Looking for your help (skin in the game)

by Russ Roberts on October 1, 2009

in Financial Markets, Looking for your help

I’m looking for some help from anyone with knowledge of life in the investment bank world. Please read on.

Peter Weinberg writes in the WSJ that the problem with Wall Street is that they didn’t have enough skin in the game. He explains how it used to be when investment banks were partnerships:

The only private partnership I can talk about authoritatively is the one in which I was a partner from 1992 to 1999, when the firm went public: Goldman Sachs. Partners there owned the equity of the firm. When elected a partner, you were required to make a cash investment into the firm that was large enough to be material to your net worth. Each partner had a percentage ownership of the earnings every year, but the earnings would remain in the firm. A partner’s annual cash compensation amounted only to a small salary and a modest cash return on his or her capital account. A partner was not allowed to withdraw any capital from the firm until retirement, at which time typically 75%-80% of one’s net worth was still in the firm. Even then, a retired (“limited”) partner could only withdraw his or her capital over a three-year period. Finally, and perhaps most importantly, all partners had personal liability for the exposure of the firm, right down to their homes and cars.

So why did that change? Why did these partnerships go public? My understanding is that by going public they could get a lot bigger. The injection of outside equity means that they can borrow a lot more money for any given level of leverage.

But that raises what I consdier the central question of the crisis. Why would lenders lend large sums of money financing investments made by people who now have less skin in the game? Before, when it was a private partnership borrowing money, the partners  were  investing their own money. Now they’re investing other people’s money–the equity holders and the larger absolute amount of money coming from the loans. Why would lenders play that game, knowing that the investors have an incentive to take more risk.

If the lenders do play this game, they should expect larger and larger amounts of leverage financing riskier and riskier loans. Why would they keep financing investments they have no upside stake in while their downside risk gets larger? Why would they keep doing this as Wall St. execs paid themselves larger and larger bonuses, further reducing their personal downside risk from their investments?

The obvious answer is that they presumed that if push came to shove, they would get bailed out. Their downside risk was actually much smaller than it appeared to be. And they were lending to each other, increasing their connectedness and the chance of a bailout if the worst-case scenario came to be. And that is precisely what happened in every case other than Lehman. Essentially, the whole thing was a Ponzi scheme played with your money and mine, taxpayer money.

Is there an alternative view? One thought I have is that one way such a strange highly leveraged world could emerge without an implicit government subsidy is by shortening the period of the loan. Was the overnight repo market a way that Wall Street was able to get more leveraged even in the absence of an implicit subsidy? Certainly this was a way of hedging their bets about the likelihood of a bailout or rescue.

Feel free to comment below on these ideas. But I wouldn’t mind hearing privately russroberts at gmail.com (or publicly in the comments) from anyone who has any personal experience of this world or data about what else changed when Wall Street stopped being a group of partners and went public. Am I right that Wall Street got a lot more leveraged? Did the funders of that leverage change?

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{ 91 comments }

Justin P October 1, 2009 at 12:48 pm

Just take a look at who’s in charge in Washington, finance wise, and that should give you a partial answer. I mean Geithner was from GS, what do you think he is going to do after his 4 year (hopefully) stint as Treas. Sec? He’ll want to go to work somewhere. Who do you think will hire someone that didn’t help out one of his own? Bailouts were/are the norm, Lehman was the Black Swan.

Anonymous October 1, 2009 at 1:13 pm

Justin,

It was Paulson who came from GS, not Geithner. But it will be interesting to see where he ends up after his time at Treasury.

Methinks October 1, 2009 at 1:44 pm

It’s not necessary for Geithner to ever be employed by Goldman Sachs to work for Goldman Sachs. Geithner’s former boss at the NY Fed is ex-Goldman (although, you’re never really ex-Goldman). It’s the only firm that keeps in touch with its “alumni” and offers to help launch political careers. Goldman creeps out some of its former employees. It’s cult-like. Former employees tend to initiate their underlings in political organizations into the cult.

Anonymous October 1, 2009 at 9:30 pm

This account rings true to me. We’re individuals, but we also have strong, tribal instincts. We follow rules, particularly if the rules seem to benefit us. You scratch my back now, and I’ll scratch your back later. Should you follow this rule, not knowing that I’ll really scratch your back later?People do follow it, apparently, and they also follow a similar rule. If you don’t scratch my back, I won’t scratch yours. Bear Stearns doesn’t play ball with the maestro’s orchestration of a bailout for LTCM, but Goldman Sachs does, so when Bear’s number is up, Paulson is ready, even eager, to let Bear twist in the wind. If you don’t play the corporate welfare game, you don’t get any corporate welfare. Seems fair enough.But is it “free market capitalism”? When we model “free markets” with “private proprietors” of capital trading in their enlightened self-interest, are we modeling all of this back scratching? I doubt it, not on the scale of LTCM and AIG anyway.I still suspect that state pension funds were and still are up to their necks in AIG and other too big to fail institutions. I’d like to see some research on this score. We’re in the last chance decade, the decade before the baby boom retires in earnest. The battle for entitlement to rents will be fierce, and the pressure to impose new rents is also fierce. Never have so many backs itched so much and expected scratching from so few.

Methinks October 2, 2009 at 12:17 am

LTCM was bailed out by willing private companies. AIG was bailed out by mostly unwilling taxpayers. That’s a big difference.

I think we are modeling “backscratching”, as you put it. LTCM version. Maybe we weren’t modeling AIG until recently – at least not as widely. A company, like a person, which shows no generosity will get none in return. This behaviour was the norm on the trading floor. If a trader didn’t participate in bad trades as well as good ones, the crowd punished him. They wouldn’t allow him to take a share of the best trades. If he’s too distracted to yell out his market (writing up a ticket or in another crowd) they won’t let him participate in a really good trade. If you pulled your weight on the worse trades, the crowd took care of you if you didn’t happen to be with it enough when the trade came to the floor to scramble for your share. Otherwise, it’s basically you against the crowd. Not a good position to be in. Often, behaving a little more generously is actually in your best interest. I don’t know if you would call that “corporate welfare”. I generally think of “welfare” as something the government steals from one unwilling party to give to another party.

