Didn’t they really have skin in the game?

by Russ Roberts on October 1, 2009

in Financial Markets

Joshua, in the comments to this post, asks the excellent question:

My understanding is that the Wall Street guys had large fortunes in the stock of their companies. If Richard Fuld of Lehman lost a billion dollars, how much more skin in the game would he have needed to have the right incentives? Why would it be that in general the firms with CEOs that had more stock and more exposure did worse than the ones with less?

Jimmy Cayne, CEO of Bear Stearns until the last months of the firm, also lost a billion dollars.

I once thought as Joshua did. Isn’t this loss a pretty big deterrent to excessive risk-taking? Not really, it turns out. These were paper losses that could not have been easily realized and captured. Fuld was able to cash out hundreds of millions of dollars from his stock holdings. Cayne confesses to be worth a mere $600 million after his billion dollar loss. Not exactly a wipe out. I will have more on this in my upcoming essay.

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Methinks October 1, 2009 at 3:39 pm

Love of risk.

Jimmy Cayne and Dick Fuld were both traders. Soloman traders were wailing that Sandy cut their leverage and killed the riskiest trades altogether when the red umbrella bought the bank. Traders are often degenerate gamblers brimming with hubris. The hubris is amplified when a bad trade turns out to make money – which is what was happening for a few years.

Also, it’s very much more easy to be risk loving when you’re either penniless or very very wealthy.

In both cases, you’re playing with other people’s money and you’ll come out relatively unscathed. If you’re poor, you’re gambling with other people’s money and have no assets to go after, so the lenders won’t bother when you default. That probably explains why so many people took the zero-down option. The downside was very low and upside was very high. If you’re very very wealthy, you can lose a lot and still be okay.

Methinks October 1, 2009 at 3:42 pm

“in both cases, you’re playing with other people’s money”

I change my mind. That’s not necessarily true. The very rich can risk a portion of their own capital and still come out okay if they blow up. It’s only true for the poor who are offered massive amounts of other people’s money – usually to finance one gigantic illiquid asset.

Dano October 1, 2009 at 5:07 pm

In other words relative risk aversion compared as opposed to absolute risk aversion

anon October 1, 2009 at 3:48 pm

I’m not sure it even make sense to say they lost $1 billion dollars. Do I lose $30,000 when I put $3 down on the horse with 10,000:1 odds who ends up losing?

Methinks October 1, 2009 at 3:54 pm

Wall Street bankers don’t get paid in cash. The higher up you are, the more of your comp (to a limit) is paid in deferred compensation which is vested over years. Often the non-cash comp is in the form of restricted company stock. Also, often, people don’t cash out when the stock vests. That’s the way an ex-boss of mine at Lehman lost the equivalent of 15 years of compensation last year.

Richard Fuld held a lot of Lehman stock.

anon October 1, 2009 at 4:09 pm

Right, but the value of that stock was based on Fuld’s gambles. Those gambles came out of the gate ok, but stumbled on the turn. Did I lose $30,000 after the first furlong?

I would agree that Fuld lost something, but I’m just not sure I’d value it at the peak stock price times his number of shares (or evening the closing price on 9/12/2008).

Methinks October 1, 2009 at 4:19 pm

fair point – but only if you ignore the market’s valuation of the stock. The convention is to use the market price. It’s a bit fishy to re-value the position after an event already occured. If this were January 2007, would you tell me the value of Fuld’s position is different than shares times stock price?

Surfisto October 1, 2009 at 4:21 pm

Why are ethics never involved? Russ had the CEO from BB&T bank on the podcast and he talked a lot about ethics and how they were involved with the companies 10 values. It was not some inspiring hippy love thing, but a realistic business model. Why can’t the “skin” be ethics?

Methinks October 1, 2009 at 4:28 pm

Ethics are a big part of most companies. Managing other people’s money involves an enormous amount of trust and most of us don’t take that trust for granted. It’s insulting and false to imply that ethics are “never involved” when an extreme minority of criminals and degenerate gamblers make the headlines.

