Fault Lines: How Hidden Fractures Still Threaten the World Economy

by Raghuram G. Rajan

  Why should a manager care about generating alpha? If she wants to attract substantial new inflows of money, which is the key to being paid large amounts, she has to give the appearance of superior performance. The most direct way is to fudge returns. In recent times, some fund managers, like Bernard Madoff, simply made up their numbers, while others who held complex, rarely traded securities attributed excessively high prices to them based on models that had only a nodding acquaintance with reality. But it is easy to track and audit the returns most financial managers generate, so fudging is usually not an option, even for those with consciences untroubled by committing fraud. What, then is a financial manager to do if she is an ordinary mortal—neither an extraordinary investor nor a great financial entrepreneur—and has no bright ideas on new securities or schemes to sell?

  The answer for many is to take on tail risk. An example should make the point clear. Suppose a financial manager decides to write earthquake insurance policies but does not tell her investors. As she writes policies and collects premiums, she will increase her firm’s earnings. Moreover, because earthquakes occur rarely, no claims will be made for a long while. If the manager does not set aside reserves for the eventual payouts that will be needed (for earthquakes, though rare, eventually do occur), she will be feted as the new Warren Buffett: all the premiums she collects will be seen as pure returns, given that there is no apparent risk. The money can all be paid out as bonuses or dividends.

  Of course, one day the earthquake will occur, and she will have to pay insurance claims. Because she has set aside no reserves, she will likely default on the claims, and her strategy will be revealed for the sham it is. But before that, she will have enjoyed the adulation of the investing masses and may have salted away enough in bonuses to retire comfortably to a beach house in the Bahamas. With luck, if the earthquake occurs in the midst of a larger cataclysm, she can attribute her disastrous performance to a one-in-ten-thousand-year event and be back in another job soon. Failing in a herd rarely has adverse consequences.

  More generally, at times when financing is plentiful, so that there is immense competition among bankers and fund managers, the need to create alpha pushes many of them inexorably toward taking on tail risk. For tail risk occurs so rarely that it can be well hidden for a long time: a manager may not even be aware he is taking it. But the returns are high, because people are willing to pay a lot to avoid being hit by cataclysmic losses in bad times. So if the manager produces the returns but his investors do not (at least for a while) account for the additional risk the manager is taking with their money, the manager will look like a genius and be rewarded handsomely. He may well come to believe that he is one. In other words, it is the very willingness of the modern financial market to offer powerful rewards for the rare producer of alpha that also generates strong incentives to deceive investors.

  Because these incentives are present throughout the financial firm, there is little reason to expect that top management will curb the practice. Indeed, the checks and balances at each level of the corporate hierarchy broke down. What is particularly pernicious about tail risk is that when taken in large doses, it generates an incentive to take yet more of it. A seemingly irrational frenzy may be a product of all-too-rational calculations by financial firms.

  Risk Taking on the Front Lines

  A well-managed financial firm takes calculated and limited risks, risks that will make money for the firm if they pay off but will not destroy the firm if they do not. Firms like AIG, Bear Stearns, Citigroup, and Lehman Brothers took risks that were virtually unbounded, albeit low in probability. The most obvious factor driving this behavior seems to be the compensation system, which typically paid hefty bonuses when employees made profits but did not penalize them significantly when they incurred losses. The profitable one-sided bet this offered employees was known variously as the Acapulco Play, IBG (I’ll be gone if it doesn’t work), and, in Chicago, the O’Hare Option (buy a ticket departing from O’Hare International Airport: if the strategy fails, use it; if the strategy succeeds, tear up the ticket and return to the office). That such strategies were common enough in the industry as to have names suggests that not all traders were oblivious to the risks they were taking.

  The Swiss banking giant UBS ran into trouble because its investment banking unit became entranced by the profit it was making from borrowing at the AA-rated bank’s low cost of funding and investing the funds in higher-return, high-rated asset-backed securities.4 The regulatory requirements for bank capital to be set aside to back such a strategy were minimal because the underlying investments were highly rated. The resulting interest spread was small, but multiplied by the $50 billion the unit invested in the strategy, it made a tidy profit for the bank while the going was good and resulted in large bonuses for the unit. Needless to say, this practice of picking up pennies in front of a steamroller was successful only until the subprime catastrophe rolled all over UBS’s profits.

  Some smart traders in a number of banks understood and grew increasingly concerned by the risks that were being taken by the units creating and holding asset-backed securities. At Lehman, for example, fixed-income traders started selling these securities short, even while the real estate and mortgage unit loaded up on them.5 Clearly, any unit that is focused on creating and holding a certain kind of asset is naturally reluctant to declare an end to the boom it has ridden. The unit’s size, power, and reputation become too closely related to the asset class, and its head becomes an interested booster. For Lehman’s mortgage unit to declare an end to the mortgage boom would have been to sign its own death warrant. But knowing that those close to the action may become unreliable in assessing the associated risks, a firm’s risk managers should step in to curtail further investment. In many firms they did not, and it is important to understand why.

