Incentives, Complexity, and the Blame Game

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But opacity, leverage, and moral hazard are not accidental byproducts of otherwise salutary innovations; they are the direct intent of the innovations. No one at the major capital markets firms was celebrated for creating markets to connect borrowers and savers transparently and with low risk. After all, efficient markets produce minimal profits. They were instead rewarded for making sure no one, the regulators, the press, the community at large, could see and understand what they were doing.

– ECONNED: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism

As the investigations of the global financial crisis ratchet up to a new level of intensity, a tug of war between Wall Street and its detractors is escalating along with it. Some commentators have argued the SEC’s suit against Goldman is baseless, since the investors were sophisticated and should have known better than to take the investment bank’s word at face value. Old arguments are newly popular, such as claims that government policies stoked financial firm risk-taking or that the the Community Reinvestment Act caused subprime excesses.

But assigning blame (which tends to focus on individuals and institutions) can be misleading if you omit the larger framework within which they operate. We now have a financial and political system with widespread, lousy incentives. While it is critical to understand the mechanisms of the crisis, and who did what to whom, it’s also important to understand how an entire system could not merely condone, but actually encourage what with the benefit of hindsight was colossally stupid, destructive behavior. If we don’t fix the incentives, the same thing will happen all over again, just as it has already.

Readers often take umbrage with me when I argue that even though investors were foolish, they were not the most culpable party. What I find puzzling about this crisis is how the posture toward investors contrasts with that of past excesses. For example, this time around, there is some pretty compelling evidence of chicanery, witness Freddie and Fannie seeking clawbacks from banks because they made contractual misprepresentations about the mortgages they presented to the agencies.

Now independent of how widespread fraud was (we will be years sorting that one out), investors and lenders in the subprime market appear to have been a combination of overly trusting (particularly of ratings) and blinded by structured finance hocus pocus. But why are they being demonized when we saw similar widespread credulousness in the dot com era? We criticize lenders for handing out NINJA loans and investors for buying first gen (mortgage bonds) and second gen (CDOs) made of them that somehow fetched AAA ratings. Yet pray tell, how different is that than giving a bunch of not even graduated MBAs $5 million for a ten page business plan for venture that was never going to generate positive cash flow? (And that’s not an isolated case; it was trivial to raise $5 million if you had a clever idea and a remotely credible, which usually meant young, management team).

Yes, the dot com bust didn’t generate a global financial crisis, but the foolishness was every bit as bad, and you had supposedly sophisticated folks falling for it too (one example: McKinsey wrote off $200 million in equity it took in lieu of fees from Internet businesses). And Alan Greenspan sincerely believes that he deserves credit for the dot bomb era being not that bad, thanks to his program of super low interest rates, which helped set the stage for our global meltdown.

An incentive failures that has gotten a free pass in the crisis is the way money is managed in the Anglo Saxon world: annual time horizons and measurement against benchmarks. One of the factors that keeps pushing investors into greater risk taking is competitive pressure. If your performance lags, even it is because you are making better risk/return decisions, you will lose assets (and if you are at a big firm, you will be replaced). Yet we see remarkably little impetus to change a system which rewards the fund managers and gatekeepers (who have a particularly powerful role in keeping this system intact) since they earn….annual fees! A classic “And where are the customers’ yachts?” problem.

And too much risk is a no-no too, but the measurement of risk was volatility of returns. So what did we see in the crisis just past? A rise in popularity of strategies that used illiquid assets….which were therefore marked to model…which therefore did not show much (any) price volatility until their credit quality decayed.

Indeed, one of the features of the crisis was, just as the dot com era saw companies like and being “manufactured” to meet investor appetite, so too were appealing-looking investment strategies ginned up this time around. From an extraordinarily prescient April 2007 paper, “Cracking the Credit Market Code,” by Henry Maxey of Ruffer and Company (no online version; more on this paper in future posts):

This leads us to the theoretical holy grail of hedge fund strategies: leveraged spread strategies in illiquid assets.

