I received a message last week from a savvy reader, a former McKinsey partner who has also done among other things significant pro-bono work with housing not-for-profits (as in he has more interest and experience in social justice issues than most people with his background). His query:
We both know that financialization has, among so many other things, turned large swaths of the capital markets into a casino
Here’s my thought/question: is there a house?
The common wisdom is that the ‘house wins’ in casinos
In all likelihood, at least in the great financial crisis, the TBTF banks were the ‘house’… yet, it’s at least a bit different from a casino house because, absent the bailouts, those banks would not have won.
So, who or what was really the ‘house’? Was it the Fed? Did the Fed actually ‘win’?
Maybe the ‘house’ is the 1% …. or, more precisely, the .01%???
I have included this fetching image to give you the opportunity to formulate your own answer before scrolling down.
The producers in finance: the managing directors and heads of trading desks at major banks, the more senior managers who are along for the ride, the hedgies, guys in private equity.
The “house” is individuals, not institutions. That is how looting works.
Remember, the question is not merely who wins from our current hypertrophied financial system, but who is set up to be the house, as in to win no matter what. The answer in this case is intrinsically linked to looting.
The concept of looting is so important that it pays to revisit the seminal 1993 George Akerlof and Paul Romer paper that set forth this concept. The key section (emphasis ours):
…an economic underground can come to life if firms have an incentive to go broke for profit at society’s expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations. Bankruptcy for profit occurs most commonly when a government guarantees a firm’s debt obligations. The most obvious such guarantee is deposit insurance, but governments also implicitly or explicitly guarantee the policies of insurance companies, the pension obligations of private firms, virtually all the obligations of large banks, student loans, mortgage finance of subsidized housing, and the general obligations of large or influential firms. . . .
Because net worth is typically a small fraction of total assets for the insured institutions, . . . bankruptcy for profit can easily become a more attractive strategy for the owners than maximizing true economic values. If so, the normal economics of maximizing economic value is replaced by the topsy-turvy economics of maximizing current extractable value, which tends to drive the firm’s economic net worth deeply negative. Once owners have decided that they can extract more from a firm by maximizing their present take, any action that allows them to extract more currently will be attractive—even if it causes a large reduction in the true economic net worth of the firm).
The difference between the classic Akerlof/Romer notion of looting, where the owner ssyphoned off funds and left the company so fragile that eventual bankruptcy was almost inevitable, is that the evolution of Wall Street has produced a much broader class of individuals who are treated as if they have claims on profit streams. That puts them in a quasi-ownership position.
These “producers” are typically perceived to have enough control over a revenue stream as to have leverage over the institution. That includes anyone who runs a profit center (and remember, a profit center can be as small as one trader and a trading assistant), as well as individuals on the more-team-oriented investment banking side of the house that have strong enough client relationships that they could take some business with them (and perhaps other members of their team) if they left. As we explained in ECONNED:
In the financial services industry version of looting, we instead have firms where operational authority, is decentralized, vested in senior business managers, or “producers.” As a result of industry evolution and perceived competitive pressures, these producers, as a result of formal incentives plus values held widely within the industry, focused solely on producing the maximum amount possible in the current bonus period. The formal and informal rewards system thus tallies exactly with the topsy-turvy scheme of “maximizing current extractable value.”
This behavior in the past was positive, indeed highly productive, as long as it was contained and channeled via tough-minded oversight, meaning top management who could properly supervise the business. The main mechanisms are management reporting systems, risk management, and personal understanding of and involvement in day-to-day operations, plus external checks, such as regulations and criminal penalties. For a host of reasons, the balance of power has shifted entirely toward the forces that encourage looting. And because the damage that results cannot clearly be pinned on the top brass… it is difficult to ascertain from the outside whether the executives merely unwittingly enabled this process or were active perpetrators.
Notice this excessive extraction that led to business failure took place even though these firms had high levels of employee stock ownership. At Bear Stearns, members of the firm owned roughly one-third of the shares. At Lehman, they held nearly 30%, and the average managing director owned shares worth on average two times his annual take. Economic theory says that share ownership by employees and managers should lead them to produce the best long-term results for the enterprise. Yet those assumptions were shown to be flawed on Wall Street, as they were with Enron, in which 62% of the 401(k) assets were invested in Enron stock, and senior management also had significant share ownership.
