Have you ever wondered why, every five to ten years or so, there is a major scandal among brokerage firms? 2008 saw Lehman Brothers and Bear Stearns collapse in a heap of their own failed (and, with the benefit of hindsight, incredibly reckless) bets on exotic mortgage-related derivatives. In 2000, we had Merrill Lynch analyst Henry Blodget writing that certain investment opportunities were "garbage" and worse in his internal memos, and writing glowing recommendations to the investors to whom the company's brokers were selling these IPOs and other investments.
Goldman Sachs VP "Fabulous Fab" Tourre boasted that he sold mortgage securities he knew were doomed to his customers. In January 2008, Jerome Kerviel was arrested in Paris after racking up $6 billion in trading losses for his investment bank, while Nick Leeson's big bets in 1995 cost Baring's Bank in London a total of $1.3 billion. Last year, JP Morgan disclosed $2 billion in trading losses, and in 2011, Switzerland-based UBS Corp, which has a significant presence in the U.S. brokerage world, lost $2.3 billion on a single trader's wayward bets.
An article on the Scientific American website explains the Wall Street scandal machine, saying that skewed (it calls them "assymetrical") bonus systems is the root of the problem. The way brokerage firms compensate their traders, it is actually smart to be reckless on Wall Street.
To see how this works, consider a trader who is making daily, sometimes hourly bets on... it could be anything, and often is. At the end of the year, the trader is paid a bonus which is usually a percentage of the trader's profit--many times between 10% and 15%. The trader takes enormous risks. If he guesses right, and makes $10 million, he takes home a $1 million to $1.5 million bonus, on top of the $200,000 base. He does this for three years, and then, suddenly, his guess turns out to be wrong and he costs the company a lot of money.
The result? By taking huge risks, and costing the Wall Street firm far more than he generated in revenues, the trader takes home between $3 million and $4.5 million in bonus income. He may be fired, but the article says that traders who lost big are often hired by other firms. One could not be allowed to lose $1 billion, it says, unless one was really important.
The author cites a trader who bet his bank's money, and received 15% of the profits. In 2005, he bought obscure and high-yielding corporate bonds, which generated profits of $40 million. The trader's share: $6 million. In 2006, he made $80 million and took home $12 million. In 2007, the markets turned, and his trades lost the firm close to $300 million.
The trader was let go, retired comfortably, and the shareholders footed the bill for the enormous losses.
Multiply that by thousands of traders moving money around for a company's own accounts, and you have one of the most efficient scandal machines ever devised.
We call it Wall Street.
Sources:
http://edition.cnn.com/2011/BUSINESS/09/15/unauthorized.trades/index.html
http://dealbook.nytimes.com/2012/05/10/jpmorgan-discloses-significant-losses-in-trading-group/
http://www.huffingtonpost.com/2012/11/20/kweku-adoboli-ubs-rogue-trader-convicted_n_2163897.html
http://blogs.scientificamerican.com/guest-blog/2013/02/27/why-its-smart-to-be-reckless-on-wall-street/?WT.mc_id=SA_sharetool_Twitter
Sincerely,
William T. Morrissey and Tammy Prouty
Sound Financial Planning Inc.
wtmorrissey@soundfinancialplanning.net
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