Moral Markets and Other People's Money

Guido has just got round to reading The Big Short by Michael Lewis, author of the eighties-era defining Liar’s Poker. It is the most readable book on the American sub-prime crisis that was the catalyst for the global sovereign debt crisis we now face. Essentially Lewis has found and written the story of the few who not only foresaw the crisis but bet on it, big bets. Was it moral for traders to bet that sub-prime lending would end in disaster? Via synthetic Collateralised Debt Obligations risk was added to the financial system, purely for speculative purposes. In a free society with a free economy it is good that consenting capitalists are allowed to take risks, the problem was that the PhD-equipped quantitative-modelling geeks who inhabit investment bank trading rooms got the models for analysing risk completely wrong. The ratings agencies bought into the models because their customers demanded it. When it all went wrong governments and central banks stepped in to bailout banks out of fear that the financial system would fail. The banks had allegedly become too big to fail.

Guido was an investment banker, has a lot of friends who are investment bankers, hell Guido even married an investment banker. Since the days of the Long Term Capital debacle at dinner parties Guido has argued that the problem with investment banking was that the geeks had brilliant reasons for losing big money, in that they had complex models that impressed management better than traditional trader’s gut instinct. The second problem was that investment banks were no longer partnerships, they were publicly listed companies, with shareholders who were not involved in day-to-day management. This has proved to be a disastrous form of capitalism, with owners who don’t know what the managers of their money are doing.

Up until Salomon Brothers listed in 1981 the investment banks were partnerships. That meant the firm’s capital was provided and risked by the partners who ran the firm. The oldest and most experienced partners tended to have the most capital in the firm. This had a risk management effect greater than any Nobel Prize winning computer-calculated risk model, the old guy with the grey hair stood to lose everything when some testosterone charged 27 year-old trader bet the firm’s capital. This incentivised senior management to control risk, because they know there are old traders and there are bold traders but there are very few old, bold traders. The bosses’ desire to keep their retirement pots concentrated their minds.

Michael Lewis points out that public listings transferred all the risks from management partners to the firm’s shareholders who had no idea what risks were being taken. Now we have huge financial combines with managements incentivised to bet the shareholders capital big, win and get out with their annual bonus. If they lose, the shareholders lose, or if they lose really big the taxpayer eventually bails them out because they have retail banking High Street subsidiaries which democratic governments are terrified will be dragged under as well. Capitalism with the risk being taken with Other People’s Money has the same fundamental problem associated with socialist governments spending Other People’s Money. Why worry if it isn’t your money?

Downing Street is briefing that the PM will be promoting the idea of “moral markets”. It is of course human nature to act in your self-interest, what has gone wrong is that the incentives have been given to those who manage the capital to take risks which informed owners would never knowingly take. There is nothing moral in asymmetric markets where the risks are borne by others than those taking the risks. If taxpayers in Western democracies are to implicitly insure retail banks – in effect owning the risk – the cost of that insurance should be such that it is prohibitive for retail banks to take exotic trading risks. Proprietary trading is for proprietors. Moral markets require risk and reward to be fairly priced.



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