Thursday, February 26, 2009

Fooled by Arrogance

Where are all the good men dead
In the heart, or in the head?

— Grosse Pointe Blank

Nassim Nicholas Taleb is at it again.

Apparently he was not content simply to inflate an interesting and thought-provoking little metaphor for our habitual blindness to randomness into a globe-straddling causal mechanism explaining the entire social, cultural, and economic history of the human race, as well as all the most interesting bits of our personal lives.1 No, our one-man Black Swan licensing machine and talk show bête noir has now turned to pontificating on public policy.

The results, I am sad to say, are less than illuminating.

Were I more confident of Mr. Taleb's capacity for self-criticism and self-awareness than his writings and public appearances have led me to be, I might point him to the credo he so proudly displays on his own website and homepage [emphasis his]:

"My major hobby is teasing people who take themselves & the quality of their knowledge too seriously & those who don’t have the courage to sometimes say: I don’t know...." (You may not be able to change the world but can at least get some entertainment & make a living out of the epistemic arrogance of the human race).

Based on this avowal, it does not strike me as too cheeky to suggest he make a little fun of himself.

I will not hold my breath.

* * *

Mr. Taleb spends the bulk of his time on the soapbox stomping rather loudly and self-importantly over the well trodden ground of what he calls the trader's "free option," the allegedly mismatched and corrupting compensation scheme which Yves Smith calls the "heads I win, tails you lose" syndrome. As certain members of the sniping class have observed, this is somewhat akin to announcing that the sky is blue, or, perhaps more aptly, that Adolf Hitler was a very naughty man. Few people nowadays will be a) surprised or b) tempted to disagree with you.

I have written on this topic before, as well, and usually not sympathetically. Nevertheless, while I am not now nor have ever been a trader, and while the bulk of my career as an investment banker has generally been spent at various kinds of loggerheads with traders—either because they have not given me what I want, or have seized political power from me and my kind at my employer, or have torpedoed my annual bonus with yet another one of their boneheaded trading mistakes—I would like to take this opportunity to mount a little defense of traders and their compensation system. In all fairness, I believe that a little clarification and correction of certain misconceptions furthered by Mr. Taleb and his fellow travelers is called for at this juncture.

First of all, for those of you who have stumbled onto this site from Perez Hilton and who have no conception what a "trader's option" is, I offer the following brief explanation. Traders at commercial and investment banks (and elsewhere) trade stuff for a living. They buy, they sell, they cross-breed CDOs with Persian longhaired cats—whatever. At the end of the year, their boss totes up the profit and loss in their trading book to see how much money they have made (or lost) for the bank. If they made a lot of money—let's say $250 million—they will usually get a big bonus—let's call it $10 million, just for laughs. If they lost a lot of money—for symmetry, let's also call it $250 million—they usually get a $0 bonus and a swift kick in the pants out the door toward the unemployment line.

This is why people call it an option: the trader gets an asymmetric payout depending on his results: $10 million if he wins, and bupkus if he screws up. His bank, on the other hand, unfortunately has a roughly symmetric payout: a $240 million gain before expenses and taxes if the trader wins, and a $250 million loss if he fucks up. Replace the term "bank" in the preceding description with "investor," and you have a general description of the dynamics of a trading operation. Traders, in their purest form, are simply employees, or agents, of their investors, who are the people who have the money to invest.

Now, a careful reader of the preceding will see that the provocative and tendentious characterization of this incentive scheme currently in vogue—"heads I (the trader) win, tails you (the investor) lose"—is not completely accurate. To be fair, one should characterize it as "heads both of us win, and tails you lose but I don't." The mismatch of returns is still there, and the trader still has every incentive to swing for the fences rather than play it safe, but it becomes more apparent why investors and banks have been willing to enter into this kind of bargain with traders from time immemorial.