I don’t know if the Goldman cult is a backscratching issue. I think it’s just a cult. No other major Wall Street bank is like that. Although, they figured out where their bread is buttered – in Washington. And they infiltrated government very well. As you said, the battle for rents will be fierce and Government Sachs is very well positioned.

Justin P October 1, 2009 at 2:51 pm

I thought Turbo Tax Timmy was at GS before the New York Fed? My bad. lol

Anonymous October 1, 2009 at 1:25 pm

I think the expectation of a bailout may make sense to a certain extent, but do you think that was really on their minds when they were deciding to make these loans or go public? “It may all collapse but then there’s a decent chance we’ll get a bailout” doesn’t seem like it would amerliorate their concerns, does it?

I think a much more likely conclusion is that they were coming out of a long boom in the 90s. The dot-com bust didn’t affect them as much as it did other sectors, and despite the dot-com bust the IT revolution that built the 90s boom was clearly here to stay. Money was cheap, and the people in charge had no real experience with a substantial economic crash. They had no reason to be afraid. Some people try to discredit this by saying “that means you’re saying they’re greedy”. That’s not my argument. I just think they had no experience with the kind of collapse we’ve seen and they had every expectation of things continuing to go well. I doubt under those conditions the likelihood that they would get bailed out crossed their minds much.

Anonymous October 1, 2009 at 2:07 pm

I think the expectation of a bailout as a major factor is over done.

Were they expecting a bailout in 1929 and every other bubble that preceded it?

sandre October 1, 2009 at 10:27 pm

The whole purpose of a central bank’s existence is to bail out. Otherwise they will cease to exist. Yes, they were expecting to be bailed out in 1929, not to the same extent as today, with the extensive history of bail outs that exist today.

People talk as if 19th century is littered with panics and depressions, because we didn’t have central planners controlling the money supply.

Here are some facts -

between 1866 and 1898 ( 32 years ), year over year decline in GDP happened during 4 of those years – in 3 recessions.

A mild recession in 1875 when real GDP declined from 140.8 billion to 140.6 billion.

Another mild recession 10 years later in 1884 when GDP declined 2% from 233.5 billion to 229.7 billion

Then a major recession in 1890s that lasted 2 years – 1893-1894 when GDP declined a combined 10% over those 2 years.

During those 32 years GDP grew 284%

Let’s compare another post war period under central management of money supply – 1946 to 1978

There were 6 years of y-o-y declines in GDP.
1947, 1949, 1954, 1958, 1974, 1975

Cumulative Total GDP growth was 216%

It is totally ignoring the fact that monetary central planners managed to cause a great depression since they started planning.

Here are some additional interesting facts -

The value of the dollar almost doubled between 1866 and 1898. In other words, What used to take $100 to buy in 1866, cost only $52 in 1898 ( based on CPI )

The US Dollar lost 70% of it’s value between 1946 and 1978. In other words, What used to cost $100 in 1946, cost more than $330 in 1978.

How about if we compare two centuries – 19th versus 20th.

In the 19th century, real GDP expanded 5348% ( 1801-1900)
In the 20th century ( 87 of those years under the Fed), real GDP expanded 2420%.

Don’t blow a gasket.

Dollar gained 1/3 in buying power during the 19th century, whereas, it lost 95% of it’s value in the 20th.

1808-1907: 5808%
1908-2007: 2591%

Here is another comparison

1814-1907: 4426%
1914-2007: 2293%

If you don’t include 1913 – 1933 ( because I don’t think it was proper gold standard, and may be you don’t think it was proper central banking ), here is another comparison

1834-1907:1956%
1934-2007:1568%

In other words, monetary central planners don’t even come close to being as effective at allocating capital as the Mr. Market.

Dollar lost 44% of it’s value from 1913 to 1929. Can you find an equivalent period of time in the prior to 1913, when the U.S was largely at peace, the dollar lost 44% in 16 years? I bet you can’t. Because under a gold standard, value of money usually increases at a really slow pace.

Anonymous October 1, 2009 at 1:25 pm

Russ you interviewed John Bogle. Review that interview. Also watch him speak to the problems of lack of ownership promoted in todays market when he was interviewed by Bill Moyers.

http://www.youtube.com/watch?v=j3mTO5QlC1M

I’d say it had a lot to do with the Reagan administrations policies that promoted mergers and acquisitions while ignoring the Sherman Antitrust Act as a faster way to huge wealth then the boring old way of growing a business. Private partnerships???? How old school. Much better to takeover, leverage against, shell out and sell a business then to run it for profits.

People, now a days especially with our complex markets, who want to make lots of money fast know that Adam Smith is worthless to them. Better to set up the rules for quick massive profit and that has nothing to do with growing a productive business…. way too slow… way too old school.

What lies behind the bank merger and acquisition frenzy?

http://findarticles.com/p/articles/mi_m1094/is_n2_v31/ai_18667993/

Catalysts in increasing the size and number of bank mergers were: (1) the revised and more lenient guidelines of the Reagan Administration (1982), (2) rising deposit and labor costs, (3) pressures on banks to economize by seeking large-sized and more efficient operations, (4) the desire to penetrate new markets in order to expand bank revenues, and (5) the opportunity to rescue failing depository institutions at relatively favorable prices. The Reagan Justice Department guidelines and the Garn-St. Germain Act (1982) made it possible for hundreds of mergers or acquisitions to take place that would have been challenged under the old guidelines.(2)

Many analysts believe that the removal of the Glass-Steagall Act will be the next step in banking deregulation. If that sixty-year old act dies, it would not be surprising to witness regional banks begin to acquire regional brokers as another source of fee income. Some banks may reengineer themselves into financial services conglomerates.

Yossarian October 1, 2009 at 1:29 pm

In this order:
1-OPM (Other People’s Money): most debt capital is being managed by pension and sovereign wealth funds who are unaccountable bureaucrats without “skin in the game.” Mutual fund managers don’t have skin in the game either and are subject to performance in investment parameters (such as requirement to be fully invested or hold rated securities) that distort their decision making process.
2-Moral hazard in the form of anticipated Federal Reserve/Treasury bailouts
3-The Federal Reserve distorts all aspect of the economy through the leverage inherent in a fiat money regime.
4-Bubbles and manias will always happen- those who made bad decisions should bear the consequences now and always.

Seth October 1, 2009 at 1:50 pm

It sounded good at the time.

