You only get these bonuses in one way: by being seen to make money for your employer. And you make money for your employer by taking an item worth $100 and selling it to someone for $101. If you sell it for what it’s worth, you’ll never make enough money to convince your employer that you’re worth retaining. Fortunately, the bias in the market makes it relatively easy to make such sales. Buyers don’t find it easy to check whether the thing you’re selling them is worth $100 or $101. Plus you’re probably smarter than they are, and better resourced, and more motivated, and harder-working. Plus you have a huge expense account, which means you can make your pitch over a fancy meal or an upmarket sports event.
You’re also helped by accounting rules which hide reality—in the form of genuine information about prices—from buyers. When market prices do emerge to suggest that their new $101 acquisition is worth only $100, the sell-side guy will be on hand to say that these prices are bullshit, that any softness in prices is only temporary, that the buyer was a smart guy all along.
In a way, none of this is surprising. Anyone selling any kind of product has an incentive to sell as many of it as possible, no matter whether they’re suitable for the customer or not, and at as high a price as possible, no matter whether that price is fair value or not. What makes the bond and derivatives markets different is that those sell-side incentives are huge, the salesmen superb, and true price discovery difficult—and current accounting standards keep price reality hidden from view long after the sale has been concluded. Those lopsided conditions themselves would likely cause problems no matter how appropriate the incentives elsewhere in the system—but unfortunately those other incentives are just as skewed as well.
The buy-side
On the buy-side, investment managers are typically compensated with an annual fee skimmed off the value of assets under management. For hedge funds, that might be set at 2% of asset value. For funds that are less actively managed, it might be 1% or even less. And it all looks logical. Fund managers go into their offices each and every day, and work hard to create value. The annual management fee is intended to compensate them for their ordinary, regular, day-to-day effort and for the expenses they incur along the way.
Yet the arrangement can also create its own perverse incentives. There are, for example, plenty of highly successful fund managers who owe their success to their sales ability. The more funds a group has under management, the more money it makes—and the bigger the fund manager’s fee. Obviously it would be nice if those funds were well invested, beat benchmarks, and made money—but they still pay nicely even if they don’t. There are managers who are wonderful at putting together the glossy brochures, at offering suites of fine-sounding services, at glad-handing investors and collecting money … but who have a poor track record at actually managing the funds they deploy.
What’s more, the more money you collect, the more the pressure is on you to get it invested. That pressure can lead to ill-judged investment decisions. I recall one promoter who pitched a construction project to me. The idea was to build some high-spec apartment blocks in Europe. Each unit was projected to sell for close to €200,000. The rate of return was estimated to be in excess of 25%. What’s more, the project had everything you’d expect: architect’s drawings, planning consents, detailed spreadsheets, careful costings—it was a very professionally designed package. Very investable, in the jargon.
Now, I’m an investment manager. If I’d chosen to plough my investors’ funds into that project, I’d have been able to get invested quickly, predict strong returns, seek more capital for more investments. As a result, I’d have made money—those annual management fees would have seen to that. Unfortunately, this project had a serious flaw. Although €200,000 sounds like a fair price for a luxury apartment, the project was located in a country in eastern Europe where the average wage was, at the time, just €9,000 a year—and that at a time when the economy was faltering, credit was deteriorating, and there were serious concerns over the value of real estate. The projected selling price was effectively an imaginary number, a fiction. The apartments would never sell for that price and those tempting 25% returns would never be achieved. I suspect the promoter knew as much when he put the package together—and he didn’t care, because he knew he’d find investors to back it anyway. (You won’t be surprised to learn that I wasn’t one of them.)
There’s another pressure on fund managers—especially the poor or mediocre ones. Let’s take the example of a traditional fund manager whose task is to invest in the US stock market. Most likely, his performance will be compared with the S&P 500, a benchmark reflecting the stock market performance of the country’s 500 largest corporations. One obvious strategy for that investment manager is simply to buy a little piece of every stock in the S&P 500, thereby perfectly matching the index. It’s tempting to think that if a fund manager does that and nothing else, he can’t fail to match the benchmark—since, after all, he’s effectively buying that benchmark.
Unfortunately, that logic is dead wrong. Because of his fees and expenses, a manager who adopts that strategy will always fall short of the index performance. That shortfall might only be a percentage point or two, but the shortfall compounds over time. Invest $100 at 5% for twenty years and it will return $265. The same amount invested at 6% over the same period will be worth $320. A 7% investment return will yield $387. Differences of this magnitude simply can’t and shouldn’t be ignored. A capable investment manager should have strategies for dealing with this challenge. If you know what you’re doing, you should be able to trade options around your equity positions, thereby earning back your fees and expenses, and perhaps even a little more.