It also should be clearer why a good trader—one who consistently makes money and avoids or minimizes losses—is worth his or her weight (and then some) in gold.2 (At $1,000 per troy ounce, a consistently successful trader who weighs 185 pounds should clear the market for around $2,697,8553, by my calculations.) Adjusting for risk, good traders such as these are cheap. Every investor or bank with money to put to work should hire one.

* * *

Of course, "adjusting for risk" is not a trivial thing. A trader who makes $250 million a year trading a risk-neutral, matched book of stocks or bonds really is worth far more than his weight in gold, whereas a trader who made $250 million a year trading risky, long-tailed mortgage-backed securities should have been handled more like radioactive plutonium, at least in retrospect. It is also a measure of how efficient securities trading markets have become—thanks to the free-market, private enterprise magic of all those would-be $10 million a year traders competing for bonuses—that the former are practically extinct nowadays. This same efficiency is also why so many banks and investors looking for $250 million a year in profits per trader began gravitating toward riskier, more complicated markets which presumably compensated for their greater risk. It turns out, sadly, that many of them did not.

Now, given the differing motivations and incentives of pure traders and pure investors, there are really only two proven ways for the investor to control his trader's assumption of risk. The first is close supervision, monitoring, and control: the investor limits what securities and positions the trader can assume, he monitors daily trading activity and marks positions to market daily, and he intervenes when things go off the rails. This is the simplest model, and it is the one that used to obtain back in the dark ages before investment banks became large, externally funded, global trading houses. Yves Smith points out that this is the model the old Goldman Sachs partnership used to use, before it went public. There really is nothing better to keep some young Turk under control than some grizzled, grouchy old bastard seated next door who used to trade the very same markets you do and whose personal partnership stake you are trading for a living.

This model, as we have seen over the past 18 months, begins to break down when the span of control gets too broad and the chain of supervision becomes too attenuated, like it did in today's huge global banks. Complicated Value at Risk models and professional risk managers are no match for crafty and devious traders, particularly when the money they are trading belongs to some absent, passive institutional investors whom no-one gives a damn about. Markets are too fast today, and securities are too recondite, to make supervision at a distance very successful.

The second way for investors to control their traders' assumption of risk is to make them investors, too. Make a trader eat his own cooking, so to speak, and you will see a marked change in how he handles and assumes risk. The trader will supervise himself. After all, it's his money too. Many hedge funds do this, by paying their important traders in shares of their own trading book, or the overall book of the firm. Investment and commercial banks have been doing this for some time, too, by paying traders—along with everyone else—substantial portions of their annual compensation in long-vesting restricted stock of the firm.

The problem with this method is twofold. First of all, you need to make sure that enough of the trader's compensation and total net worth is tied up in this way; otherwise, he will just view unvested compensation as "house money" to play with, and he will have little incentive to care. The temptation to swing for the fences, or assume dangerous risks, will overwhelm any proprietary instincts for preservation of personal capital. Second, even if the trader has a substantial portion of his wealth tied to the overall results of his firm, the firm cannot be too big in relation to his stake, or he will feel that nothing he does will matter anyway. The rubber band tying his personal trading performance to the price or value of his employer's equity will be too elastic and contingent on the actions of others to act as a real incentive. This is the problem faced by large investment banks, where a trader holding even $50 million in unvested stock feels that nothing he can do—good or bad—will make a difference to the price of Citigroup stock.

Finally, neither of these methods controls for another importance source of trading risk: ignorance. It does not require a dishonest trader and an incompetent risk manager to screw up a trading book (although I am sure some instances of these happened). All it takes is for both of them to be honestly unaware of the real risks embedded in their positions. I think this fairly characterizes a helluva lot of the blowups we have been suffering over the last year and a half. It does you no good to have perfectly aligned incentives and top-notch supervision and control if both your trader and your risk manager haven't a clue about the risks they are running. Here Taleb and I converge a little, although I disagree with his implicit assumption that most traders consciously pursued short-term profits (and current bonuses) at the expense of long-term catastrophic risks. I think most of them just didn't know.