Illiquidity in the assets is essential. The danger with liquid assets is that market forces can change prices for both fundamental and haphazard reasons. Ordinarily holders of assets expecting a 20% return will accept commensurate volatility, but in a world demanding smoothed returns, this is unacceptable. Consequently, it becomes key that the capital value is not left to the vagaries of the market place.

Without a liquid market to price an asset, pricing is supplied by, for example, models. These frameworks tend to be self-serving because they are developed by players, such as ratings agencies and investment banks, who are more incentivised to give investors what they want than to ensure the price is an accurate reflection of the fundamentals. Prices, therefore, don’t change until the fundamentals, e.g., default rates, force a reassessment of the model inputs.

Everything hangs on default and downgrade. Actual default or downgrade become the critical events rather than markets’ forward looking pricing of that event, so problems are withheld until discontinuous pricing events occur rather than being anticipated in a continuously priced market. The capital prospects for the asset beyond 12 months are not of primary importance while the leverage yield spread provides the necessary return/volatility performance figures. Such a strategy is encouraged by a lack of visibility of the underlying portfolio (strategy secrecy), and a lack of regulation.

Yves here. This is a key point: it wasn’t just the demonized, presumed “dumb money” that took losses in this game. Hedge funds and prop trading desks were on the wrong side of many of these trades too. The John Paulsons of the world seek the limelight, while the others hope their mistakes go unnoticed.

Indeed, the other aspect of the “who wound up with the CDO hot potato” is that, as we have discussed in earlier posts, that it was increasingly the dealers themselves. Goldman’s retention of its now notorious Abacus 2007 AC1 trade looks like a portion it could not offload; Merrill looks to have had even more serious pipeline problems.

But this widely accepted pipeline explanation is insufficient, at least for most firms. Unsold inventory winds up on the trading book; it becomes a risk management problem. CDOs piling up with the dealers should have shut down the CDO market and didn’t. Why not? Because the traders could game their firms’ bonus systems.

If a trading desk hedged an AAA instrument with a credit default swap from an AAA counterparty and had income left over (a negative basis trade), the banks’ P&L systems would typically reward the desk for “freeing up capital” to the tune of millions of dollars. The mechanics typically were tantamount to taking all the future income (income less hedge cost) and discounting it back to the present (some banks, like UBS, used a variant that cut the hedge cost by insuring only part of the position, yet taking the same “risk adjusted return on capital” profits the day the trade closed).

So let’s hope the digging continues. As much as this crisis had many parents, efforts to shift blame away from Wall Street are not going to survive continued investigation and due diligence.

Update: I neglected to include this section of a Goldman document, which while classic CYA (as in designed to allow the shifting of blame to employees when necessary) also serves to illustrate that the “caveat emptor” standard that many readers argue for (and believe is implicit in the “market maker” standard that Goldman touts) is lower than the standard brokers are expected to adhere to. See pages 259 and 260 for context:

• Trading and sales personnel have an obligation to “know their customers” before recommending or entering into any securities transaction

– Learn the essential facts about the customer and the customer’s orders and accounts

• All recommendations to a customer must be suitable and appropriate for the customer

• The salesperson should know as much as possible about the customer’s objectives, strategies, tolerance for risk, and the type of information the customer is relying on

• Even when a customer is making its own investment decisions, special care and judgment need to be exercised in situations such as the following:

– The customer has trouble explaining in plain language its investment strategy, objectives, or risk tolerance, or how a transaction or product fits those criteria
– The customer wants to recoup, roll, hide, or avoid losses, or evade taxes, and proposes a transaction or structure clearly intended to do so
– A customer proposes a completely atypical transaction
– The customer has a history of litigation or a record of being a “sore loser”

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  1. Abhishek

    Nothing much seems to be done to change the existing structure.RBS chairman recently said that salaries were too high making it difficult for him to retain key personnel.There has been no strong reaction against unsustainable banking practises , I think that the Goldman hearings are just a start

  2. attempter

    After all, efficient markets produce minimal profits.

