Tuesday, 8 December 2009

The Two Abbreviations that Explain the Financial Collapse

I was traveling this weekend -- back! -- and last night it occurred to me that if you want to understand why this financial crisis occurred, you can look hard at two often bandied-about abbreviations. Forget about low interest rates, regulatory lapses, securitizations, risky derivatives etc. etc. Those are reasons, but these are meta-reasons. These are the reasons that create the environment for the reasons. These abbreviations are easy to understand, but have deep, wide-ranging implications.

1. OPM ("Other People's Money)
What does it mean to make bets with other people's money? I think the answer is obvious. When I'm betting my house on an outcome, you can be assured that my thinking moves down a different decision tree than when I'm betting your house.

How was Wall Street betting with "Other People's Money"? Largely, this came about because of a shift in ownership models. The old wingtipped investment bankers worked at firms owned by partners. The oft-repeated joke about partners is that they live poor, but die rich. Their wealth is tied up in the worth of the firm. Under this type of model, you can bet that Wall Street CEOs over the past decade would have known exactly what types of risky wagers their traders were making each day. But they didn't.

Because they were using "Other People's Money."

"Other People's Money" is what you get from the new ownership model: becoming a public company. You sell shares to a vast swathe of investors, everyone from Aunt Edna to Fireman Joe's Pension Fund, to raise capital. And so when your company starts trading for itself in credit default swaps or liquidity puts, you as CEO don't risk losing your house if the bets go bad. You risk losing Aunt Edna's house. (Note: even with CEO "incentives" that try to align your pay with performance, you still tend to capture the upside of your company's gains and escape most of the pain of the losses.)

Big difference. And a slew of Wall Street banks went public in the 1980s and 1990s (Goldman was late to the party, making the jump in 1999).

Yves Smith at naked capitalism and the always incisive (and often acerbic) business journalist Michael Lewis have noted repeatedly the significance of changed ownership models, re: this financial crisis. And they're right: This constitutes a huge meta-reason for the meltdown. On top of all this, once you really start to leverage up other people's money, the danger of excessive risk-taking compounds fast.

2. IBG (I'll Be Gone)
If you were to use this in a sentence, it would sound something like: "IBG (I'll Be Gone) by the time that trading strategy blows up." The prevalence of short-term thinking -- trying to make the numbers for quarterly earnings reports to satisfy investors and analysts (that's a consequence of playing with "OPM;" you're always performing for the stockholders), trying to hit yearly targets for that fat bonus -- it all tends to focus the mind on the end of the money-seeking nose, and not much farther out.

"I'll Be Gone" actually represents the convergence of two bad trends: one, this short-term thinking that reflects in part the stunting of our attention spans, and two, the abdication of personal responsibility ("Hey, my trades went south? So they went south ... that's life, seeya.").

So think about it: if you've got a financial industry with a belief system centered around "get mine, get out, and use other people's money to do it" ... well, why are you surprised that a lot of big reckless bets were made and everyone got out with their bags of gold and no one's being prosecuted?