Why It?s Smart to Be Reckless on Wall Street

Here is a guaranteed way to get paid well if you work on Wall Street. Find a best friend at a competing bank or hedge fund and take opposite sides of the same large bet. In one year?s time one of you will have a huge profit and get paid well. The other person will have lost and perhaps be fired. The sum of both your profits will be zero, but the sum of what you get paid will be positive. Split the pay.

This scheme is one of the more fanciful ways to exploit Wall Street?s compensation structure that pays absurdly well in the good years and just okay in the bad years. Losing money never means having to give anything back.

That asymmetry in pay (money for profits, flat for losses) is the engine behind many of Wall Street?s mistakes. It rewards short-term gains without regard to long-term consequences. The results? The over-reliance on excessive leverage, banks that are loaded with opaque financial products, and trading models that are flawed.

Regulation is largely toothless if banks and their employees have the financial incentive to be reckless.

How does Wall Street pay its employees? At the end of each year traders are paid a base salary and a bonus. The bonus, which fluctuates wildly, is usually a percentage of a trader?s profit. Some companies even pay a contractual amount, often between ten and fifteen percent. The average bonus of all employees is about three hundred thousand dollars but payments of $1 to $15 million are common. If traders lose they still get their base, often around two hundred thousand dollars. If their loss is great enough, they are fired. They never have to return money.

The incentives are clear. If you make a bunch of money you get personally wealthy. If you lose then you just go home and look for a new job.

Losing lots of money is hardly the career ender that outsiders imagine. If traders lose big then they will get fired, but they will now have experience. If one loses really big then one has almost a badge of honor. One could not be allowed to lose $1 billion unless one was really important.

Wall Street is littered with traders who have ?blown up? at multiple establishments or funds. There are enough to fill up a town about the size of, well, West Hampton.

Here is a more conventional blueprint to personal wealth via Wall Street.

Join a business that has an established track record. Start small, building up a few solid years of making decent profits. Do this for six or seven years. It?s called ?milking the franchise.? Soon you will have respect and, most of all, expanded limits on what you can trade. Wait for a year when everyone is bullish. Then swing big. Really big. Don?t take judicious risk; take the most risk the firm will allow you. Follow the momentum, piling into trades others are doing.

If you win, since you followed the herd, Wall Street will be flush with cash and you will get paid well, tens of millions well. If you lose you may get fired, but since everyone lost they will understand.

This strategy is certainly not in the long-term interest of the firm, but it?s the smartest strategy to benefit the trader.

The closest other field of employment to Wall Street in compensation is professional sports. They also pay large yearly contracts meant to encourage employees to increase their performances. Sometimes those employees fail miserably, hurting their team.

Banks are not sports teams though. They are institutions that occupy a special place in the economy and are given special status, and as such, have an obligation to ensure their long-term health. The only harm if the Yankees overpay for a pitcher (and they always do) is distraught Yankees fans. If banks lose, especially ones with $2 trillion in assets, we all lose.

The incentives at these banks should consequently be structured to discourage, not encourage, short-term speculation and risk taking, with the primary goal of guaranteeing the bank?s solvency. Rather than pay employees based on how much they made the prior 365 days, pay should be based on their entire careers, with the bulk of compensation coming in a form that can be taken away with future losses.

Independent hedge funds can pay however they want. It is up to the investors to decide how they want to compensate their money manager and few funds are large enough to be ?too big to fail.?

Here is a third scheme. Sell insurance on a rare event, something with a payoff around one in a hundred. Sell lots of it and convince regulators that it?s a one in a thousand event so you can account for the premium as a profit. You now have a steady revenue stream, which will pay your company well.

What if it?s actually a far more common event, something like one in ten? You will lose huge eventually. Your company, if it did enough of this trade, will go bankrupt. You however will have had three to four good years and can walk away.

Far fetched?

This is exactly what happened from 2002 until 2008. The one in a hundred event was US housing prices dropping 30% or more. Who did this: Bear-Stearns, AIG, Lehman Bothers, Merrill Lynch, and others. The insurance they sold: Buying and structuring esoteric mortgage bonds.

How did it work? If housing prices rose or stayed flat or fell slightly, the bonds paid a small premium, about a quarter of a percent. If however, housing fell dramatically, then the bonds plummeted.

From 2003 to 2007 housing prices rose. Wall Street took in record profits as the bonds paid. Bonuses paid to traders and executives were also records, with senior traders and managers receiving bonuses between $3 million and $10 million in 2006.

In the middle of 2007 things turned. The housing market did collapse over 30%, triggering huge drops in the bonds. Who lost? Well the banks did, many going broke and requiring a government bailout. The traders and managers who did these trades did well personally. Many were fired, but with enough money to never work again, having collected compensation of roughly $15 million over that period.

Many were later rehired, by hedge funds, to buy the securities at cheap prices after the banks disgorged them.

Were they doing anything illegal? Hard to say. They were doing what Wall Street incentivised them to do.

This also leads to misconceptions about most employees on Wall Street. Few actually abuse the system, contrary to their personal self-interest. Still there is a minority who do, stigmatizing the industry. It often works out wonderfully for them and awfully for the rest.

In 2000 a young PhD in mathematics approached me about a job before eventually landing at a European bank in research. In 2004 he started proprietary trading, where traders bet with the bank?s money. Pay was 15% of the profits. In 2005 he bought obscure and high-yielding corporate bonds, which generated profits of $40 million. He took home $6 million. In 2006 he made $80 million and took home $12 million. In 2007 the world turned and the group was disbanded as losses mounted. He was dismissed, and his trades eventually lost the firm close to $300 million.

What was his PhD thesis about? Game theory, or using math to find the optimal solution to complex systems.

Late last year he sent me an email. ?Chris, why are you still working??

Source: http://rss.sciam.com/click.phdo?i=e313b1214edc03043f97c8074b88e11d

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