I wouldn’t short change the intoxicating effects of “geeks bearing statistical models”, which provide hubris to investors who didn’t know what they were doing.

I recommend speaking with John Paulson of Paulson & Co. He can probably give you some great insights into this.

Joshua October 1, 2009 at 2:22 pm

I’m not sure that makes sense. 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?

Seth October 1, 2009 at 2:51 pm

How much of that billion dollars was his to begin with? I think behavioral econ says something about the difference in losing something you already have vs. something you view as a windfall.

Anonymous October 1, 2009 at 3:30 pm

I agree. Or even if it wasn’t a windfall, there’s going to be diminishing marginal utility to an additional dollar. Even if it’s all earned by the sweat of his brow, he’s going to care about it less if he knows he still has hunderds of millions in the bank.

Too often we talk about “profit and loss” as if absolute dollars matter. They don’t – it’s utility that matters. And the fact is, losing half your wealth along with your job when you have that much is a far less significant loss than losing half your wealth and your job when you make $40K a year.

Methinks October 1, 2009 at 3:48 pm

What you say is true.

But you’re underestimating the emotional toll of destroying your company. It’s much more difficult to quantify than dollars, but it’s no less real. Fuld isn’t kicking back by the fire in his mansion saying “oh well…easy come easy go. At least I’m still rich.” There’s a legacy and self-esteem and guilt issue that no amount of money can fix. He’s not mourning the loss of the money. He is devastated by what he did to his company and its employees. Probably much more so than Stan O’Neil who was responsible for taking down Merrill but was out of the spot light by the time the poo really hit the fan.

Anonymous October 1, 2009 at 3:51 pm

:) how can I underestimate something I never talk about?

I definitely agree with everything you say here – I didn’t mean what I said to be an exhaustive treatment of his incentives. I just think too often we naturally think in terms of absolute dollars, when we should be thinking more on the margin.

Anonymous October 1, 2009 at 3:53 pm

And in agreeing with you on that I should also add that expecting a bailout WON’T make his self-esteem whole. Insofar as it’s a self esteem issue, I’m guessing the difference between a failed company and a failed company propped up by the government is minimal. I certainly wouldn’t take much pride in that! Which is another reason not to fully accept the “they were expecting a bailout if they failed” argument for going public.

Anonymous October 1, 2009 at 4:03 pm

Methinks – what does self-esteem have to do with this? I thought we’re talking about economic science here? :-)

Seth October 1, 2009 at 5:43 pm

Methinks – Do you have personal experience here? In my experience with execs that have blown things up, I’d be shocked if one them had genuine guilt for what they did to their company and employees.

Also, I agree, they’re not driven entirely by money. Perhaps because they are beyond the point of utility. I’ve often pondered the motivations for people beyond that point, especially when I’ve worked with them close up. Ego seems to be the biggest motivator. Much like in politics, narcissism is rampant in the upper echelons of company management. Their position exists to deliver them ego, they don’t exist to deliver value to shareholders. Which makes me wonder how boneheaded the people sitting on the Board of Directors are in many companies.

Anonymous October 1, 2009 at 10:15 pm

There’s a legacy and self-esteem and guilt issue that no amount of money can fix.

Maybe. But some people just don’t have guilt. They just choose to believe that they do “the right thing” and every calamity is someone else’s fault or beyond anyone’s control. Most politicians fit this profile, and how different are corporatists in the upper echelons of an administrative hierarchy?My candidate for funniest youtube video of all time:http://www.youtube.com/watch?v=uH8owcMHc34

rpl October 1, 2009 at 2:24 pm

Russ, you ask, “If the lenders do play this game, they should expect larger and larger amounts of leverage financing riskier and riskier loans. . . . Why would they keep doing this. . .?” Is it possible that during the period between the first investment banks going public and the crash nobody realized how much of the discipline that investment banks had exercised in decades past was due to the partners’ unlimited liability, which was now gone?

In other words, perhaps lenders looked at the decades long history of Bear, Goldman, et al. and judged them to be prudent risk managers on that basis. What they didn’t understand is that something crucial had changed in the makeup of those firms and that that change radically changed the incentives the banks’ managers faced. Under that scenario, it isn’t necessary for lenders or investment bankers to expect a bailout; rather, they were just due for a painful lesson about incentives in their industry.

Roman October 1, 2009 at 3:04 pm

rpl, I like your take on it. The best way for inefficient organizational structures to get eliminated is by allowing them to fail and allowing those who invested in them to learn a lesson.

The question is now, will those inefficient organizational structures survive because of the gov’t intervention?

anon October 1, 2009 at 2:31 pm

You’ve interviewed Michael Lewis on a different topic, but he talks about the incentives investment banks face when public vs. private in Liar’s Poker. He also says something to the effect of, “If an investment bank say’s its a systemic risk, don’t believe them.”

Even though its not a current book, it has lots of relevancy to the recent credit crisis because it covers the start of the mortgage securitization business and one of the important players behind “the original bailout” (LTCM) in John Meriwether.

Anonymous October 1, 2009 at 2:36 pm

I worked in investment banking for 20 plus years. I was a pretty senior guy at the end. Weinberg is correct. Investment banks went public so they could have their cake and eat it too. By going public partners were able to sell their ownership interests at 2-4 times its cash (or book) value. Then, with an absurd slight of hand, were able to give themselves the firm right back. This is accomplished through employee stock option programs. These are truly “heads I win, tails you lose” propositions. Each year employees get awarded options at new strike prices—one can make millions simply on volatility even if in the long run the shares go nowhere. I never understood why investors ever purchased an investment banks stock. It made no sense.

Having said all that, no one wants their company to go under. But the natural discipline which Weinberg describes in a partnership is not there. The chance for enormous windfalls are just too great. For example, Lehman Brothers (among many other firms) was able to create several hundred million dollars of wealth for many of its senior guys in the 1998-2000 period. Crashes are great for these firms if they survive them. The senior people get paid in options struck at the bottom of the market. Look at Goldman Sachs stock price today—it is about 4 times what it was at its fiscal year end 2008. Think of the value of the options issued to employees.

This phenomenon is true in all industries. But the investment banks play the game the best. I am not sure what can be done about it. My perspective is “caveat emptor” as it relates to investors. I also believe we should let them fail when they deserve to fail.