  Risk managers should adjust every unit’s returns down for the risk it takes, reducing perverse incentives to take risk. The kinds of risks that were taken in the recent crisis—default or credit risk and liquidity risk—were not difficult for a trained risk manager to recognize, so long as she could see the unit’s books. For risk managers to become concerned, however, and for top management to share their worry can be two very different things.

  In many of the aggressive firms that got into trouble, risk management was used primarily for regulatory compliance rather than as an instrument of management control. At Citigroup, for example, risk managers sometimes reported to operational heads who were responsible for revenue, putting the fox in charge of the chicken coop.6 Reflecting the typical firm’s view of their importance, risk-management positions were paid significantly less than positions in operational units, thereby ensuring that they attracted less talented people who commanded less respect: not surprisingly, studies show that firms where risk managers were not independent of the operational units and were underpaid relative to other managers performed poorly in the crisis.7 Their weakness was compounded as the boom continued. When a CEO adjudicated a dispute between his star trader, who had produced $50 million in profits every quarter for the past ten quarters, and his risk manager, who had opposed the trader’s risk taking all along, the natural impulse would be to side with the trader. The risk manager was often portrayed as the old has-been who did not understand the new paradigm—and the risk takers had the track record to prove it.

  I remember a meeting between risk managers of major banks and academics in the spring of 2007 at which we academics were surprised that the managers were not more worried about the risks stemming from the plunging housing market. After our questions elicited few satisfactory replies, one astute veteran risk manager took me aside during a break and said: “You must understand, anyone who was worried was fired long ago and is not in this room.” Top management had removed all those who could have restrained the risk taking precisely at the point of maximum danger. But if that were the case, then the blame for encouraging the bet-the-firm tail risk taking that was going on must lie with top ma
nagement.

  Risk Taking at the Top

  What was management thinking? An obvious answer is that they, like their traders, were taking one-way bets. However, an intriguing study suggests that bank CEOs in some of the worst-hit banks did not lack for incentives to manage their banks well.8 Richard Fuld at Lehman owned about $1 billion worth of Lehman stock at the end of fiscal year 2006, and James Cayne of Bear Stearns owned $953 million. These CEOs lost tremendous amounts when their firms were brought down by what were effectively modern-day bank runs. Indeed, the study shows that banks in which CEOs owned the most stock typically performed the worst during the crisis. These CEOs had substantial amounts to lose if their bets did not play out well (no matter how rich they otherwise were). Unlike those of some of their traders, their bets were not one-way.

  One explanation is the CEOs were out of touch. An unflattering portrayal of Fuld has him holed up in his office on the 31st floor of Lehman’s headquarters with little knowledge of what was going on in the rest of the building.9 Indeed, in a tongue-in-cheek op-ed piece in the New York Times, Calvin Trillin argued that Wall Street’s problem was that it had undergone a revolutionary change in the quality of personnel over generations.10 In Trillin’s time in college, only those in the bottom third of their university class used to go on to Wall Street careers, which were boring and only moderately remunerative. But even while the dullards ascended to the top positions at the banks, Wall Street became a more exciting and challenging place, paying people beyond their wildest dreams. It started attracting and recruiting the smartest students in class, people who thought they could price CDO squared and CDO cubed (particularly egregious forms of securitization involving collateralized debt obligations) and manage their risks. As Trillin writes: “When the smart guys started this business of securitizing things that didn’t even exist in the first place, who was running the firms they worked for? Our guys! The lower third of the class! Guys who didn’t have the foggiest notion of what a credit default swap was. All our guys knew was that they were getting disgustingly rich, and they had gotten to like that.”11

  The suggestion that bosses, recruited in a staid and regulated era, were of lower caliber than the employees they had recruited from the top of the class in a deregulated and high-paying era is not completely without foundation. An intriguing study of the U.S. financial sector indicates that the earnings of corporate employees in the financial sector relative to employees in other sectors started climbing around 1980, as the sector was deregulated.12 Moreover, jobs became more complex in the financial sector, requiring significantly more mathematical aptitude. Indeed, although there is little divergence between the wages of financiers and engineers at the college level, there is significant divergence among postgraduates (with postgraduate financiers increasingly earning more than postgraduate engineers). MBAs and PhDs began to fill the ranks of analysts and managers in financial firms. Therefore, not only was the financial sector demanding more highly educated people, but it was also paying them more and therefore probably attracting better talent than it had in the past—consistent with my observations that many of the smarter students in my MBA classes gravitated to finance. Clearly, deregulation and the subsequent surge in competition and innovation increased the demand for, and hence returns on, skills in the financial sector.

  Although it is tempting to conclude that some of the CEOs were both untalented and clueless relative to their subordinates, the corporate hierarchy is inherently a tough climb and weeds out a lot of incompetents, especially in the unforgiving and fiercely competitive financial sector. It is hard to imagine that the majority of top management in the early 2000s, most of whom had probably joined in the already exciting 1980s and survived a number of ups and downs, were not highly capable and intelligent individuals. Sheer incompetence among the top management does not explain the crisis.

