 7% of their loan-loss reserves, 1% of their equity, and 0.5% of their investment portfoio

[2] During the Credit Crisis of 2008 many of the TBTF banks reported losses 10X this size, multiple times!

[3] Except obviously the risk management folks at JP Morgan.  When I say ‘nobody’ I mean the rest of us.

[4] that separated deposit-taking banks from securities trading banks

[5] In fact I kind of enjoyed making fun of him here.

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Book Review: The House of Morgan

Since the beginning of the Great Recession, JP Morgan’s Jamie Dimon has played the role of the United States’ Alpha Banker: snatching Bear Stearns’ franchise at bargain basement prices, modeling superior risk management,[1] and publically pushing back against government regulation of his industry, all the while acting as Obama’s BFF when it suits him.

So it takes a great book like The House of Morgan to see Dimon’s Mini-me status compared to the original John Pierpont Morgan.  In sweep of history, stretching from the original J. P. Morgan to Jamie Dimon, the former looms like the Atlas statue outside of Rockefeller Center over Dimon’s diminuitive Oscar statuette.

Size matters in this story.  Even in paperback form, The House of Morgan arrives bigger than a breadbox.  And Ron Chernow can write big. The one-hundred-year epic sweep of the bank’s rise and evolution tracks the United States’ rise as the world financial center, a position wrestled from the Brits in the first half of the 20th Century.

J.P. Morgan himself, a giant of a man with his 19th Century prejudices and a horrifyingly bulbous, pockmarked nose, shaped the entire world through force of will and unerring capital deployment.  In contrast to today’s mega-banks, saved from the brink by massive government intervention, the House of Morgan intervened to prevent government collapse.  In 1907, one hundred years before our own 2008 Credit Crunch, Morgan single-handedly engineered a market-saving trust merger.

Here are a few more essential reasons to read The House of Morgan.

First, if you work on Wall Street and don’t understand the original deep divide between Jewish and Gentile banking worlds, start here.  JP Morgan, the ultimate white-shoe firm[2], fought bitterly and ultimately unsuccessfully to keep the likes of Kuhn, Loeb; Lehman Brothers; and Goldman, Sachs from competing on equal footing for banking assignments.

In the latter half of the 20th Century, cozy relationship banking gave way to a competitive world that required top intellectual talent and drive.  Morgan and its (predominantly) Protestant brethren often chose family pedigree over talent, a choice that put them at a disadvantage when sons didn’t exhibit the same drive as their fathers.  The traditional Jewish Wall Street firms, by contrast, tended to welcome a variety of backgrounds into their ranks, based on intellectual and personal qualities, rather than limiting their employees to those of Jewish heritage.  By the 1980s, Goldman Sachs, Salomon, Bear, and Lehman began to out-compete Chase, PaineWebber, Merrill Lynch, Morgan Stanley and First Boston.  The white shoe firms reluctantly adopted a meritocracy approach to talent acquisition, by necessity.

Second, although Chernow’s story ends in 1989,[3] he captures the evolution from wholesale merchant banking of the early 20th Century to the aggressive M&A takeover and trading culture with which we associate Wall Street now.  Wall Street’s reputation as a rapacious casino, in which profits accrue privately to the few while the public picks up the unlimited liabilities after the bust, is a relatively new phenomenon.

Third, it’s fascinating in the age of TBTF[4], to contemplate a single banking behemoth so much bigger in importance than any one bank today.  The original JP Morgan, split forcibly in 1933 to comply with the Glass-Segall Act, lives on in its descendants Morgan Stanley (originally for investment banking) Deutsche Bank[5] (originally the UK Branch) and JP Morgan (originally for commercial banking).  Imagine those three banks re-merged[6] and even then you probably don’t get the sense of the scope of the original JP Morgan Bank’s influence, nor of the man himself.

Jamie Dimon, you’re pretty huge.  Does it bug you that there’s always someone bigger?

Please also see related post, All Bankers-Anonymous Book Reviews in one place.

 


[1] With the obvious notable exception of missing the London Whale’s trades until it was too late to save a few $billion.  But really, in my mind, that episode highlighted Dimon’s solid reputation.  We’ve come to expect BNP Paribas or UBS to periodically blow giant holes in their balance sheets via rogue trading positions.  It was quite another thing – and quite a surprise, when it happened on Dimon’s watch.

[2] Along with its successor firm Morgan Stanley

[3] Wall Street’s image frozen in time with the image of Michael Douglas’ Gordon Gekko suspenders!

[4] Again, Too Big To Fail.

[5] The UK bank Morgan Grenfell became Deutsche’s investment bank in London.

[6] As they contemplated doing in the 1970s

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