It has always amazed me how uninformed investors seem to be.

anon October 1, 2009 at 3:06 pm

And it seems like investment banks can have shareholders who are particularly uninformed. Although there are lots of regulations regarding financial reporting, there are many positions which don’t even make it on the balance sheet (such as the special purpose vehicles used to securitize mortgages). Moreoever, there are positions, such as interest rate swaps that trade at a price of zero, and so don’t negatively impact a firm’s balance sheet and allow the firm to really leverage up these positions. It is difficult to impossible to uncover for an outsider to uncover the true positions a firm is taking.

I guess that still begs the questions of why buy a stake in an I-bank.

But as a comment above says, there really wasn’t much data to go on that would suggest otherwise- you have 80+ good years, who think’s it’ll stop?

And even worse, it’s amazing the identification problems present in these data- I mean you have Lehman going public in 1994. That means before they blow-up you have less than 60 quarterly reports to base your judgements on- meanwhile, you’ve got a ton of covariates- a housing boom, a dot-com bubble, monetary policy, new securities, the rise of the internet and discount brokers,… And it gets worse- in the sample, many of these covariates don’t vary much (e.g. look at home prices from 1994-2007).

Anonymous October 1, 2009 at 5:17 pm

Yeah–we both kind of begged the question of why investors buy their stocks or bonds. I cannot answer that question. My belief is they do not realize what these companies do–or they would not invest in them.

I am generally biased against the public equity market. My bias relates to the concept I learned and believed in business school—”dividends don’t matter”. I believed that for many years, until I finally understood that “incentives do matter”. These two principles are in conflict with each other. This is not original to me of course, but by forcing companies to pay dividends it creates a need for all companies to generate cash earnings. Enron is the classic example of this idea. For years dividends had a different tax structure, but that is not true anymore. I think paying dividends are different than buying back stock. Most stock repurchase programs are designed to at least partially “launder” compensation to employees. Dividends are more regular and are more transparent. Yes, it would cost money to have to raise new capital more often. But this is a feature, not a bug. Management has to make the case everytime they need to raise capital. Now, they just do what they want. I think it is a fiction that shareholders discipline the market. My preference is all companies should be structured like REITS, except with capital gains rates.

So that is my bias. But take my bias and multiply by some factor–that is my view of investment banks. Mark to market is a sorcerer’s game. I am not against mark to market–again it is just another useful approximation like VaR, Income Statements and Balance Sheets, etc.. Using a Hayekian principle–inside knowledge at IBs are extremely local to time and place–and I would argue more opaque.

My own “solution” is forced discipline of cash pay outs on dividends; more transparency on the laundering which is the payment method (Lehman insiders owned 4% of the company when it went public, and 45% 7-10 years later—all through compensation–even after insiders would sell back into the market); and low tax treatment for REIT like structures.

So I am saying investors are mistaken—which is hard for me to say given my “efficient market” education.

Anonymous October 1, 2009 at 3:08 pm

This is largely right and the best comment so far on the issue. Partnership was not some magic fortress structure, public ownership was the best deal at the time so the bankers took that route, and investors are/were silly to invest in the likes of GS, LEH, Bear etc. Although stock ownership was definitely a more flexible and ‘gameable’ structure than partnership, by no means did bankers lack skin in the game. In a large sense the government supplanted its skin for private skin. Everyone knew that congress’s housing crusade resulted in a cockamamey structure that ultimately left taxpayers holding the bag. the exploitable hole was so wide, that everybody drove their trucks right through it and the reason that banks lent so freely via things like repo lines was they knew the predominant purpose of the financing was short time horizon trading and the GSs of the world were adept at taking both sides of many trades and capturing huge spreads. They ran the markets in many of these exotics and the financing was just the working capital to enable them to be the croupier. Banks therefore didn’t see their risk in the same way as they would if this was more traditional lending or longer time horizon stuff. Stock ownership and stock options was a way to play this game and press the reset button every year if things went south. When the government provides the skin, the rational thing to do is take some of yours out.

Anonymous October 1, 2009 at 5:35 pm

Correct. The government bailout (through the purchase of AIG) for some of these firms was a true sight to behold. It is hard to say to what extent this created forward policy on the IBs part re: risk taking. But, when GS was likely to have to take a P&L hit approaching double digit billions when AIG was unable to pony up cash collateral (another tale in its own right which I have written about), they certainly lobbied Treasury and the Fed–and apparrently got their way. So you are correct—the government was their to be the backstop.

Methinks October 1, 2009 at 3:08 pm

I always thought the biggest mistake banks made was going public, but not because they don’t have enough skin in the game now. Whether they’re playing with other people’s money or their own, the culture of risk on Wall Street is astonishing. That’s why I think it’s best to remain private – you can take as much risk as you want and pay the price without arousing the puerile mob in congress. I don’t think I’ve ever heard anyone say “well, if this doesn’t work out, the government won’t let us go down.” – before last year, that is. I think the bigger problem is they don’t really consider the possibility that they’re wrong in the first place! If they do consider it, they severely underestimate risk.

I don’t think the repo market was a way to hedge their bets about the likelihood of a a government bailout (if I understood you correctly). The repo market always existed. Everybody just thought they could all make more money and the net lenders in the repo market (which I think was probably the commercial banks) thought they were adequately diversified and the loan was sufficiently short term. You’re basically implying that there was a lot of collusion on the Street for the purpose of insuring themselves via government bailout. That sounds far-fetched to me.

Part of the reason the leverage increased was the growth of derivatives – which has continued unabated throughout the “crisis”, especially at Goldman Sachs. Fixed income (which is always highly levered) also grew as percentage of total investments as MBS and CDOs grew in popularity. The problem isn’t necessarily the leverage. An equity derivatives operation can safely carry 30x leverage because equity derivatives are perfectly hedge-able with the underlying. An options book can still blow up – but that will only happen if the trader doesn’t hedge and the clearing firm will ask for a larger haircut for unhedged positions. CDS (for example), like most fixed income instruments, is not perfectly hedge-able with the underlying and is more risky.