  A better explanation is that CEOs were vying among themselves for prestige by making more profits in the short term or by heading league tables for underwriting or lending, regardless of the longer-term risk involved. I wrote a paper describing such incentives following bank troubles in the early 1990s, and I think the phenomenon is more widespread.13 Stan O’Neal, the CEO of Merrill Lynch, pushed his firm into the seemingly highly profitable asset-backed securities business in an attempt to keep up with rivals like Goldman Sachs. He monitored Goldman’s quarterly numbers closely and often questioned colleagues on the companies’ relative performance.14 Merrill’s lack of experience in the area eventually resulted in enormous losses and a shotgun marriage with Bank of America.

  The pressures on the CEO may have come not just from shareholders or personal egos but also from aggressive subordinates. Citigroup CEO Chuck Prince’s comment in July 2007, only a month before markets started freezing up, has become emblematic of CEOs’ role in the current crisis. Replying to a journalist who asked why his bank continued to make loans on easy terms to fund takeovers, he said: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”15

  This comment was commonly interpreted as reflecting the cavalier attitude of bankers toward risk and the mad chase for immediate profits. Months later, I met Prince at a conference where we were on a panel together, and I asked him what he had meant. He explained that even though he knew there were risks, as the first sentence of the quote suggests, he simply could not shut down lending, which was critical to securing investment banking deals: the moment he did so, he would have lost many key employees to other rivals who were still “dancing.” So the decision to continue lending was not so much an attempt to make short-run profits as an attempt to preserve Citigroup’s franchise in investment banking and its capabilities for the future. Of course, in making the kind of loans they did, his employees jeopardized not only their unit’s franchise but the entire bank. Hindsight suggests that Prince and Citigroup would have been better off if they had sat out a few dances.

  A few CEOs appear to have stood up to their employees. The CEO of JP Morgan, Jamie Dimon, played a key role in preventing his bank from taking a bigger position in highly rated mortgage-backed securities, and in unwinding its existing positions, beginning in 2006.16 As he often emphasized to his staff, “We have got to have a fortress balance sheet! … No one has the right to not assume that the business cycle will turn! Every five years or so, you have got to assume that something bad will happen.”17 He also beefed up pay for risk managers, so that these positions attracted knowledgeable traders. He tried to ensure that they had clout. And although he had a much deeper understanding of derivatives than many of his fellow CEOs, he also had a rule: if he did not understand how a business made money, he would not participate in it. Not taking risks one doesn’t understand is often the best form of risk management. Firms with less confident or respected CEOs simply followed the herd over the cliff, pushed by the ambitions of their employees.

  But before we attribute too much or too little foresight to CEOs, let us consider the findings of another sobering recent study, which looks at total top-management pay across financial institutions before the crisis and its relationship with subsequent performance.18 The study finds that some firms tended to pay their top management a lot more aggressively in the period 1998–2000, correcting for obvious factors like the size of the bank (big banks pay more because they tend to attract, and need, better talent). Aggressive payers included the usual suspects like Bear Stearns, Lehman, Citigroup, and AIG, whereas more conservative paymasters included firms like JP Morgan. The study finds that those who paid the most aggressively before the crisis were also those who had the worst stock-return performance during the period 2001–2008, the highest stock-return volatility, the highest exposure to subprime mortgages, and, by some counts, the highest leverage. Aggressive pay practices seem to have gone together with aggressive risk taking and subsequent poor performance during the crisis, much as my earlier discussion suggests.


  Interestingly, though, the researchers repeated the exercise over a different time frame, looking at how those who compensated aggressively during the 1992–94 period fared between 1995 and 2000. Over this period, the same firms were aggressive payers, but they did phenomenally better than the conservative payers. Their stock returns were much higher, though measures of risk, such as stock-return volatility, were also high. The authors conclude that performance did not depend on the astuteness or incompetence of particular CEOs: rather, some banks had a culture of risk taking and of compensating very heavily over the short term, which attracted like-minded traders, investors (aggressive banks had more short-term institutional investors holding their shares), and even CEOs. When these banks did well during boom times, their CEOs were lionized as heroes; but when they did extremely poorly during the credit crisis, their (usually former) CEOs became villains. The CEOs were probably neither. They were just loading up on risk, including tail risk; but this time it just did not pay off.

  Past experience may even have led CEOs to overestimate their ability to deal with tail risk. A passage from a New York magazine article about Lehman is revealing:

  By the end of 2006, some at Lehman had begun to think that real estate was nearing the end of its run. Mike Gelband, who was responsible for commercial and residential real estate, had by then turned decidedly bearish. “The world is changing,” Gelband told [Richard] Fuld during his 2006 bonus review, according to a person familiar with Gelband’s thinking. “We have to rethink our business model.”