Risk and Reward
A whole lot to chew on in today’s New York Times piece on Citigroup, but this graf is of particular interest to me:
“Chuck Prince going down to the corporate investment bank in late 2002 was the start of that process,” a former Citigroup executive said of the bank’s big C.D.O. push. “Chuck was totally new to the job. He didn’t know a C.D.O. from a grocery list, so he looked for someone for advice and support. That person was Rubin. And Rubin had always been an advocate of being more aggressive in the capital markets arena. He would say, ‘You have to take more risk if you want to earn more.’”
Obviously not what you want on your epitaph as the company goes under. But at the same time, it’s perfectly true. The more risk you take on, the more potential for profit. And this is what’s so disturbing about what’s going on in terms of financial institution bailouts. I’m happy to believe the folks who say these kind of interventions are necessary. But if they’re going to be done, there’s both the practical question of how to regulate so as to avoid moral hazard, and also a huge question of social justice. If people can get very rich taking on risks that are partially offloaded onto the public at large, we have a problem. Or, more specifically, we need to tax those people and use the revenues to better-assist ordinary people in dealing with risks.
Consider the contrasting fates of a financial sector CEO who earned tons of money and through mismanagement caused his firm to go bankrupt and that of someone who operates the cash register at Circuit City and through no fault of her own wound up laid off. Both are looking at unemployment; perhaps even a prolonged spell of unemployment. But the CEO was living very high on the hog throughout the fat years, the woman at the cash register not so much. And the CEO, even with a large swathe of his fortune wiped out by the crash, will still be left with savings and assets that dwarf those of the average American. And why? Skill-biased technological change? Was the woman running the cash register really not competent enough to run Citigroup into the ground? Anyone can make money while the market goes up and lose it when the market goes down.
35 Responses to “Risk and Reward”
Register
RSSLogin
Topic Cloud
ArchivesBlog RollAbout Matt YglesiasContact Me
Donate
November 23rd, 2008 at 3:35 pm
No, Matt, you don’t understand! The CEO is really, really smart and needs to be rewarded for his smartitude. The woman at the register can go suck it. This is the nature of market efficiency, which is the highest goal of the American project.
P.S. The picture made me laugh.
November 23rd, 2008 at 3:51 pm
Where did Michael Chertoff get that hideous toupee?
November 23rd, 2008 at 4:09 pm
What is most sad is that in reality, nothing is going to change, as the entire idea of Moral Hazard is too complex for most average Americans to understand in order to allow legislation aimed at mitigating this sort of risk. But try to offer assistance to a single, out of wedlock mom working the register at Circuit City….and guess what…Americans understand that to be Socialism, and dammit, we like our poor to suffer.
November 23rd, 2008 at 4:14 pm
You know what is scariest here:
The CEO did not even know how his own Investment Banking/Asset Management group worked. I mean seriously - if any of us were to apply for a job, and we had this utter lack of understanding of the basics, something tells me we do not get this job.
November 23rd, 2008 at 4:36 pm
Best post in months. Absolutely right, moral hazard remedies should be applied most vigorously to company execs, secondarily to shareholders.
But on progressive taxation, don’t you think a 5% rise in the marginal rate would have induced Rubin to “work” less hard and run the company into the ground more slowly- we can’t have that!
November 23rd, 2008 at 4:39 pm
Anyone can make money while the market goes up and lose it when the market goes down.
Not true. You need to have an MBA from Harvard or Wharton before anyone will lend you the big bucks to do it properly.
November 23rd, 2008 at 4:47 pm
Yes, but if a Circuit City cashier really messed up, she’d never be the subject of a Mathew Yglesias post, now would she?
We are now all participating in the “Britney Spears Meltdown” phase of Prince’s career. His humiliation will be a public one, and in the end, we may only help support the notion of a celebrity CEO. He was paid to be a celebrity, and even in his failings, we are still treating him like one.
None of this is to say he doesn’t deserve ridicule or that he actually deserved his insane compensation plan, but we are all still feeding the beast of celebrity that is arguably at the root of many of these problems.
November 23rd, 2008 at 4:50 pm
I highly recommend reading Brad DeLong’s post on why this Times article is so problematic.