But not everyone has the ability to do that. The investment management world has plenty of sophisticated managers, but also far too many mediocre ones. Those mediocre ones are always struggling to catch up with their benchmarks—and consequently also tempted to ‘chase yield’ wherever it can be found. There are a million ways to chase yield, many of which can be extraordinarily destructive. For example: you borrow some money (at a low interest rate) in yen, and invest the cash (at a high interest rate) in Aussie dollars. Or you switch out of (low-yielding) US Treasuries and buy into (higher yielding) AAA-rated mortgage market securities founded in part on subprime debt. Or you get out of (low-yielding) German bonds in order to enjoy the higher rates available on Greek, Italian, or Portuguese ones. Or you decide to insure some AAA-rated securities—maybe even those CDOs—and collect some insurance premiums along the way.
There are countless other recipes that have been fashionable at one time or another, and they all work. That is, in a typical year, these investment strategies will add modestly, but significantly, to profits. They can transform an ordinary (sub-benchmark) manager into one who equals or modestly exceeds the benchmark. You can see why they catch on.4
They all work; and they’re all lethal. They’re shockingly dangerous. There are no free lunches in the financial markets. These strategies may show a modest profit in most years—but in others they will bring huge losses. Collectively they have been nicknamed a way of ‘picking up nickels in front of steamrollers.’ For a little while, you get to fill your pocket with nickels. But one day you’ll get unlucky and that bad luck will destroy you. It was a steamroller which blatted AIG out of existence. It was a steamroller that wrought vast damage to institutional balance sheets in 2008–9. It’s a steamroller that’s back right now, crushing bank balance sheets across Europe.
No organization’s investment fund, no individual, should ever want their investment manager to be fooling around anywhere close to steamrollers—but the remorseless logic of the industry inevitably creates an eternal search for easy nickels. So wherever there’s a trail of nickels glinting in the sunshine, there’s a rush of investors scrabbling to pick them up—and a steamroller grinding away in the nearby shadows.
Incentive fees
In addition to those regular annual management fees, investment managers are sometimes also incentivized with performance fees. When well designed, those performance fees can do a lot to align the fund manager’s incentives with those of his clients. They can encourage thoughtful, active, value-creating investment strategies. And on average, the performance of the hedge fund industry over time has been creditable. Up until 2008, hedge funds exhibited less volatility than the broader market. They made money in good times, and either made money or preserved it when markets were falling. In 2008 some of that gloss was removed when the industry lost money in calamitous markets—but it still lost less than the market overall.5 (And of course, some fund managers saw the collapse coming and made money out of it. I was one of them.)
The overall, average result, however, conceals the danger lurking at the fringes. Poorly designed performance fees, or even well-designed fee structures applied by idiots, can cause immense harm by encouraging high-risk, high-reward strategies which may be directly contrary to investors’ interests. The poster-child for irresponsible risk-taking was Long-Term Capital Management, which failed in 1998 under a senior management too impressed by its own academic excellence. Unfortunately, the real world is no respecter of academic reputations. The firm took on too much debt and bet the proceeds with too little thought for what might happen if things didn’t turn out as expected. When the Asian financial crisis was followed by a Russian one, LTCM found that its ‘safe’ bets had turned sour on a colossal scale. Given the scale of leverage at the firm—its capital represented just 3% of assets—there was no return from that misjudgment. A bailout, organized by the New York Fed, saw the firm’s creditors take control. The $1.9 billion which the firm’s principals had invested in it was wiped out.6
The story contains another moral. The Fed organized a bailout of the fund because it was deemed too big to fail, because it was seen as being of systemic importance. That was a crazy decision. Lenders who make bad credit decisions should lose money. That’s the only mechanism which will force them to improve their decisionmaking. The Fed chose to send precisely the opposite message: lenders who lend money to large, well-connected Wall Street firms will never lose money, because the government will protect them. It’s no coincidence that the bailout of LTCM inaugurated a decade in which credit standards sank to all-time lows. More remarkable still, the authorities haven’t even now understood their error. The bankruptcy of Lehman Brothers was a one-off. Everyone else got bailed out. Bear Stearns, AIG, General Motors, Citigroup, Goldman Sachs, Morgan Stanley—virtually everyone on Wall Street and plenty of firms in the world beyond. As long as creditors believe they’re going to be bailed out in the event of disaster, their incentives are crazily upside down. Make money—and you win. Lose money—and the government pays. That era is coming to an end as governments run out of money, out of borrowing capacity, out of financial and moral creditworthiness. It can’t end too soon.
Ratings agencies
In the chaos of the bond markets, you’d hope that it would at least be possible to rely on the calm good sense of the ratings agencies. After all, they’re independent, they’re among the few players who don’t have a dog in the fight. Naturally, they won’t get every judgment correct, because no human on earth ever will, but at least they try.
