Why Financial Companies are Stupid
It seems to happen far too often, doesn’t it? Financial companies make bad choices on investments, leading them ultimately to implode. Of course, it’s not the companies making those decisions; despite what some would have you believe, they’re not people. No, it’s employees of those companies making those decisions.
Yet, in order for those employees to have control over enough money to make headlines (such as JPMorgan’s two billion dollar loss last week), they need a good enough track record to merit such broad control. How do they get it?
The answer may just surprise you.
Let me start by describing an old scam that’s quite effective. You receive an email every day for a week, from Sunday through Thursday. Each day, the sender tells you that a particular stock will close higher or lower the following day. Amazingly, the emails’ predictions are correct, every single time. At the end of the week, the sender tells you that, by giving him some significant sum of money, he’ll be able to grow the funds at a tremendous rate, because he knows the direction of that stock every single day. You give him the money, and never hear from him again.
The big question is…how does he know which direction the stock is going to go? And, if he does, why on earth is he not richer than Mitt Romney?
The answer is that you weren’t the only recipient of the email. On Sunday, he sent the email to 32,000 people. To 16,000 of them, he predicted the stock would go up. To the other 16,000 he predicted the stock would go down. On Monday, he sent email only to the 16,000 who got the correct prediction; 8,000 got a prediction that the stock would rise, while the other 8,000 received an email predicting the stock would fall. This repeats through the week, with half cut out each day, until there are only 1,000 left when the market closes on Friday. If he only gets one percent of those to then bite, he’s got ten suckers. Naturally, with the low cost of email, this scales very well.
How does this scam play in at the financial companies? It’s a similar game of large numbers. Large numbers of people enter the firms. The ones who do better than the others, even if only by chance, rise to the top, and are given larger purses with which to work. They don’t have to win every single time; they merely have to do significantly better than average. With enough people coming in, such an outcome is inevitable for some of them. In that regard, it’s little better than winning the Mega Millions lotto, except that few people consider the winners to be brilliant for their choice of numbers.
I’m exaggerating the similarities here, but not by all that much.
So why on earth do the financial firms do this? One reason is that it’s extraordinarily difficult to tell the difference between someone who has a brilliant financial mind and someone who merely “chose the right lotto numbers”. The outcomes look the same, and since the employee is never going to claim that he simply got lucky, the illusion of having better knowledge becomes indistinguishable from the real thing.
But why would the employees themselves take such risks? This is where it starts to get really interesting. Remember “The Dark Side of Personal Responsibility”, where I talked about moral hazard? Provided they’re not doing anything illegal, the worst thing that can happen to these employees is to get fired. Such employees will end up with no salary, and no bonus, but (provided the loss wasn’t too high profile) can simply go work for another company. And they typically do. On the other hand, the payoff for success can be huge. And they’re all told, from management and from peers, about how great those rewards are.
So, no matter how much of the employer’s (or, more accurately, the employer’s investors’) money the employee loses, the employee isn’t on the hook to cover it. But the employee gets a cut of any winnings. Remember what I said in “The Ideology Gamble” about how it’s worth it to have many small losses if they’re more than compensated by a few large wins? This is an example of such a scenario at work.
So you can see why the employees do it. And you can see why managers are unable to discern whether they’re good or just lucky. But why would the companies (or, more precisely, the companies’ senior managers and shareholders) support this?
First, it’s worth noting that some financial companies do this. Many don’t. We read stories in the press about the ones that do, and naturally conclude that it applies across the board. In any case, those companies with high-risk investments at their core are run by people who are looking for the big payout. Typically, senior executives at these companies get contracts that pay them handsomely for the big win, but still pay well even if they lose big (there are many reasons for this, but it’s a topic for a future article). With a downside that looks good, and an upside that looks amazing, of course they’ll shoot for the moon. It’s a “heads I win, tails you lose” proposition.
Moreover, while the investments are paying off, the ledgers look great, and the company’s stock reflects this. Shareholders are happy, senior executives are happy, the people directly managing the risky investments are happy…why on earth would anyone change anything?
Are these companies really stupid? Certainly if they want to be around in the long run. But this is a classic example where everyone acting individually in their own best interest causes a great deal of collateral damage. It’s a reason pure laissez-faire isn’t as rosy as its proponents believe.
And it is one (but only one) of the factors that led to the Great Recession.
- JP Morgan Chase CEO: we were sloppy and stupid (telegraph.co.uk)
- Jamie Dimon Blames $2 Billion Loss on Sloppiness, Stupidity (nymag.com)
- A black mark for survivor of financial crisis (onlineathens.com)
- JP Morgan loss renews calls for stricter oversight– VIDEO: Bank reports $2B loss on hedging flop — OPINION: Bust Up the Big Financial Houses (foxnews.com)
- JPMorgan CEO: ‘Dead wrong’ about trading concerns (heraldonline.com)
- Barney Frank: JPMorgan’s ‘Leave Us Alone’ Argument Has Blown Up (huffingtonpost.com)
- After $2 Billion Trading Loss, Will JPMorgan Claw Back Pay? (dealbook.nytimes.com)
- No sign of shareholder revolt against Dimon (wvgazette.com)