London
I’M fairly risk-averse by nature and so have always ignored the offers from my bank to help me “manage my money more successfully.” Put the money in a savings account, earn a bit of interest, but mainly work hard, that’s been my philosophy. Like everyone else, though, I’ve been looking into the small print lately to see just how safe my safe-as-houses account really is.
In Britain, the government will guarantee roughly the first $62,000 in a bank account. If you have more than this saved up then an obvious solution is to spread the money around several accounts. Fine in theory, but this rapidly becomes tedious if you want to protect the savings of a lifetime. So finally I succumbed to the calls from my bank manager. As of the middle of last week I have a man who will give me advice day or night, and crucially can help someone as conservative as me to not suffer while all hell breaks loose.
At our first meeting, one of the questions I raised was how to deal with the money I owe the tax man. Could he recommend a safe yet interest-bearing haven where I could keep the money until Her Majesty’s Government asks for it? He proposed an insurance bond that will mature on the date I have to pay my taxes. Insurance bonds have the nice feature that 90 percent of your money is insured, with no cap, and so even in a disaster I would lose “only” 10 percent. This is how my first venture outside my comfort zone ended with me being invested in American International Group.
When I hear about the potential collapse of A.I.G. shortly thereafter, I contacted my manager. “We are in talks with A.I.G.,” he tells me.
“I want out!” I tell him.
Luckily for me, I’m within a cooling-off period in which I can get my money back, losing none of the principal. At least I think I am. I hope. I’ll know more in the next couple of days. Even though A.I.G. has now apparently been rescued by the Federal Reserve and downgraded relatively little — and even though I can theoretically lose only 10 percent, with the rest being insured — I want to play it safe.
That last sentence contains quite a few important concepts that are all worth thinking about. First of all, “the rest being insured ...” Insured by whom, exactly? The main problem with the current crisis is not just that all financial institutions are now intertwined, but rather the new manner of this interlacing through their complex derivatives transactions. In the Long-Term Capital Management hedge fund mess of 1998, the transactions were fairly transparent and with obvious counterparties. The cancer, if I may use that dramatic word, was contained and operable. (The long-term impact for me, as someone who researches and lectures on finance, is that I can tell some great tales about the fall to earth of Nobel laureates who tried to put their theories to work in the real world.)
The current crisis, however, is nowhere near as simple. The cancer has metastasized — it has spread through all the organs of the financial markets and a straightforward excision is probably not possible. That’s what makes the question of whether to rescue each institution such a difficult one. Sure, people have to learn a lesson. But, and this is my final surgical analogy, would that be cutting off one’s nose to spite one’s face?
Back to my money with A.I.G., I ask myself, “Who insures the insurers?” I want out.
I mentioned “downgrading.” Institutions and products are graded by various credit-rating firms so as to supposedly give an objective view of the risks and of the possibilities of default. Can anyone say, while keeping a straight face, that the current system of having the institutions themselves pay for this service is a good idea? The moral hazard is so obvious you can almost taste it.
I spend a great deal of time speaking to people in banks about their mathematical models. I know which are using good models (a very few banks) and which are using bad models (most banks). I know of the dangers present, from a quantitative-finance and risk-management perspective. And for many years I have explained these dangers to anyone who would listen, and I will continue to do so. So it is incredible to think that ratings agencies, which must also have detailed knowledge of the nature and, more important, size of the toxic transactions, will happily give out their multiple A grades without any feeling of shame.
And then the word “theoretically” becomes very important. I have attended many conferences on quantitative finance, at which professors and practitioners describe their latest models for derivative instruments and the like. All the time I’m sitting in the audience thinking that these models are far too simplistic and based on countless unrealistic assumptions. I tell people that these instruments are dangerous, that no one understands the risks. But no one cares.
As long as people are compensated hugely for taking risks with other people’s money, and do not suffer equally on the downside, then those risks will inevitably become outrageous. Whether markets are efficient or not I don’t know for sure, but I do know that if there’s a way for someone to make money at another’s expense, he will. In spades. I want out.
So where next? And, most important, what should be done?
I’ve taken to comparing the current situation to “Hamlet.” We’ve had the deaths of Polonius, Claudius and Laertes — that is, the falling house prices, the rising commodity prices and the collapse of banks. As of now there is no sign of Hamlet himself, a catastrophic fall in the markets. Yet it’s difficult to believe that markets are not going to undergo a climactic implosion some time soon. If the current situation doesn’t fill investors with fear, then what are they smoking?
I believe that to get to the root of the matter, we have to address the bad side of greed. We know from Ivan Boesky and Gordon Gecko that greed can be good. Greed makes the world go around; it makes people take risks that ultimately lead to economic or scientific advances. But the greedy must also face the consequences of taking those risks.
Thus the current system of compensation at financial companies does not lead to anything good at all. If you give $10 million to random people on the street and tell them that they’ll get 20 percent of any profit they make, without any consequences if they lose it, then many of them will go into the nearest casino and bet it all on red. (The really clever ones will find a way to leverage it up first — after all, a $2 million bonus is nothing; you can’t seriously expect people to live in New York or London on less than eight figures, can you?)
Many Lehman Brothers employees received some of their compensation in Lehman shares. They aren’t feeling too happy right now. But a system run on that principle could achieve exactly what is needed: a closer link between a person’s paycheck and the longer-term success of his trading. At the moment, a trader can sell a 10-year toxic contract, pocket a nice bonus after a few months based on some theoretical valuation, and then disappear to another bank or off into the sunset, leaving nine years in which that contract could blow up.
These companies need to tie compensation to long- rather than short-term performance. This won’t be popular on Wall Street, but if we want to turn investment banking back to performing something useful and positive rather than some sort of riverboat-gambling scheme on which we are all unwitting participants, then there’s not much choice.
Meanwhile, I will be in contact with my new best friend, the bank manager, day and night. I will be closely monitoring every twitch of A.I.G.’s share price, balance sheet and credit rating. And I’ll just hope that if all does not end well, Her Majesty’s Government is understanding of this loyal, faithful and increasingly risk-averse subject.
Paul Wilmott is the founder of Wilmott, a journal of quantitative finance.