And that is, to an extent, true. Ratings agencies do OK. Perhaps, given the circumstances, they do very well. On the other hand, there are at least two major reasons for doubting the credibility of any ratings agency on any issue. For one thing, the agencies are paid by the people issuing the security, not the people benefitting from the credit analysis. That’s precisely the wrong way round. For example, if you’re out to buy a used car and you are not yourself expert in judging the mechanical condition of the car you’re about to purchase, you might well want to make use of an independent auto expert. But if so, wouldn’t you want to be the one paying the expert? If the expert is being paid by the used-car salesman—which is how it works in the securities market—do you really think you’re going to be told the full truth about the vehicle?7
These are not theoretical concerns. William Harrington, a former senior vice president at Moody’s, exposed the dangerous reality of the conflict of interest in a filing presented to the SEC. In the words of the British Guardian newspaper:
Harrington claims that Moody’s uses a long-standing culture of ‘intimidation and harassment’ to persuade its analysts to ensure ratings match those wanted by the company’s clients. He says Moody’s compliance department ‘actively harasses analysts viewed as “troublesome”’ and said management ‘rewarded lenient voting’.
‘The goal of management is to mold analysts into pliable corporate citizens who cast their committee votes in line with the unchanging corporate credo of maximizing earnings of the largely captive franchise,’ he said.8
That is, if true, terrifying.
Secondly, the guys at the ratings agencies are paid way less than their counterparts on Wall Street, have far fewer resources available to them, and do not participate directly in the markets themselves. Conversely, when some bunch of super-smart, super-well-paid, and massively bonus-driven Wall Streeters come to issue a security, their task is to play the system in order to achieve the highest possible rating. The contest is wholly, and structurally, unequal. You could change the top management of any ratings agency or shake up their recruitment and training policies and you’d still have the exact same mismatch, the exact same problem.
I have direct experience of these issues myself. I’m a recognized international expert on the energy and carbon markets. It’s that expertise which, over the past few years, I’ve successfully put to work on behalf of my investors. At one point, I received a call from a ratings agency asking if they could pick my brains on the way these markets worked. I was happy enough to say yes, and before too long I had three guys from the agency sitting in my office. But what the heck was I to say to them? I had three options. The first was to stick with generalities, to offer a few helpful pointers, a little friendly advice, but to stay clear of anything genuinely useful. Option two was to tell the full truth, as I saw it. Telling the truth would have involved explaining how my firm evaluated credit and other risks, and to set out our detailed pricing model. The third option was the sneaky one. I could tell my visitors what I wanted them to believe. If I could give them a misleading picture of risks and pricing, they would influence the market in a way that would create some fabulous buying opportunities for me.
The last of those options is unquestionably the one that would have made me the most money. Unfortunately, my ethics prevent me from telling outright lies in the pursuit of profit, so option three was not available. Option two might look attractive, except that my edge in the market arises from my slowly acquired authority and expertise. To give that knowledge away for free would be doing myself no favors and would have been directly contrary to the interests of my investors, whom I am paid to look after. So I handed out the coffee, offered a few banalities, and explained why I was not in a position to say anything useful. That was a useless outcome for the agency and a pointless one for me, but at least I wasn’t lying and they went away no worse informed than they arrived. I’m certain, however, that most investment banks would have seen such a meeting as a wonderful opportunity to rig the system in their favor—and indeed, you’d have good grounds for arguing that in so doing those banks would simply have been working hard on behalf of their shareholders.
Finally, the ratings agencies are placed in an impossible situation by the regulators. Because the ratings given to certain securities can affect how those securities are treated by regulators and central banks, a change in an agency’s opinion about a particular bond can cause dramatic sell-offs as investors rush for the exit. Naturally, it was never the regulators’ intention to cause such herdlike shifts of behavior, yet that’s often precisely what happens.9
Y
ou see this effect time and time again in the crisis in the euro bond markets. Take, for example, the genuinely bizarre discussion of when precisely Greek government bonds would be ineligible for use as collateral at the European Central Bank.10 Because a number of European banks were seeing their liquidity and solvency come under pressure, the ECB wanted to make it as easy as possible for them to get access to cheap funds. It therefore offered a facility whereby banks would post collateral—typically, eurozone sovereign bonds—and it would lend money in exchange.
As you’d expect, I have a fundamental disagreement with the Ponzi-ish logic at work here. If a bank is experiencing financial distress because it’s mismanaged its business, either it should be left to go bust or it should find a way to repair its finances by raising capital and starting again. That’s what would happen in any other industry, and that’s what has to happen if mismanagement is not to be rewarded and encouraged. But let’s put those heretical thoughts to one side, and agree that the best way to help a weak bank is to extend easy credit on the back of unsound collateral. The ECB, however, could bend its rules only so far. It was able to accept collateral of doubtful worth and minimal saleability, but it was not permitted to accept securities that were actually in default … and it was left to the ratings agencies to state whether a given security was in default or not. All of a sudden, the fate of financial markets hung on whether or not an independent agency would or would not declare default. Even though the entire world knew that Greece was effectively in default, what came to matter was what the three major agencies would say on the subject. They were subject to strong—and wholly inappropriate—political pressure. Markets which were already febrile were ready to charge off a cliff if the ratings agencies declared default.
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