    This is perhaps smokiest of the smoking guns that there’s no such things as textbook “capitalism” in America, but only racketeering.

    There’s no sector which isn’t mature, and therefore none which can legitimately still generate high profits. By definition any high “profits” we see among large corporations are actually rent extractions by racketeers.

    And as we saw with the piece on Chase a few days ago, right down to the most nickel-and-dime level the whole effort is to generate as much needless economic complexity, interpose as many obstacles to real efficiencies, run as many cons, perpetrate as many frauds, get the best return on investment on bribery (campaign contributions and gangster patronage jobs like Rubin’s at Citi), as possible.

    We know that none of this has any legitimate reason to exist. “Complexity” is always the strategem of criminals. As with the health racketeering bill and now the finance bill, we can measure the level of its fraudulence by how it adds new layers of complexity while rejecting attempts at simplification.

    For example, Obama and the Dems claim to want a “CFPA”. But did they include the vanilla requirement measure, a no-brainer from any rational or moral point of view? They did not. That proves it’s a scam, and that the Dems are acting in bad faith.

    1. fresno dan

      That is very insightful point.
      After all, CDO’s aren’t patented are they? All trades are based on publically available data? (except get the data sooner than others).
      And if stock prices (or financial instrument prices) are truly a “random walk down wall street” no one should be able to guess the roll of the dice better than anyone else. Unless they know something about how dice are manufactured, the quality control tests used to assess dice, and the flaws in the testing regimens of the dice regulators, and the statistical outcomes of these flaws.
      You don’t have to make a dice never roll a “1” or always roll a “6.” Just a tenth of a percent should do you nicely.

  3. fresno dan

    “Readers often take umbrage with me when I argue that even though investors were foolish, they were not the most culpable party.”

    I actually was sympathetic to the arguements of Goldman at first. Than I read:

    A lot of this depends on the words used:
    Was it a casino and everybody should know you could lose money? A buyer and a seller – where both know that the “price” can go up or down?

    Or is a CDO more analogous to a bond – where people are very conservative and want safe yield? With insurance like aspects – I don’t think my insurance company is long and I’m short (I sure hope my house burns down so I get to collect) – as well as the fact that when I buy insurance I have no idea of the financial strength of the insurance firm. Was it reasonable for CDO buyers to believe the rating agencies (at the TIME people, at the time)?

    I still believe a lot of “financial inovation” is uneconomic – just fee generating activity that takes a bigger and bigger slice of what return their is. The reason “sophisticated” buyers buy it is probably why a lot of things get bought – its OFFERED. But it is really no different than why “unsophisticated” buyers buy toaster insurance at Sears – the desire for security.

  4. NS

    ‘Caveat Emptor is not a business plan’ as one professor put it. Unfortunately, not only is there a thick veil over the eyes of investors broadly but the political beasts practice the same behind closed doors in our highest of offices and under the guise of protecting the public. uh-huh.

    As a consumer or investor, or as a newly minted shareholder of businesses (taxpayer) one must not only provide ones own due diligence with the complex multi-thousand pages of legealese but also think about what is NOT stated.

    The practice Yves refers to became a standard rather than an exception in the wonderful world of SIVs closed to all but the most ‘sophisticated investor’. The dark underbelly of Capitalism isn’t that at all, its cronyism and cabals of first order. It isn’t limited in its scope to the world of high finance either. Incentives do count. The incentives to rob pension plans, depositors/savers, entire market sectors make Gordon Gekko look like first year unpaid intern. He could never rise as he didn’t possess the right pedigree from Harvard or Yale to even get in on the very lucrative world of Lobbying and writing the loopholes for an industry.