As stock trading and equity options have become more commoditized, the drive for new derivatives has created a few monsters. It’s very difficult to construct a derivative product well. If they’re poorly constructed, they are obviously more risky. Worse, they effect the ovarall market negatively. ultra-short and ultra-long ETFs are great examples. They tend to be both long and short gamma (the second derivative of price). However, they are short gamma at the time when markets are highly volatile and gamma is most useful and they are long gamma when the market is calm and gamma is worth a lot less. This happens because they are always selling when the market goes down and buying when the market is going up. So, as a hedge in a portfolio they are pretty unreliable and they’re regularly front-run by market participants who understand the weakness of the product.

The growth in derivative products over the years meant that larger positions could be taken with less capital. Even if the number of lenders didn’t change (and I don’t think it did), the leverage increased because a smaller haircut was required. The growth in new derivative products also lulled people into thinking that they could control risk better than before. Sometimes that was true – certainly, that is the case for many many derivative products. But, as the push for more products became more frenzied and worse products were created, the new derivatives increased risk rather than diminished it. The CDS market became huge, but the risks inherent in CDS are similar to those of teeny options – hard to price and hard to hedge. Derivatives pricing models don’t lend themselves well to pricing tail risk. The capital requirements for such derivatives should have been higher – but that meant that everyone made less money.

I’m sure it’s infinitely more complicated than that, but that’s my observation.

Anonymous October 1, 2009 at 4:00 pm

The end result of all the witch hunts will be capital remaining super-private and business ventures drying up = sky high unemployment in America. I think all that capital will get diverted to places like Dubai and Singapore which are business-friendly.

Gary October 1, 2009 at 4:15 pm

One thing to keep in mind: bailouts weren’t funded with “our tax” dollars. They were funded by rich people, who pay most of the taxes in the USA. A lot of those rich people work in finance, so they got paid back with their own money.

Anonymous October 1, 2009 at 4:17 pm

Assuming they earned “their money”. It’s really all OUR money.

Methinks October 1, 2009 at 4:23 pm

Ummm…I earned all my money. How is the money I earned suddenly your money?

Anonymous October 1, 2009 at 4:28 pm

In investment banking it’s really debatable the concept of “earned”.

Methinks October 1, 2009 at 4:29 pm

Really? How do you figure?

Gary October 1, 2009 at 9:56 pm

It’s difficult to recall what it was like to think like you, as I once did.

Anonymous October 1, 2009 at 10:01 pm

I was just kidding. Can’t you tell?

Methinks October 1, 2009 at 10:45 pm

Arrow, if that was a joke, I think it would have been taken as a joke if said in a group of I-bankers. Outside a group of insiders, it’s not clear that it’s a joke.

Anonymous October 1, 2009 at 8:50 pm

Don’t fall prey to the collective fallacy–a rich person is a rich person is rich person is a rich person.

Gary October 1, 2009 at 9:53 pm

I’m not entirely sure I know what you’re saying. If you mean that one result of the bailouts was redistribution amongst rich people, I agree. Some rich people lost out while others did well. The key point remains: it’s ridiculous to pretend like the typical fella lost anything other than the ability to take the rich peoples’ tax dollars for himself.

Anonymous October 1, 2009 at 10:37 pm

I meant you can’t refer to a rich people as a collective without referring to each person in it. It is not true to say “they got paid back with their own money”. It might be true to say some rich people got paid back with other rich people’s money, or with their own money. But your sentiment neglects the injustice to the large majority of rich people who most certainly did not get paid anything back, but rather paid for and will continue to pay for them.

Gary October 1, 2009 at 10:49 pm

Yes, I simplified. I considered writing a more nuanced post, but decided against it in order to make the other point more succinctly. We’re on the same page.

Mike Gibson October 1, 2009 at 4:50 pm

Russ, have you seen that Michael Lewis article from Portfolio Magazine, October 2008? That’s the first time I recall someone floating the principal agent problem as one of the prime movers in the crisis. At the end of the essay Lewis sits down with his former boss/nemesis John Gutfreund. Lewis writes:

“You can’t really tell someone that you asked him to lunch to let him know that you don’t think of him as evil. Nor can you tell him that you asked him to lunch because you thought that you could trace the biggest financial crisis in the history of the world back to a decision he had made. John Gutfreund did violence to the Wall Street social order—and got himself dubbed the King of Wall Street—when he turned Salomon Brothers from a private partnership into Wall Street’s first public corporation. He ignored the outrage of Salomon’s retired partners. (“I was disgusted by his materialism,” William Salomon, the son of the firm’s founder, who had made Gutfreund C.E.O. only after he’d promised never to sell the firm, had told me.) He lifted a giant middle finger at the moral disapproval of his fellow Wall Street C.E.O.’s. And he seized the day. He and the other partners not only made a quick killing; they transferred the ultimate financial risk from themselves to their shareholders. It didn’t, in the end, make a great deal of sense for the shareholders. (A share of Salomon Brothers purchased when I arrived on the trading floor, in 1986, at a then market price of $42, would be worth 2.26 shares of Citigroup today—market value: $27.) But it made fantastic sense for the investment bankers.

“From that moment, though, the Wall Street firm became a black box. The shareholders who financed the risks had no real understanding of what the risk takers were doing, and as the risk-taking grew ever more complex, their understanding diminished. The moment Salomon Brothers demonstrated the potential gains to be had by the investment bank as public corporation, the psychological foundations of Wall Street shifted from trust to blind faith.”

Mike B October 1, 2009 at 4:56 pm

One simple reform would mitigate most of this problem. Home buyers should be required to put at least 20% down. This would dramatically limit speculation and produce a buffer against home declines. Even if mortgage investments are securitized, investors would have great confidence that there is enough value to back up their slice of the mortgages. Of course, it will never happen. Public policy is geared toward making an inoptimally high percentage of the public home owners. Probably 4-5 trillion in mortgates that should have never been made went through because of political pressure from the Community Reinvestment Act and lowered underwriting standards by Fannie and Freddie. To some extent, we are blaming the bartender for the hangover.

Anonymous October 1, 2009 at 5:11 pm

No, just stop having the federal government stop purchasing these loans. Then the free market will decide on its own what % of down payment is required in each individual case. Stop trying to solve over-regulation with over-regulation.

dano October 1, 2009 at 5:20 pm

Is it true that when the investment banks were private partnerships, the partners actually had skin in the game? It is my impression that when someone became a partner, the firm would usually lend the new junior partner the funds for the required cash investment. If so, the partners actually had no more skin in the game then than they do now.