November 23rd, 2008 at 5:04 pm
The article neglects to mention why 2 very unqualified people got to be CEOs of Citigroup and AIG (Prince, Martin Sullivan) during this critical time.
It was Eliot Spitzer who forced the retirements of Sandy Weill and Hank Greenberg, for infractions they have never been charged with. He then forced the companies to be run by those 2 lawyers, to make up for their “bad” behavior.
Another result of the Law of Unintended Consequences.
November 23rd, 2008 at 5:44 pm
Anyone can make money while the market goes up and lose it when the market goes down.
This is populist posturing. It is eerily reminiscent of the right-wing meme that “anyone can run government” (how did that work out?). It’s the intellectual analogue of NRO.
These firms are failing despite the intelligence of the people in charge, not because of the lack of it. The obvious explanation is that there is a systemic cultural problem (for example, a dangerously naive conventional wisdom about the nature of risk), not that we happen to have a bunch of idiots in charge.
Or maybe you’re right, and Obama should get a store clerk to advise him on economic policy…
As for moral hazard, I actually don’t think there has been a great deal of moral hazard. As happened with Enron, the leadership of these institutions (Greenberg at Bear, Fuld at Lehman, etc.) lost enormous sums of money, and shareholders got wiped out. The problem wasn’t incentives–it was the systematic failure of the industry to make rational decisions in the face of those incentives.
November 23rd, 2008 at 6:08 pm
Ethan, I’m not convinced that there was a systemic failure to make rational decisions. I think there was a systemic failure in the models and tools used to assess risk. Based on the information that these firms had, most of their decisions were rational. But that information was flawed, and no one, including regulators, realized that until it was too late.
As for moral hazard, I agree. These guys are huge egotists.
They’re not going to knowingly risk running their company and reputation into the ground to make a few more bucks, even if they think the government will put them on life support. Moral hazard comes into play much more strongly for stuff like GSEs, where there are constant reassurances that the government’s got their back.
November 23rd, 2008 at 6:30 pm
Rubin is scum. Clinton by adopting the Wall Street paradigm of wildcat finance, through Rubin, was really the author of our disaster. Democrats lost the political will to fight it. The rest is history.
Rubin et. al. were not just wrong. They are crooks.
Rubin, having been a leader of public policy knew that systematic risk was too the moon and what did he do. Urged Citi to bring it on. He is scum.
November 23rd, 2008 at 7:53 pm
MikeF, I think we actually agree on the question of rationality. People followed their risk models, but the risk models had serious flaws. That none of the people at the banks noticed the flaws indicates not that they were stupid, but rather that they were caught in a collective mania. They small-picture rational and big-picture irrational.
This is what Buffett calls the “institutional imperative”, and he refers to this corporate lemmingism as the most important thing they never taught him at business school.
November 23rd, 2008 at 7:59 pm
I don’t agree that there is no incentive-based solution to the moral hazard problem (if it exists). As long as your upside and downside are both proportional to the upside and downside of your shareholders (or society, etc.), there will be no moral hazard.
My point is simply that from what I can tell, the CEO’s were properly incented (they made a bunch of money on the way up, and lost a bunch on the way down). It’s not like they cashed out at the top.
I do think that society (and shareholders) would be better served if compensation was more long-term in nature. For example, I’d like to see executive bonuses be something like “X % of free cash flow over the next 20 years”. I think this would tend to reduce foolish risk-taking.
November 23rd, 2008 at 8:40 pm
Somehow the biggest issues of risk reward and moral hazard have escaped view.
It’s other peoples money. That’s all you have to know. It’s very easy to gamble with other people money. It’s very interesting that the great investment banks were not public corporations until the 90’s. The names on the buildings were the names of the biggest stake holders in what were partnerships. It was their money. They day they went public they cashed out. It was stockholders money then. The rest is hisory.
November 23rd, 2008 at 9:00 pm
I don’t think this article is accurate, factually. I remember very distinctly in the Clinton era that Rubin was the cautious one on finance - urging greater regulation of new financial instruments - while Summers and Greenspan were the ones who wanted to allow the financial markets to innovate. It sounds like this “former Citigroup executive” may just have an ax to grind.