    Cheers and glee come out of our markets when thousands are laid off from their jobs under the auspices of a more ‘efficient’ businesses and subsequent quarterly rosy profit reports. In fact the operation moves overseas to near and some outright slave labor force to ‘compete’ in this globalized world. Honest people doing honest work for a living wage is sooooo last century. If you fail, never fear, the taxpaying public will rescue you, the precedent already set. You’ll still get your outsized salaries and bonuses even if your business majority share is owned by the fed/treasury/taxpayer.

    The Trillions of ‘illiquid assets’ on the fed reserves balance sheet will somehow, magically, be converted to a profitable asset. Looks like the FASB and rating agencies have their work cut out for them in how those standards can become less standard. The fed window bridge loans are like a bridge made out of threads of cotton candy.

    I must admit, Goldman, JPM, Citi, BoA, have done an outstanding job of creating an alternate universe which sucks the life force out of everything they touch, winning no matter how bad the deal goes. Now the deal is our very sovereignty as well as the sovereignty of other nations.

    Might as well change the flag and call ourselves the United States of Goldman Sachs liquidity. Our new religion is that of Goldmanites as its possesses all the elements of a perverse cult. My tithing is assured and forced.

  5. Toby

    I agree with attempter here. This is the point we need to publicly discuss, as loudly as possible:

    “After all, efficient markets produce minimal profits.”

    And this, which is a follow-on point:

    “it’s also important to understand how an entire system could not merely condone, but actually encourage what with the benefit of hindsight was colossally stupid, destructive behavior. If we don’t fix the incentives, the same thing will happen all over again, just as it has already.”

    The incentive of money-profit for its own sake is wrong at its core.

    I’m reading Econned at the moment, and welcome it wholeheartedly. This period of our history could not be a more perfect time for such books (which are by no means new) to really bite. Thank you Yves for doing such a great job, and to your untiring dedication to this battle.

    Efficiency is the enemy of profit. “Efficiency” is oft touted as the desired result of zero-regulation market activity, but no one really wants it. It’s a smoke-screen argument, one of many ejected by the vampire-squid empire to keep inquiring minds as lost in the labyrinthine nonsense of orthodox economics as possible.

    It will be a difficult and protracted battle, but it is vital to engage and perservere. My take is that money, in it’s current debt-only form, is the root problem. That so much socioeconomic energy is deployed making profits from money, is a long term crime against humanity and the ecosystem. Where is there room in the current paradigm of monetary-profit as ultimate arbiter of success, for notions of profit in growing trust, higher literacy, lower crime, greater community cohesion? These things cannot generate monetary-profits, so are left to be tended by the Invisible Hand. As they wither, only sociopaths thrive.

    We live in a sociopathic system, whose true nature is clearly revealed in debt-money, the obsession with eternal GDP growth, the legal structure we call The Corporation, and the almost total regulatory capture by money-interests of all spheres of society; media, politics, and business. The paradigm has us in a death grip, but efforts by people like Yves Smith, Randall Wray, Steve Keen, Bernard Lietaer and many others give hope.

    Sorry to get all emotional, but these are topics and issues which touch me deeply.

    Keep up the excellent work!

    1. Francois T

      “Sorry to get all emotional…”

      WHAAAT? Please, don’t be sorry!

      This is precisely the lack of emotion that has us in this pickle. Outrage is a powerful driver to initiate change. Why do you think the powers that be are working so hard to discredit any manifestation of it?

      1. Toby

        I’m English, so I feel another apology is in order.

        Sorry, I’ll try to be more emotional in future. Damn it! All to hell!


  6. Percy

    This is a profoundly disturbing set of very persuasive observations. To “After all, efficient markets produce minimal profits” one might add that markets free of conflicts of interest are not very profitable either.

  7. Francois T

    Ordinarily holders of assets expecting a 20% return will accept commensurate volatility, but in a world demanding smoothed returns, this is unacceptable. Consequently, it becomes key that the capital value is not left to the vagaries of the market place.

