Why It’s Smart to Be Reckless on Wall Street – Scientific American 02-27-13

Salient to Investors:

Ex-trader Chris Arnade writes:

The asymmetry in pay is the engine behind many of Wall Street’s mistakes and rewards short-term gains with disregard to long-term consequences. The result is over-reliance on excessive leverage, banks loaded up with opaque financial products, and flawed trading models.

Wall Street’s pay structure pays absurdly well in the good years and just okay in the bad years, while losing money never means having to give anything back. Traders are paid a base salary around $200,000 and a bonus based on their profit. The average bonus of all employees is $300,000, but payments of $1 to $15 million are common.

If the loss is large enough, the trader is fired – but never has to return any money and now has experience – if allowed to lose $1 billion the trader must be really important. Regulation is toothless when banks and their employees have the financial incentive to be reckless. If banks lose, especially the big ones, we all lose.

Example 1. Two hedge funds take opposite sides of the same large bet. In one year, one makes a huge profit and gets paid well. The other takes the loss and earns nothing. The sum of both profits will be zero, but the sum of compensation will be large.

Example 2. A trader joins a firm with an established track record, starts small, builds up a few years of making decent profits. The trading limit will be increased. Take the most risk the firm will allow you in a year when everyone is bullish, following the momentum. If the herd wins the trader gets paid tens of millions. If the herd loses then the trader may get fired, but everyone else lost so no great sin.

Example 3. Sell insurance on a 1 in 100 event, convince regulators it’s a 1 in 1000 event so you can take the premium as a profit. If the event is actually 1 in 10 then you will lose huge eventually but you will have had 3 to 4 good years and can walk away.

From 2002 until 2008, the 1 in 100 event was US housing prices dropping 30% or more and the insurance was esoteric mortgage bonds. From 2003 to 2007 housing prices rose and Wall Street took in record profits and paid senior traders and managers big bonuses – from $3 million to $10 million in 2006.

The housing market collapsed over 30% in 2007. The mortgage bonds collapsed and many banks required a government bailout. Yet traders and managers kept millions of dollars, many of whom were later hired by hedge funds to buy the securities at cheap prices after the banks dumped them.

Read the full article at http://blogs.scientificamerican.com/guest-blog/2013/02/27/why-its-smart-to-be-reckless-on-wall-street/

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