Surfisto October 1, 2009 at 4:38 pm

I agree and that is why I mentioned BB&T. I was trying to say why is the question about never asked about ethics, but that the skin always seems to be money.
Although a minority make the headlines we can’t forget the impact they have. Think of the millions/billions lost by fraud. Many people are financially wiped out by this fraud not to mention the miss allocation of capital. Plus the political impacts that has gov’t changing rules that will again affect productivity and wealth loss.

Methinks October 1, 2009 at 5:00 pm

By mis-allocation of capital, I assume you mean taking positions that eventually lead to negative outcomes. When one is allocating capital, it’s never clear if the the allocation will result in a win or a loss. That’s always an estimate.

Many people are financially wiped out because of fraud or sour investments only because greed leads them to put too many eggs in one basket or to lever up too much. Why do we never talk about the fraud perpetrated by home buyers? Every Tom Dick and Harry was trying to get rich quick in the real estate market.

Idiotic risk taking, fraud, and mis-allocation of resources is by far not the exclusive domain of Wall Street. Why aren’t you asking why the average Joe wasn’t worried about the expansion of government and the how walking away from his zero-down mortgage would wipe out his creditors?

Surfisto October 1, 2009 at 5:38 pm

You make good points and have me thinking.
Thinking of Enron as an example if someone had their entire pension tied up in Enron stock that is not necessarily greedy, they just wanted to retire comfortably like everyone else. It may have been unwise as to not diversify, but calling every grandpa greedy I think is a bit harsh. Also, the capital was mis-allocated because of fraudulent reporting, this is bad information and effects market outcomes and is a problem.
The average joe is in favor of expanding gov’t because of this press the fraud receives, that is why he is not worried, Joe is misinformed and also expects the gov’t to protect him from his zero-down mortage I agree it’s ludacris.

spencer October 1, 2009 at 4:59 pm

The point is not so much how much skin in the game the CEO has.

Rather it is what he believes will happen to his wealth when he makes a decision.

If when he makes a decision he expects his stock holding in the bank to trend higher over time with only minor corrections this is the relevant point.

For the actual loses the bank officer realized in 2008-09 to matter you have to demonstrate that the bank officer expected to have terrible loses when he made his decisions back in an earlier time.


Greg_Ransom October 1, 2009 at 5:08 pm

Russ, also look at the money the CEO of WaMu cashed out, or all of the money the various CEO of the Orange County, CA mortgage origination firms cashed out before going belly up. Daniel Sadek is still a very rich man. In fact, all of these guys are still ROLLING in money. Equity was not were the money was.

And the folks who worked for a bonus were also playing this game — everyone working for those subprime lenders in Orange County knew they were making repeated bad loans (talk to anyone inside the industry down here) but they were making a killing doing it, and they weren’t going to stop till the gig was up.

The Orange County Register has come good stories on this, but you get a better insider view simply talking to the people who worked in the industry (you can get a flavor of this from CNBC’s “House of Card”).

Anonymous October 1, 2009 at 5:40 pm

Although I understand Russ’s point, I think it is worth remembering that some people, especially those who are likely to amass large fortunes, tend to value money more than others. Ofthen they see their bank balance as a kind of scorecard, and their self-esteem is tightly correlated with being richer than their peers.

In short, I think a loss of $1 billion, even though they may still be worth $500 million, is going to hit some people harder than others.

Anonymous October 1, 2009 at 6:20 pm

It is also important to remember that if these people wanted to live the good life, they could’ve cashed out at any time. They work because they have a sense of self in what they do. It is not a small thing to them to be seen as a failure.

Methinks October 1, 2009 at 6:46 pm

That’s true. Just to add to your point:

Money is often seen as security. The more you have, the more secure you feel. It’s also often a scorecard for the business. The more you make, the more valuable your creation becomes.