November 23rd, 2008 at 9:25 pm
I’ve got a form letter sent out to all these financial firms, offering to crash their companies for 1/20 of what these fat cats are charging.
From what I can tell, I’m perfectly qualified for the job. I have an AWESOME haircut and some very expensive suits.
And seriously, this whole “Hank Greenberg would never have crashed AIG” is too much bullshit. This financial meltdown wasn’t caused by bad personnel, it was caused by a profoundly fucked up system that’s been built up over the last 30 years.
Hank Greenberg is not Jesus. He would not have saved us all.
November 23rd, 2008 at 9:38 pm
“For example, I’d like to see executive bonuses be something like “X % of free cash flow over the next 20 years”. I think this would tend to reduce foolish risk-taking.”
While I do think that’s probably an improvement, that’s still quite problematic. Say the firm’s done well in the first 15 years - the executive will then be inclined to be extremely risk-averse for the remaining few years (why not lock in the profits by coasting?) - and those remaining years may be the very time the company needs to take on lots of risky activities. Or if the firm done badly the first 10 years (and it may not be primarily the executive’s fault), he might rationally swing for the fences and take on very high risks just to make some money (whose downsides may well become apparent only during his successor’s term).
You’d partially tie the company’s performance to WHEN it’s executives were hired, which is sort of a weird thing to do. On top of analyzing the companies’ prospects, balance sheet, business model, etc, a big factor would be: “Ed CEO is 2 years away from his 20 year mark” or the like?
November 23rd, 2008 at 9:44 pm
“That none of the people at the banks noticed the flaws indicates not that they were stupid, but rather that they were caught in a collective mania.”
Manias are a bad way to explain things - they happen, but it’s all too tempting to say “it was the mania that made me do it, man!” It’s too easy to just say it was irrationality of some sort.
November 23rd, 2008 at 10:42 pm
If people can get very rich taking on risks that are partially offloaded onto the public at large, we have a problem. Or, more specifically, we need to tax those people and use the revenues to better-assist ordinary people in dealing with risks.
How does that work?
November 23rd, 2008 at 11:38 pm
DTM, it is possible to impose greater risks than they would be willing to undertake, but this requires that the risks go beyond the financial. Even penury is probably more than the would risk, but maybe not. The potential for roommates named “Pindick”, now that’s incentive.
November 24th, 2008 at 12:20 am
Why not just stop giving executive bonuses entirely? Simply fire the bastards if they can’t do their jobs right. You know, the same way it goes with everyone else in the work force.
November 24th, 2008 at 6:59 am
I think this moral hazard issue is a rather moot. The argument seems to labour under the misunderstanding that if we save the banks they might base their future decisions on the assumption that if they fuck up big time they will be saved again.
This is wrong. The whole financial industry has been based on this assumption for quite some time. The future is now and all the bets that have been made in the boom years assume that if the worst happens, the goverment bails them out.
Why do they assume this? Because it is both true and obvious. Goverment will not let the whole financial sector collaps because that sector has a central role in a capitalist economy and such an economy cannot function without it.
So you shouldn´t worry about moral hazard, because that ship has sailed, crossed the ocean and has a girl in every port.
November 24th, 2008 at 7:55 am
Matthew writes, “The more risk you take on, the more potential for profit.” NO. Just taking on more risk does not increase the potential for profit. To make more profit, you may have to take more risks, but not just any risks. It is not the risk of failure that is desirable but the potential for success.
November 24th, 2008 at 11:55 am
One thing I definitely think we need to do is to find a way to cut back on executive compensation at these firms. Because these guys make so much money it is perfectly reasonable for their personal time horizon to be 5 years or less. Force them to expand their time horizon and you will get improved corporate management. If you bankrupt the company, you’re not going to get another job. Just doing so-so will stand land you another job in some other executive suite, maybe not as a CEO.
Of course, this is only a small part of the solution. But it would be helpful.
November 24th, 2008 at 12:02 pm
Yeah, echoing Carl: do you really get more profit from high-risk/high-reward investment? I always figured that over time your returns would even out because although you have fewer successes (and obviously, more failures), your returns are higher. But if you expect to make more money than a conservative investor (or other high-risk investors), then you must figure you have special insights into risk management that your competitors don’t have. Either that, or you know how to quit when you’re ahead.