Opinion: Greed or Playing By The Rules?

The Massacre of October 2008 was blamed on many people and many events.  I'm going to discuss one aspect: greed.

Banks and their traders, hedge fund managers, corporate executives – but especially CEOs have all been accused of taking too much risk, using too much leverage and being greedy.  And that greed played a large role in the disaster that followed.

I am wondering who's to blame?

Many CEOs are given contracts that pay huge annual bonuses, with or without stock options, for achieving specific goals.  Those goals may include the stock price reaching a predetermined level or the company's earnings reaching a specific number of dollars over a short period of time – typically one year.

Traders who worked for investment banks (we all remember investment banks, don't we) that no longer exist, were well rewarded for making piles of money in any given year. 

There are also banks and brokerage houses with large trading operations, and these businesses hire talented traders.  The norm is for annual bonuses to be so high (when traders are successful) that they dwarf the annual salaries.

Hedge fund managers handle other people's money.  And lots of it.  They are also paid 2% to manage the money.  But the key number to consider is that those managers keep a full 20% of all earnings.

Those are the rules.

The question is: How should the participants in this game play?  What is their best strategy?

Choice One.  Let's call it the high integrity choice:

Try to make good money.  Take reasonable risk.  Manage that risk to be certain that large losses do not occur.  Look out for the best interests of your shareholders, employees, or investors.  At year end, you make a decent return for everyone and are rewarded with a decent, but not fantastic bonus.  Something to be proud of – a job well done.

Choice Two.  This is the "I'm looking out for myself" choice:

Put yourself in the shoes of any of the people described above.  If you make big profits, you are enriched with more than enough money to last a lifetime.  If you fail, you may lose your job or be given another chance next year.  Just look at that reward/risk ratio.

These people were encouraged to gamble, to take big risk, to maximize leverage in an attempt to reap huge rewards.  They were encouraged to gamble with other people's money.  If they lose the gamble, they probably lose their jobs (but have a good chance to land another), and if they lose the gamble big enough, their organization may fail.  that means employees lose their jobs.  It means stockholders lose their investments.  And it means that hedge fund shareholders lose almost 100% of their capital.

Let's call this the "I have no integrity, but who can blame me because I was tempted by the conditions of my contract.  Wealth was available for me, and I went for it" approach.  "Too bad everyone else got hurt,' they say, 'but if they wanted me to invest money more safely, they should not have given me the contract they did.  It's not my fault."

Do you have an opinion?  Was this human nature taking its course with the inevitable results, or was it unethical behavior on all those who should have know better, but still over-leveraged?

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2 Responses to Opinion: Greed or Playing By The Rules?

  1. TR 10/29/2008 at 6:45 PM #

    Mark
    Thanks for a great post. Being a process minded person, I have to say that I beleive the reward structure for the fund managers has a lot to with the behaviour and the ensuing results. We can bame to fund manager for being greedy, but perhaps it was our (the investors’) greed that led to such a reward structure.
    It is easy to label the “aggressive” fund manager as unethical in times like these when all of us are losing money and want to hang somebody. But at the end of the day is it not the same investors (or people to coming up with products to meet our needs) who come up with these structures of paying somebody 20% of the gains. If the average investor doubles his money in a good year by investing in a mutual fund, he could prbably care less that 20% of the gain that was paid out to the manager. But of course when the markets are down, we want to hang the same guy who couldn’t give us the return we wanted.
    Incentives – in any profession – should be designed to drive the right behaviour. If the behaviour is wrong it probably has to do with the wrong incentives. In fact on occasion, the wrong incentives can de-motivate a manager who wants to do the “right” thing.
    These are just some of my thoughts, not so much from the investment world but from my experience in the working world. Would live to hear your comments or those of any others.
    Rgds
    TR

  2. Mark 10/29/2008 at 8:03 PM #

    TR,
    One correction: hedge fund managers get 20% of the profits – not mutual fund managers.
    You and I agree on the main point: The incentives produced unwanted, and perhaps, unexpected behavior. But I don’t think it should have been unexpected.
    Too many people look out for themselves, not caring about others. That’s a huge shame, but when temptation is right in your face, it’s difficult to see beyond it. I believe those who are highly ethical can do it.
    Mark