Anonymous October 1, 2009 at 7:34 pm

Most CEO’s greatest dream is to retire with the reputation of a Jack Welch. Their greatest nightmare is to be a Dick Fuld. Therein lies their primary motivation.

Anonymous October 1, 2009 at 6:14 pm

I think you might be over weighing the incentives in regard to compensation. If you can show that following a different course Cayne would have stood to make substantially less money–or even lose money–it would make for a stronger argument. But reputation is no small thing to these people. I doubt Cayne, if given the opportunity, wouldn’t gladly give back all his Bear earnings for the chance to do things over.And you still have to explain why after decades there was a sudden coordinated lapse of ethics and responsibility at multiple levels of many different corporations.Serious risk-assessment mistakes due to seriously wrong signals is the oldest and best explanation. You can blame businessmen for being fooled, but in bubbles they always have been, and they always will be. If you want to fix blame and try to prevent future occurrences, you need to focus on the cause of the misdirected signals, not their consequences.

mark October 1, 2009 at 7:21 pm

If you are worth $2 billion, and you loose $1 billion, it may be a blast to your ego, but that person still has $1 billion. Not exactly devastating.

Like any successful investor, none of the Wall St. Titans were solely invested in their own firms. I can see how they would be willing to play dangerously with a large portion of their own money (even if it is just paper wealth), when they have an equally large share invested conservatively.

Ray Gardner October 2, 2009 at 2:44 am

I think that’s the main thing most people miss is that the value of their stock cannot be easily accessed.

It’s more of an illusion actually as if to say “See? See? There’s personal accountability here.” While they are making very real incomes in the hundreds of millions despite their performance.

Name October 2, 2009 at 11:08 am


We investigate whether bank performance during the credit crisis of 2008 is related to CEO incentives and share ownership before the crisis and whether CEOs reduced their equity stakes in their banks in anticipation of the crisis. There is no evidence that banks with CEOs whose incentives were better aligned with the interests of their shareholders performed better during the crisis and some evidence that these banks actually performed worse both in terms of stock returns and in terms of accounting return on equity. Further, option compensation did not have an adverse impact on bank performance during the crisis. Bank CEOs did not reduce their holdings of shares in anticipation of the crisis or during the crisis; further, there is no evidence that they hedged their equity exposure. Consequently, they suffered extremely large wealth losses as a result of the crisis.

Methinks October 1, 2009 at 5:59 pm

My point is that it’s just as accurate to call every Joe Home Flipper a greedy bastard as it is to call every Wall Streeter a greedy bastard.

Capital was rarely mis-allocated because of fraudulent reporting. That was the case for WorldCom and Bernie Madoff, but a sell-side analyst was able to point out the entire Enron deal in the publicly available information which the company filed quarterly with the SEC. Fraud is actually very very rare, happens in every business and is impossible to eliminate entirely. People’s savings got wiped out because they concentrated too much of their savings in one place. Bernie Madoff could have legitimately lost everyone’s money just fine without resorting to fraud. Past performance is not a guarantee of future returns. That’s a basic lesson even Average Joe should know before committing his capital. If they want to retire comfortably, they need to diversify – not gamble on a single horse. I think blaming large amounts of capital mis-allocation on fraudulent reporting is a bit of a stretch.

You’re right. Average Joe expects the government to protect him from any downside when he takes a risk. That’s a much broader way of looking at it and that brings up the issue of expectations of bailouts by Average Joe as well as by Government Sachs. So, it turns out that Wall Street likes bailouts and Average Joe likes bailouts. It’s just that neither wants to pay for them.

The only people who don’t like bailouts are the forgotten men in this scenario – the honest prudent businesses and individuals who work like mad to make an honest living, control their risks and expect to suffer the consequences of their own actions, good or bad. Those are the people who get screwed. Understandably, their herd is thinning.