    Isn’t it the kernel of the predicament we’re in? I can’t count the times I’ve seen this grade-AAA bullshit sputtered by (usually big clients) while reading Market Wizards and other opuses about trading. From Jerry Parker to Amhet Okumus, same blurb: “What has changed is that now, investors tell us they don’t want to see much month to month volatility.”

    Forgive me for being particularly obtuse, but how in this universe can you even get above average returns if you do not have volatility in the markets to begin with?

    While we’re at it, let me venture a guess: these smoothed returns ought to be consistent too? Would you like it 2% above the S&P? Oh! 10% you say?


    It’d be fascinating to examine when the pipe dream of “smoothed returns” took hold. Because it is a delusion of the first order. Last time I checked, the laws of Nature and the randomness of life still apply.

  8. zak822

    “Because the traders could game their firms’ bonus systems. ”

    This is the heart of the matter, at all levels. Everyone on the inside knew they were going to reap huge rewards. And they were not about to jepordize that money.

    It’s not complicated. And we really do need to remember that not everyone with a thiefs mentality is in the Mafia.

  9. Doug Terpstra

    Yves, It seems that this focus on illiquid assets to enable such explosive leverage was, just like GS’ toxic CDOs, by design and not systemic happenstance. And this is what makes the current FASB’s fraudulent “extend and pretend/mark-to-myth” policy, allowing banksters to continue spinniing the roulette wheel, so indidious and potentially vicious, (perhaps also by design?). While Helicopter Ben’s reflation strategy seems to be successful so far, to this financial neophyte, it seems it could also be enabling even greater (torqued/compounded) leverage and looting than what exploded in ’08. And still, housing and CRE don’t seem to be cooperating with Ben’s ostensible goals. So what happens if/when these mythical asset values finally evaporate?

  10. craazyman

    Send me your alms, sinners, and I will buy off the Big Man and keep you all out of hell. You can tell I’m a serious dude because of my robes, gold and headgear. Can’t get that at home, can you? Not to mention my private language, which you can’t speak, dumb illiterate peasants, you’re lucky I’m here to help with your spiritual growth. Where’s my wine, Abelard? The good stuff, not the shit the weed pullers drink in their mud huts!

    -Cardinal Debtus Ordinatus, Church of the Holy Penny

  11. MIchaelC

    After all, efficient markets produce minimal profits.

    And there’s the rub. At the heart of the defense of free market capitalism is the concept that its the least bad of all alternatives precisely because transparent (forget efficient, that’s been debunked to death) markets are corrected through arbitrage till the arb premium disappears. That case still has merit.

    The alternative is a hopeless corrupt world of arbitrary cronyism orchestrated in the dark by the political and financial elite. During my professional life (from early 80s on), I believed the fatal flaw with the European model was the tolerance of state meddling, and as a result an open Anglo model was preferable, with the caveat that transparency wasn’t perfect, but was a core principle that could expose the opaque machinations of state (and predatory banker) intervention to allow markets to eventually check abuses.

    The compromises required to make the European model work may be possible in a union of states with homogenous populations and a very long history of conflicts and compromises, but could never be made to work in more diverse states.

    Clearly that core principle (of transparency) has been violated and the system was cynically gamed by ‘free market capitalists’ who disingenuously advocated open markets but traded in the dark and brought about the collapse.

    But a modified Anglo model is still required, lest we continue on the Euro path of permanent state protection of the predatory banksters.

    So I think we pursue two paths here in the US:

    Prosecute the past frauds aggressively, both to punish the perps (including the FED and especially Treasury) and to identify the disclosure gaps.

    Define full disclosure procedures and mechanisms for every regulatory change as an overarching goal.

    I trust Dodd to deliver the same package the Germans delivered to their citizens via the Landesbank bailout (which was as politically necessary as the AIG/GS/Paulson/Paulson’s ,Magnetar’s et al, clients bailouts in the US) and leave us with the worst of both models, ‘free market capitalism’ backstopped by the state.