Methinks October 1, 2009 at 6:02 pm

Who would do the lending to the new partner? Probably the other partners? Don’t know – I’m asking.

If it is the other senior partners, then it’s pretty hard to say the borrowing partner doesn’t have skin in the game when he stares into the eyes of his creditors every day and those people have the ability to kick him out and ruin him.

Anonymous October 1, 2009 at 6:25 pm

“Why did these partnerships go public?”

Partnerships are a dying structure. In all industries they are converting to corporations and LLCs. New businesses rarely even consider the partnership structure.

The reason is limited liability. There is a cost to converting from a partnership to a limited liability business, but other than that, the partners have all gain and no loss in doing so.

Methinks October 1, 2009 at 7:05 pm

Still, LLC’s are a private partnership-like structure. The “partners” are called “members”, but other than that they’re still pretty much partnerships.

Anonymous October 1, 2009 at 7:19 pm

If I understand the argument being made, it attributes the problem to degraded incentives caused by limited liability. That argument must then also apply to LLCs and corporations that are wholly owned by the “partners”.

Methinks October 1, 2009 at 7:41 pm

I don’t think that’s the argument. Limiting liability wasn’t the reason for going public. Partners wanted to cash out and they wanted access to more capital for growth.

Professionals can’t really limit their liability anyway. If the firm enters into a lease contract and then doesn’t honour the contract, the managing members’ personal liability is limited. However, if the firm loses investing members’ money, the liability of the managing members is unlimited. If you’re a fiduciary, no limited liability for you!

Anonymous October 1, 2009 at 7:48 pm

So the incentive problem has to do with ownership rather than liability?

Anonymous October 1, 2009 at 9:16 pm

Why would lenders play that game, knowing that the investors have an incentive to take more risk.

Aren’t the lenders lending other people’s money too?

Anonymous October 1, 2009 at 9:20 pm

Pure, unadulterated greed.

John Thacker October 2, 2009 at 2:41 am

Jon Corzine is the one who took Goldman Sachs public, after which he left and Paulson came in. For that alone, he may not deserve re-election.

simon... October 2, 2009 at 2:42 am

This back-scratching you described should not exist with normal level of competition.
You won’t find anything like this between Microsoft, Oracle, IBM, etc., quite the opposite – temporary alliances crumble as soon as common enemy is weakened enough.
Sounds like cartelization of Wall Street to me… And as we know from history it only succeeds with a help of government.
Could that be that SEC (and other?) regulations provide enough entry barrier and weaken competition enough for this to work?
Is FED also kind of a legal cartel?
Just a though…

Methinks October 2, 2009 at 3:31 pm

Well, from the perspective of someone who has dealt with the SEC for a long time, I think that financial regulations provide significant barriers to entry and then competition even among the relative few who do get in.

Artturi Björk October 2, 2009 at 10:53 am

I think people by and large are looking this from the wrong perspective. The CEO’s deffinately had skin in the game. Not quite as much as the owners (relatively), but still substantial skin none the less. This means that their incentives were quite similiar to the owners interests.

The problem is that the owners and managers interests were such that it was rational to roll the dice with taxpayer money, where if they won they got to keep the winnings. It’s about expected value and not about bankruptcy.

Name October 2, 2009 at 11:07 am

http://www.nber.org/papers/w15212

“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 4:01 pm

“how can I underestimate something I never talk about?”

The two are intimately connected, so not talking about it underestimates the full risk.

If I gamble my money and I’m very rich, I don’t care if I win or lose very much. But, if I gamble the same amount of my money and the loss results in the destruction of my company, misery for my employees and financial ruin for investors, then I care very much. So, his gamble was much larger than the amount of money he had at stake. Losing the money is not that big a deal, as you point out, but that underestimates the loss – and an economist would want to account for the whole loss, right?

Methinks October 1, 2009 at 4:06 pm

Insofar as it’s a self esteem issue, I’m guessing the difference between a failed company and a failed company propped up by the government is minimal.

You are SO underestimating the egos of these guys. They see extracting a bailout as a clever way of “saving” their company from ruin. Or just collecting additional rents. You and I would die of shame, but that’s why you and I will never ever ever make it to the top the heap in a large investment bank.

I don’t accept the expectation of a bailout if they’re a public institution either. The partners wanted to cash out and the premiums for equity stakes in the banks were often high. The partners weren’t even dreaming of bailouts.

Methinks October 1, 2009 at 4:21 pm

emotional turmoil, then.

Unless we’re talking about Bernie Madoff. That’s a different creature. Literally – creature.

Anonymous October 1, 2009 at 5:10 pm

Yes – but as I say I never endeavored to account for the whole loss. I agree with you methinks! :)

Methinks October 1, 2009 at 5:30 pm

Okay. You never endeavored to think account for the whole loss. What I’m saying, if that’s true, you can’t then make this statement:

the fact is, losing half your wealth along with your job when you have that much is a far less significant loss than losing half your wealth and your job when you make $40K a year.

That’s not analogous to what happened.

leaving it here:

Too often we talk about “profit and loss” as if absolute dollars matter.

Would have been more accurate. Do you see my point? It’s not terribly subtle.

In this business people continue to bust their butts for the marginal dollar long after they make much more money than they could possibly spend on their family’s needs and wildest wants. That’s when they start setting up foundations, but that’s a different discussion. Success becomes much more than just making enough money to buy a bigger yacht. So, when you say that he isn’t as devastated, as a guy making $40K, you’re wrong. Neither are his wife and kids as they become instant pariahs.

Anonymous October 1, 2009 at 6:18 pm

Re: “In this business people continue to bust their butts for the marginal dollar long after they make much more money than they could possibly spend on their family’s needs and wildest wants. ”

You cut off the “two often we talk about…” quote too early and it removes context. I wasn’t talking about the marginal dollar, I was talking about marginal utility. And obviously other things go into utility than just salary – one of which being the machismo of growing your company simply for the sake of being bigger – or short term run-ups in the stock price. Status also goes into utility. I never made a claim to be exhaustive in my discussion of what goes into marginal utility. I was just pointing out the fallacy of equating absolute dollar losses with marginal utility.