Surfisto October 1, 2009 at 6:23 pm

I agree with what you are saying.
Getting back to my original post, I am trying to say that the emphasis is on Capitalist and Greed. Not enough people see the good side of those things. A year ago I saw only the bad side. So when people see greed they blame Capitalists and wall street because we want someone to blame even if we were doing the same thing (Joe Home Flipper). As we argue if we “they” had enough skin in the game we add to the fire. The fire being people blame capitalist and capitalism and turn their attention to socialism and a false idealogy of a perfect world that socialism will create. If we could eliminate fraud, I know impossible, we can bring focus to the positives of Capitalism. To help in this we can sometimes discuss ethics and bring it to front of discussion and by our actions, like moving our assets to BB&T and supporting other honest businesses. This may be wishfulf thinking, but we can start somewhere.

Methinks October 1, 2009 at 6:55 pm

I see what you’re saying. But, I still think your conclusion is too fraud-centered. Fraud isn’t the reason for most losses.

The downside of capitalism isn’t fraud – it’s that there are winners and losers, full stop. I think people hate capitalism when they lose on an investment and want the government to protect them from the losses. They love capitalism when they make a lot of money on an investment. Of course, as with any hedge against loss, the protection from the downside comes at the expense of the upside and most people don’t understand how expensive government insurance is.

Anonymous October 1, 2009 at 9:07 pm

Ethics, morals, or standards all have everything to do with character and nothing to do with capitalism.

You’re expressing yourself as if you think capitalism is a creed or a philosophy, perhaps some sort of theology, and it isn’t. Capitalism is a tool just like your wrench or pliers, you can use it to improve your personal security and use it to enrich your life.

Your character is yours, and greed and dishonesty are character flaws which you would have whether you were a socialist, aristocrat, royalty, or tyrant.

A wise man once said that sports do not build character, they reveal it. I submit that we can say the same of capitalism, it reveals character, but that character came from the inculcation and enculturation of an individual not the capitalism.

Surfisto October 1, 2009 at 9:40 pm

I think we are on the same page, you just said it better. When people complain about capitalism and capitalist they are really complaining about the character of the people involved, but they don’t say that, they blame capitalism. I agree those character flaws will be present no matter what system we are in. However, at the moment capitalism is under attack as a tool and as a creed, even if it is only a tool. So how can we turn the bullets away from Capitalism and towards character flaw. Or should we just learn to accept it will always be there and create harsh punishment to mitigate it.

Methinks October 2, 2009 at 12:49 am

Is capitalism a tool or is it just what happens when you leave people alone to make their own arrangements? Maybe you meant that capital is a tool.

Methinks October 1, 2009 at 10:04 pm

Yes, I think we’re on the same page. I don’t even pretend to have a clue how to answer the question you pose (assuming I understand it).

So far, the only effective method of getting people to favour capitalism I’ve ever seen is to subject them to fascism and socialism. Nothing cures people faster. As for punishing fraud – always an excellent idea. Unfortunately, government will always use fraud as a pretext for growing its power. If only the world were perfect, eh?

Anonymous October 1, 2009 at 11:01 pm

I personally think that capitalism can best be promoted by taking people to its roots and showing them that it is as natural to life as breathing.

No capital no capitalism.
No profit no capital.
No surplus no profit.

Virtually every single form of life on the planet can be seen to be making an effort to make a natural profit on its efforts in every single endeavor it attempts. Why? Because it is hard wired into life by nature. Nature is random and no form of life can predict what nature will throw at it on the morrow, therefore the hardwired instruction to produce surplus, surplus which will carry life through hard times (hopefully) that will come sure as the sun rises.

We humans with our ability to reason developed the means to produce and store surplus external to our bodies, and once that was learned capitalism became just as inevitable as the sun rising. Stored dried fruit is capital to a primitive. Investing that stored dried fruit into trade that will better the primitive’s life is, in my view capitalism.