Just as we have seen in Corporate America, using equity to align the interests of managers and shareholders has produced the converse of what the theorists expected, a pathological fixation on short-term results. On Wall Street, where the business model and rewards systems already had an intrinsic propensity to emphasize the quick kill, widespread employee ownership was an ineffective counter at best and more likely served to reinforce the fixation on current performance, irrespective of the true cost of achieving it.
The very worst feature of looting version 2.0 is that it has created doomsday machines. In the old construct, the CEO fraudsters would drain a business, let it fail, and move on. The fact of bankruptcy assured that the trail of wreckage would catch up with them sooner or later. But here, the firms, due to their perceived systemic importance, are not being permitted to fail. So there are no postmortems, in particular criminal investigations, to determine to what extent fraud, as opposed to mere greed and rampant stupidity, led to what would otherwise have been their end.
Now mind you, these producers aren’t the Ayn Randian rugged individualists that they often envision themselves to be. Their success depends on institutional infrastructure: concentrated capital and information flows, access to cheap leverage, risk control systems, a back office, etc. Quite a few successful Goldman traders have flopped when trying to launch their own hedge fund. John Meriwether, a storied Salomon trader, has presided over a series of hedge fund failures in his later life, the most spectacular being LTCM. Former Goldman CEO Jon Corzine is another high profile example of a supposedly successful trader and trading manager who came a cropper when given more degrees of freedom at MF Global than at his former home.
But while these individuals’ ability to succeed on a stand-alone basis or in different type of firm is subject to question, they nevertheless hold their employers hostage. If they decamp to a competitor, they not only take some (or a lot) of their revenues with them, but they can damage the ability to be competitive in closely aligned businesses. Senior people cannot be replaced quickly and each unit’s activity is so specialized that employees from other area can’t pinch hit for the recently departed producer or team. And if the loss is significant enough, competitors will poach on other business units, which in a worse case scenario can put a firm in a downspiral.
And the worst is given the present structure of these firms, there is no simple way to curb the leverage these staffers have over their employers. Again from ECONNED:
On paper, capital markets enterprises look like a great opportunity. The firms that are at the nexus of global money flows participate in a very high level of transactions. Enough of them are in complex products or not deeply liquid markets so as to allow firms to find ways to uncover, in many cases create, and capture profit opportunities. New, typically sophisticated products often provide particularly juicy returns to the intermediary. And in theory, clever, adaptive, narrowly skilled staff can stay enough ahead of the game so that the amount captured off this huge transaction flow is handsome.
Once again, however, the real world deviates in important respects from the fantasy. Why? This business model is also a managerial nightmare.
We have a paradox: “success” and profitability in the investment banking context entails giving broad discretion to individuals with highly specialized know-how. But the businesses have outgrown the ability to monitor and manage these specialists effectively. The high frequency, meaningful stakes, and large absolute number of decisions made at the operational level, the geographic span of these firms, and the often imperfectly understood interconnections among business risks make effective supervision well-nigh impossible.
What is intriguing about the ex-McKinsey partner’s question is that even after reading extensively about the crisis, he was unable to see the true locus of power in the financial services industry. Yet the answer is obvious to anyone who has worked in or closely with major capital markets firms.
And the conundrum we have outlined means the people who call for prosecutions of individuals are exactly right. Punishing firms is ineffective. Firms are fluid; key players can and often do move around. And the culpability for bad practices typically resides both at the producer level (the manager immediately responsible for the unit in which the bad conduct took place) and more senior management (which typically benefits directly from any ill-gotten profits, in terms of their compensation levels, and needs to be held responsible, even if they were simply derelict in duty, as opposed to actively complicit).
When the SEC was respected and feared, back in the stone ages of the 1970s, the capital markets delivered far better value for society as a whole than they do now. But even though financial services industry looters are the big winners in the capital markets casino, many members of the 0.1% have been along for the ride. Until some of the uber-rich join the great unwashed as victims of financial services industry looting, the house has nothing to worry about.