As usual methinks, stop putting so much effort into inventing disagreements between us. There’s nothing you’ve written so far in your response to me that I’ve disagreed with (except, of course, your characterization of me!).

Anonymous October 1, 2009 at 6:25 pm

So basically you admit that after the first 500K of net worth it’s all about status-hunting? Which you admit to be engaging in, very proudly in fact.

Methinks October 1, 2009 at 6:39 pm

I don’t have personal experience blowing up a firm or even a portfolio! So, no. No experience at all there. I’ve come close and I never ever ever ever want to get anywhere near the edge of that abyss again.

I have personally known people in this business who have blown up and they’ve been devastated – even though they’re still rich. That emotion is highly individual.

We can wax philosophical all day about what drives people. Personally, I think it depends on the culture of the company and if the person in question is a founding partner or a guy who made it up the ladder. People who are the former are often driven by some of the same instincts as parents – the nurturing of something you created. Starting your own business is too brutal for money to be the only reason to start it and grow it. watching it it blow up is devastating – especially if you’re responsible. And I argue that you always are.

It’s different if the guy at the top climbed the ladder at an existing firm. And it seems the larger the firm, the more this is true. I hated my time in investment banking because how well your career went was more directly related to identifying which ass to kiss and then puckering up with gusto rather than how competent you were. So, the people who made it to the top were usually (although, not always) incompetent schmucks who were better at politics than at running the business. As you said so well, their position existed to deliver them ego – a self-assurance they couldn’t attain by creating value, since they weren’t competent to do that.

I also think it depends on the culture. I don’t know about every company, but trading firms tend to have less of that sort of ass kissing culture because it’s harder to hide incompetence when you are directly responsible for a P&L and because those firms are extremely flat. That’s why I always preferred trading – it’s a put up or shut up business where there’s nobody else to shift the blame on. I-bank CEO’s who came from trading always struck me as smarter and less egotistical than those who came from the investment bank because the market beat the hubris right out of them and the ones whose hubris was immune to the beating were just fired early on. But, I’m generalizing here.

Methinks October 1, 2009 at 6:56 pm

Where did I say anything like that anywhere else other than your vivid imagination? Quote me.

Methinks October 1, 2009 at 7:14 pm

I’m also still waiting for you to explain to me how the money I made is actually yours and how nobody in investment banks actually ever earns anything, thus all their compensation actually all your money too.

This should be interesting.

Methinks October 1, 2009 at 7:02 pm

machismo of growing your company simply for the sake of being bigger

Pretty offensive. Consider that if people didn’t grow their companies, you wouldn’t be employed. Machismo and status, by far, is not the only reason people grow companies.

you could have just replied with this:

I wasn’t talking about the marginal dollar, I was talking about marginal utility. And obviously other things go into utility than just salary – one of which being the machismo of growing your company simply for the sake of being bigger – or short term run-ups in the stock price. Status also goes into utility.

In place of your usual whining and sniveling about how misunderstood and mis-characterized you are.

Anonymous October 1, 2009 at 7:56 pm

RE: “Pretty offensive. Consider that if people didn’t grow their companies, you wouldn’t be employed.”

You take offense too easily. You’re also confusing average firm employment with total employment in the economy. Ten firms that employee ten people each provide the same amount of employment as one firm that employs 100 people. Growing a company should only be justified on the basis of the profit maximizing firm size. Firm size growth in and of itself is neither good nor bad (as an example – take massive Chinese state owned enterprises. Should people approve simply because those enterprises employ a whole lot of people?).

RE: “Machismo and status, by far, is not the only reason people grow companies”

Of course not. There are lots of reasons.

RE: “In place of your usual whining and sniveling about how misunderstood and mis-characterized you are”

I don’t care if you mischaracterize me or not. I’m just amazed you waste so much time tilting at windmills and inventing conflicts because people don’t phrase things exactly how you’d phrase them.

Anonymous October 1, 2009 at 7:57 pm

Aha – pretty frustrating when people invent things that you never said, huh?

Arrowsmith, I have to side with methinks. I never saw her say anything of the sort.

Methinks October 1, 2009 at 8:09 pm

Yes. That’s the argument. Instead of committing their own capital and the capital of their other partners (who all have expertise in the business and a say on operations), they now commit the capital of a mass of faceless shareholders. Since less of their own capital is at risk, they are willing to swing for the fences.

Methinks October 1, 2009 at 8:14 pm

No. This joker is the son of Soviet immigrants. The implication that he knows exactly what net worth is enough for everyone and the moralizing about “status-hunting” is far more irritating to me than any perceived misunderstanding because of that.

You whine whenever you’re honestly misunderstood, Dan. That’s unbelievably frustrating.

Anonymous October 1, 2009 at 8:18 pm

Ok, I was kidding about your money belonging to everyone. I just resent the idea that I-Bankers are somehow morally superior to the rest of us who don’t play around with money all day. Also yeah people in your profession are about status-hunting. What else is it after a certain amount of net-worth has been achieved and the marginal utility of the next $50K decreases?

Anonymous October 1, 2009 at 8:27 pm

Haha – putting words in his mouth in response to him putting words in your mouth. This is getting funny, methinks.

Methinks October 1, 2009 at 8:21 pm

Dan, Come on. We’re not and never have been talking about Chinese state owned companies! A private firm will only grow if it’s profitable. It can’t find the capital to continue to grow any other way (government created rents aside). You effectively called profit chasing “machismo” and “status-hunting” for the head of the firm. And for one firm to employ 100 people it has to GROW. Quit justifying your offensive remark and changing the subject to employment. If it came out wrong, just say so and be done with it. If you meant it, then you have a lot of growing up to do.

You think that every disagreement with you is tilting at windmills because you can’t imagine that you are ever wrong or unclear. Guess how that makes you sound.

Anonymous October 1, 2009 at 8:34 pm

RE: “A private firm will only grow if it’s profitable.”

That’s quite an assumption. Jack Welch might tell you otherwise.

I’d take a more evolutionary view – firms that grow profitably survive. Those that can adjust their size before they fail survive too. I wouldn’t necessarily assume that growth comes from a foreknowledge of what’s profitable (although certainly it can).

But this is all besides the point – weren’t we talking about the specific cases where growth is a function of manager’s ideas of “legacy and self esteem” (to use your words). The Chinese example was simply to point out that growing firms in and of themselves say nothing about employment rates – the connection you seemed to make.