Once people are at least exposed to the understanding of how natural and basic capitalism is to life, then having them understand that capitalism is a tool and not a creed or theology like socialism becomes much easier and certain.

Blame the man/woman, not the tool.

Methinks October 2, 2009 at 12:50 am

Sorry, didn’t see that the response was to vidyohs, not me.

Anonymous October 2, 2009 at 2:28 am

I am not so sure about the effectiveness of that method. It is not only horrible in itself but it degrades society and degenerates people in a way that feeds itself in a downward spiral that only complete exhaustion after a very long time could make things start turning around for the better.
That process is reinforced if capable and free-loving individuals have the option to flee, leaving behind the wretched.
I have seen the process going on in Cuba and my skepticism about experiencing communism as a way to make people to understand, love an appreciate freedom is not only based on the attitudes of those still in the island but on the attitudes of many of those who managed to leave the island and now live in relative freedom and certainly in an environment where they could explore the issues, yet by lack of introspection, intellectual curiosity, atavisms, etc, still support many statist fallacies.
It is not by chance that oppression and slavery have dominated most of human history. In a recent podcast Russ and John Nye touch that issue. We, freedom lovers, must be aware of the appeal of statism and collectivism if we want to counteract it effectively.

Surfisto October 2, 2009 at 3:10 am

Yeah, let’s put the thinks back in Methinks huh. Just kidding.

Anonymous October 2, 2009 at 3:27 am

yes to your first question. No m’lady, I meant capitalism is a tool. A box wrench is a simple tool that has no moving parts.A Skill saw is a tool that is more complex and has many parts, yet is still a tool. You might say that a Skill Saw is a process yet a tool all the same.If I trade my surplus dried fruit to you for your surplus Pemmican, we are both presumably better off and we have used the tool of investment in capital goods to do so, that is capitalism at its root.If I really have a huge surplus of dried fruit and my woman makes decent pemmican then I can use the superior pemmican I got from you in my trade and invest it in a more storage pots from Olga the potter, thus next year I can dry and store even more fruit and maybe take another wife so that my labor force grows and I can spread my efforts to other fields.Understand, Methinks, I am just a simple businessman who sat in a crowd of ignorant college age kids who were chanting “kill capitalism” in response to the goading of an older man who was indoctrinating them. I did not, and still do not, believe for a minute that you could approach those kids and counter that man’s influence by arguing Marx. The only way I can see to do it is to demystify capitalism and show it as the natural process it really is, and to show that capitalism has roots, roots that grow in your bedroom when you get up in the morning, get dressed and go out into the world to profit from your efforts. Without those roots, no capitalism.No capital, no capitalism.No profit, no capital.No surplus, no profitOnly a rare few in this world believe they work for no profit, and they are mistaken.
Where does the surplus come from, and do I have to be Warren Buffet to be a capitalist, when my own efforts produce surplus, profit, capital, which I can then use to invest in the market, the whole thing is a process like the Skill Saw and like the skill saw it is a tool.Capitalism is a tool, no mystery there.This is the way I it from a pure street level reasoning of the facts I see in history, anthropology, and personal experience. Perhaps with more education I could say it better, but the facts are there to support what I am saying and the process of human practice of capitalism began so far back in distant history no one can say when that first human brought back food to its den or nest as an investment against having to get up early on the morning to go look for more food.Everything has a root, a foundation, and it can not be divorced from that root or foundation, they have to be seen as one interconnecting process from beginning to end. Capitalism is no different.

Anonymous October 2, 2009 at 6:09 am

I think Keynes was tool. I blame him.

Methinks October 2, 2009 at 3:27 pm

I wasn’t seriously suggesting we try it. I’m from the Soviet Union and I fully understand the drawbacks (which you describe brilliantly). Socialism turns people into wild animals who will sell their neighbours into the camps for a scrap of bread from the state. We both saw this, I think.

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