Why Wall Street Repeats Risk-Related Mistakes

Dennis Berman penned an article in today's Wall Street Journal's Money & Investing section, entitled, "Why Street Bankers Get Away With Repeating Old Mistakes."

Mr. Berman's pieces are typically interesting and well-reasoned. Today's is no exception. He asks the question, in reference to subprime mortgages and CDOs,

"What would happen if Boeing Co. or Johnson & Johnson rolled out products with similar defect rates?"

He quotes a money manager as saying,

"That's the thing about Wall Street that amazes me. They keep making the same mistakes."

Toward the end of his thought-provoking piece, Mr. Berman writes,

"Consider another sector of this upside-down world. Over the last few years, standard bank deposits became less desirable. It was too costly building branches and bidding for deposits, especially when more flexible wholesale funding could be created at a moment's notice via fresh short-term paper. That was the reasoning of Countrywide Financial, and a slew of other players such New Century Financial and Northern Rock PLC of the United Kingdom.

It was great, as long as the paper could be repeatedly rolled over. When it couldn't, the companies would be well out of business. But how could that possibly happen?

As a hedge-fund manager himself, Mr. Bookstaber acknowledges that in the real world of "normal accidents and primal risks, limitless trading possibilities might cause more harm than good."

Financial cycles are natural, we're told. Of course they are. But they also make a wonderful excuse for lots of bad, or downright dumb, behavior. Does it really have to be?"

I actually sent an email to him at the address provided at the article's end, saying, "yes," it does really have to be.

Let me explain. A few weeks ago, while talking with my brother, a creative SVP at a major ad agency, he asked me,

'What happens to traders and investment bankers when they get older? Do they retire?'

And I realized, as I began to explain the industry's career paths, that few people actually understand this key driver of the behavior Mr. Berman has observed.

Most people have little idea of the compensation structures and career paths of Wall Street traders and investment bankers. Or even, for that matter, lower-paid people in other highly-paid service sectors, such as consulting.

For instance, a little less than fifteen years ago, an acquaintance of mine who was a retired Fortune 50 CEO was shocked to learn the pay structure of Andersen Consulting's partners. I worked there at the time, for a very skilled managing partner who wore many hats. Between running a large regional industry practice, the local city office of the same industry, representing the Americas for that industry segment, and selling some engagements, he was earning something north of $400K. This would have been in 1993.

Further, there were easily at least 50 other managing partners at Andersen making as much or more as my direct manager at the time.

My acquaintance was stunned, remarking that in his very large commodity-producing giant, perhaps only three executives were making that much money.

Well, compensation is even more disparate on Wall Street.

For example, most really good traders are off the floor by age 35. They either burn out or move up the ranks to manage larger 'desks,' and collections of trading units. In the process, it's nothing for a good trader to make a few million dollars per year. The same is true for investment bankers involved in mergers and acquisitions, or active underwriting areas. As business volumes ebb and flow, these amounts will, of course, change.

But in general, a young investment bank employee who rises through the trading or M&A ranks can amass compensation worth tens of millions of dollars by his or her mid-thirties. And, as I mentioned in this video post, more young investment bankers are being counseled to remain with their firm, and eschew going to business school for a graduate degree, because it no longer makes economic sense.

So, we have the situation of many mid-thirties bankers in a position to 'retire' anytime they wish, and likely own more assets than most Americans will earn in a lifetime of work.

If a senior executive at, say, to use Mr. Berman's example, Boeing or J&J, do really well, they might retire with a few million dollars. They make planes, or drugs, or medicines, but are paid in dollars.

Traders and investment bankers use, work in, money, and get paid in it, too. And because of the incredible volumes of money that flow through their hands, paying the better players millions per year makes economic sense.

Thus, to get back to the answer to my brother's question, old traders and bankers don't really 'retire.'

First, on the way up, they realize that risk taking pays. As I wrote in this recent post, which I sent to Mr. Berman, by way of answer to his question,

"At diversified financial service firms, managers compete for promotions, compensation and control. In order to win these, they must out-grow their peers.

So they take excessive risks in the mid-cycle of a business, riding high growth and turning it into more explosive, riskier growth.Sometimes, this approach works and the executives involved rise to lead the firm. If not, they still get compensated well, and the firm takes the hit to its balance sheet when the risk catches up with the earnings.

When I was at Chase Manhattan Bank in the early 1990s, the Real Estate division pushed for high, risky growth via construction lending in Manhattan. Eventually, that bubble burst, leaving the bank to take several hundred million dollars in writedowns in 1990. Meanwhile, the executives who made the loans, often found, upon later auditing, to be improperly documented, if documented at all, received large bonuses for making loan origination quotas.

In a large, diversified financial services firm, this drama plays continuously. That is why some element of a diversified financial conglomerate like BofA, Citi, Chase, Merrill, et.al., seems to explode in fantastic losses every few years.

In short, it's risk management that brings down large, diversified financial service firms every time. More than anemic growth, excessive growth in one or two businesses inevitably leads to excessive risks, which are typically hidden from the credit and audit functions, as well as senior management. After all, the executives are playing with the firm's money, so it's a win/win or lose/win proposition for them. Either way, their firm takes any losses.

The days of smallish Wall Street partnerships in which risks were well-understood, acknowledged, and managed, because the partners owned the risk, are long gone now. Instead, diversified financial mega-firms such as Merrill and BofA own many business units, in which managers play a risky game to advance their careers.

Thus, the entire complexion of financial service businesses, markets, and the risks inherent in them, have changed irrevocably, as a function of the sector's current organization. That's why you can expect something like the current Merrill writedowns and firings every few years at one or more diversified financial giants."

Remaining direct descendants of the original private partnerships among investment banks- Goldman and Morgan Stanley- still appear to have superior risk management cultures. Newer entrants into the field- Lehman, Merrill, and the large commercial banks- seem to have problems like I described.

So you have a lot of 30- and 40-something multi-millionaires who can easily leave one large, public financial services firm, and either: start their own fund, or; join a hedge fund, or; join a private equity shop.

Many well-paid, even moderately successful traders and bankers can start their second career in their 40s and make even more money. Or move to a smaller shop and enjoy a somewhat more relaxed schedule, compared to a bigger job, with more pressure, at a large publicly-held investment or commercial bank.

Because the rewards for failure are not that bad, and the rewards up until a possible failure are great, virtually nobody in the publicly-held firms has an incentive not to push the boundaries concerning risk to their firm's capital.

And that, Mr. Berman, I contend, is the answer to your question. The behavior you are observing is neither bad, nor downright dumb, for the people at these firms. Only for the firms and, temporarily, the financial system in which they exist.

Even traders and front-line investment bankers can make enough money over a good five-year run to 'retire' financially secure and ready for their second career, even if they blew their firms up in the process through excessively risky behavior.

Are not traders from Amaranth, the commodities firm the blew up last year due to bad bets on natural gas, are already back in circulation?

The key to all of this is to realize that in the financial services sector, it's fairly typical for ten-year veterans of the money-making functions- trading, underwriting and M&A- to amass sufficient capital to make them indifferent to being fired, resigning to join a smaller firm, or simply to (more prudently) risk their own capital in a similar endeavor. To these people, mistakes that get them fired simply end a lucrative merry-go-round ride a little early. But not usually too early to walk away in shape for their next act.