Re: “You effectively called profit chasing “machismo” and “status-hunting” for the head of the firm.”

No I didn’t. And I’m not going to feel obligated to respond to things that you’ve imagined I’ve said.

RE: “Quit justifying your offensive remark and changing the subject to employment.”

YOU BROUGHT THAT SUBJECT UP!!!!! Good Lord Methinks! Do you have a short-term memory loss problem?!?!?!?!?

Methinks October 1, 2009 at 10:18 pm

It’s beside (not “besides”) the point because you went off on a tangent. But you are correct – your tangent is both incoherent and beside the point.

weren’t we talking about the specific cases where growth is a function of manager’s ideas of “legacy and self esteem” (to use your words)

Well, I don’t know what you were talking about, but that’s not what I was talking about. One can stop expanding the company at any time – even if there are profitable opportunities still to be taken advantage of. Growing a company is expensive in terms of time commitment, risk and nerves. The question is why someone who is incredibly wealthy would continue to work and expand his company. Self-esteem, security, building something of value, ego, fame, the joy of the game etc. are all non-monetary reasons.

Methinks October 1, 2009 at 10:54 pm

Jack Welch might tell you otherwise.

Then you you can take it up with Jack Welch.

It’s says a lot about you that you think that claiming disagreement from Jack Welch is a strong enough statement to stand on its own.

Methinks October 1, 2009 at 10:42 pm

Morally superior? What idiot told you that? I’ve heard a lot of things said about Wall streeters, but I’ve never heard “morally superior” used to describe them – not even by people working on Wall Street.

What does “playing around with money all day” mean? I’ve worked in investment banks and now I’m a market maker. I’ve never played around with money in either business – whatever that means. Every day I commit my own capital to make a market in securities. Does that make me morally superior? No more than the owner of a retail shop who commits his capital to purchase inventory. Investment banks take companies public and facilitate M&A deals (mostly badly, IMO – but that’s a discussion for another time). How is that “playing with money all day”?

For some people it isn’t actually status hunting. You have to be careful with sweeping generalizations. You only ever hear about the status hunters because the people who aren’t status hunters are as boring as drying paint. You won’t turn up much on the internet for some of the most successful and smartest people in this business. They do what they do because they love it. Jeff Yazz is a prime example. The man is a billionaire and started Susquehanna International Group in 1987 from his poker playing bank roll. SIG is now one of the largest and smartest trading companies in the world. Yet, Jeff Yazz is one of the most low-key, media-shy and humble individuals I’ve ever known – in any business. I can’t tell you how many six o’clock dinners he starts with “guys, you think it’s possible for us to get out of here by eight?”. He just wants to get back to his kids and his lovely first and only wife. Stevie Cohen of SAC capital is another example. It’s hard to even find a photo of the guy online. There are tons of guys like that in this business and many other businesses.

I’ll tell you what it is for these guys – it’s the game. Every business is a game and these guys love to play the game. They love their employees, they love the interaction with them, they love to find new and exciting things to do.

It’s sometimes about status. Not always.

Methinks October 1, 2009 at 10:48 pm

BTW, Even for status hunters – why so much derision for them? Why do they bother you so?

Anonymous October 1, 2009 at 10:59 pm

RE: “It’s beside (not “besides”) the point because you went off on a tangent.”

Both are actually correct, although “beside” is more common (I don’t know why – sounds weird to my ears). “Besides” is usually an adverb, which is probably why most people don’t use it in this phrase, but it can also be used as a preposition meaning “other than”. The phrase “beside the point” implies that the subject being discussed is next to but not on point. The phrase “besides the point” means that the subject being discussed is other than the point. Essentially identical meaning, which is why they’re both used and acceptable.

But I’m glad you’re keeping us from getting on a tangent!!!!

Anonymous October 1, 2009 at 11:10 pm

RE: “It’s says a lot about you that you think that claiming disagreement from Jack Welch is a strong enough statement to stand on its own.”

Wow – how many times today have you assumed that I was making an exhaustive statement when I never made a claim to?

The fact is, you’re the one that made the strong assumption that “a private firm will only grow if it’s profitable”. I think it’s patently absurd. You can absolutely grow if you’re not profitable. You can grow very large even if that growth hurts your profitability. Why not? You may not survive, but that’s sort of the whole point of the market isn’t it? You’re putting the cart before the horse if you think that a private firm will only grow if it is profitable.

But you’ve really done me a favor. By stating your position in such absolutist language, I honestly only do need one example.

mesaeconoguy October 1, 2009 at 11:57 pm

An illustration of how IBs don’t get along well with traders…
;)

Methinks October 2, 2009 at 12:24 am

Wow – how many times today have you assumed that I was making an exhaustive statement when I never made a claim to

hey, aren’t you jumping to conclusions and putting words in my mouth?

I think it’s patently absurd. You can absolutely grow if you’re not profitable.

Great. Now, who’s going to give you the capital to do that if you’re not profitable? Besides the government, of course.

Methinks October 2, 2009 at 12:37 am

Tangent? My remark was two words. You wrote two paragraphs and chose to address this issue instead of the main point.

There’s a hot debate. “Beside” is winning – probably because when people use the phrase, they mean that the point made is beyond the topic of conversation. “Besides the point” is in addition to the point. As in, “besides, he didn’t want to go to the movie anyway”. The way you used “beside the point” is the first way. You clearly thought the point you thought I was making was beyond the topic of conversation. That’s why I suggested you use “beside”. It sounds weird to you because you probably heard it “besides” all your life. Like people why say “aks” and think it’s normal. But write whatever you want. You certainly don’t have an obligation to me.

Methinks October 2, 2009 at 12:44 am

LOL! Psuedo-folksy hand gestures!

Some people aren’t capable of guilt. Corporatists aren’t different from politicians. If my definition is the same as yours, I don’t think there’s any difference. But not all people who run businesses – even big businesses – are corporatists. And some calamities are beyond anyone’s control.

None of that is any reason to deploy a Hillary Clinton, though!

Methinks October 2, 2009 at 12:51 am

OMG. Tell me about it.

Seth October 2, 2009 at 2:20 pm

Fair enough. Thanks.

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