  12. MIchaelC


    At this point we have a pretty good idea of who the ultimate losers on the Abacus trades are, (ie. Washington state employees who invested in IKBs SIVS which contained the Abacus dreck.

    Do you know if anyone has made any progress identifying the winners who invested with Paulson and shared in his firms 15-25b windfall on these deals? Any idea which prime brokers were funding Paulson’s clients investments? I wonder how many of Paulson’s clients were also GS clients who were financing their trades through GS. Since it was such a sure bet they must have been easy loans to fund.

  13. readerOfTeaLeaves

    Yves, as blog posts run, this one strikes me as a ‘Tour de Force’.
    Again, thanks for adding the audio links; enormously helpful for this reader/listener.

  14. Anon48

    “…An incentive failures that has gotten a free pass in the crisis is the way money is managed in the Anglo Saxon world: annual time horizons and measurement against benchmarks. One of the factors that keeps pushing investors into greater risk taking is competitive pressure. If your performance lags, even it is because you are making better risk/return decisions, you will lose assets (and if you are at a big firm, you will be replaced). Yet we see remarkably little impetus to change a system which rewards the fund managers and gatekeepers (who have a particularly powerful role in keeping this system intact) since they earn….annual fees!”

    As a CPA I completely agree! Question- doesn’t “mark to market” accounting exacerbate the problem of short term measurement horizons? By its very nature mark to market emphasizes the balance sheet to the detriment of the P&L. Making sure that the last short term valuation gyration is captured on the balance sheet is theoretically a never ending battle. Where to draw the line? And is it that meaningful? Whatever the last value reported- most likely it will be different a just few moments later. The downside of this endeavor is that P&L results can get muddied by the changes in asset and liability valuations that arise as a result this process.

    What to do? Take the focus and place it back on the P&L. Assets and liabilities should be tracked on an “amortized cost basis” with few exceptions. Secondly, the focus should change from monthly and quarterly to a more long term horizon. In most cases, it is only when a business produces profits over extended periods of time, and between which balance sheet values are periodically reported exclusive of the fair market value fluctuations. By having strongly anchored reporting models for balance sheets P&L reporting will become a much more reliable metric. BTW while auditors are very good at validating historical cost the current crisis shows they’re not so good at validating FMV’s. Changes in balance sheet FMV’s should go no further than footnote disclosures in audited financial statements. This will still allow F/S users to apply valuation metrics that best reflect their own view of things.

    Some people will complain that this is a stoneage mentality. But this actually makes much more sense than the current practice of trying to come up with Valuation methodologies that will be most appropriate for all financial statement users (clearly impossible). Strategic buyers may focus upon a completely different set of metrics and methodologies than other types of investors. It’s really only after the test of time that a particular methodology can be truly validated anyway.

    1. MIchaelC

      What to do? Indeed.

      Report changes in capital correctly and fully. Reflect all changes in the value of the Balance Sheet in plain English, Ignore the distinction between current P/l and adjustments to retained earnings in the periodic reporting.

      If only Lehman, or Bear, had been able to report based on amortized cost. Maybe they wouldn’t have collapsed, ya think?

      I’ll be happy to settle for a footnote schedule that shows the total Assets of JPM (for example) at amortized cost as of 5/31/10, alongside a column that shows total Assets of JPM at current market value, alongside (for good measure) a column that shows me those same valuations as reported for P/L reporting purposes.

      Stone Age mentality? Maybe not, but arguing amortized cost is appropriate for trading books is absurd.

  15. ChrisPacific

    Very well written and nicely summarizes my reservations about the whole Caveat Emptor argument, which you express much more clearly than I could have.

    Re: “efficient markets produce minimal profits” – the idea that efficient markets are best for everyone is largely fictional. Sellers want efficient markets on the buy side, buyers want it on the sell side, but neither wants it on their own. Those with the power to restrict or eliminate competition will usually choose to do so (look at Walmart and Microsoft, for example).

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