* * *

Pace Mr. Taleb's casual invective about invidious incentives and "capitalism for the profits and socialism for the losses," I am unpersuaded that he has come up with an effective solution to our current dilemma or even an accurate description of the problem. The trader's option and its variants have been the preferred method of compensating traders forever, even by banks and investors who are fully cognizant of the risks they entail. (And no, investment banks and commercial banks are not comprised entirely of traders, so their corporate interests and incentives cannot be so neatly identified with those of their traders.) Does he think he has a better way, one no-one else has thought of in the last 50 years? Please, don't keep us in the dark.

He wants traders and banks to be subject to disincentives that counteract the trader's option, citing as justification the claim that "[e]ntrepreneurs are rewarded for their gains; they are also penalised for their losses." But how, in fact, are entrepreneurs—and capitalist firms in general—penalized for failure? They lose their jobs, their investments, their savings, they go bankrupt. Which of these things has not already happened to multiple investment and commercial banks and perhaps hundreds or even thousands of individual traders and other investment bankers? Virtually all traders' incentives have been aligned with those of their investors for quite some time now. The fact that this did nothing to prevent the multi-car pile-up we are digging ourselves out of now gives me little comfort that the problem was misaligned incentives in the first place, and even less confidence that fixing it is a simple matter of designing "better" incentives.

He wants to nationalize "the utility part of banking," whatever that is, without specifying how government control would offer a better solution, rather than just an opening for the intrusion of politics into the relatively less compromised world of finance. Where would we draw the line around "utility" finance: commercial lending, retail lending, residential lending, commercial real estate lending, leveraged finance, asset-backed lending, securities underwriting, securities trading, insurance? How could we prevent contagion from the unnationalized bits—where, presumably, private banks would be free to succeed and fail relatively unconstrained—back to the nationalized ones? At what cost in efficiency, the price of money, political interference?

Those private individuals who commit their capital to the pursuit of risky returns, investors, pay taxes on their gains (at least most of the time). When they make money, we taxpayers benefit, and when they lose money, we taxpayers suffer, even if we are not investors ourselves. It is willfully shortsighted to deny that we already have an extremely robust, multifaceted system in this country for socializing both gains and losses from the activities of private capital. (Job creation, anyone?) It is appallingly disingenuous to assert that investment and commercial banks were the only entities which benefited from the multi-year credit bubble, and therefore should suffer disproportionately. And it is laughably ludicrous to compare military and security personnel—much less Roman legionnaires—to finance professionals. For the same reason I do not want to pay soldiers for the number of enemies they kill and security personnel for the number of threats they forestall, I do not want to pay a commercial banker for the number of loans he declines.

It is the height of epistemic arrogance to claim otherwise.

Back to the drawing board, Nassim.

1 You think I exaggerate? I do not:

A small number of Black Swans explain almost everything in our world, from the success of ideas and religions, to the dynamics of historical events, to elements of our own personal lives. Ever since we left the Pleistocene, some ten millenia ago, the effect of these Black Swans has been increasing. It started accelerating during the industrial revolution, as the world started getting more complicated, while ordinary events, the ones we study and discuss and try to predict from reading the newspapers, have become increasingly inconsequential. ...

Fads, epidemics, fashion, ideas, and the emergence of art genres and schools. All follow these Black Swan dynamics. Literally, just about everything of significance around you might qualify.

— Nassim Nicholas Taleb, 2007, The Black Swan: The Impact of the Highly Improbable. New York: Random House, p. xviii.

I am particularly impressed that Mr. Taleb can claim with confidence that these effects have been increasing since the Pleistocene. He must be older than he looks on TV.
2 Good luck trying to figure out whether a "good" trader has generated superior returns because he is skilled, or just because he is lucky. Some people, channeling Napoleon, might claim that you shouldn't care: good is good. Then, even if you can figure out the source of his outperformance, decide whether you want to bet that his skill or his luck will continue in the future. That way lies madness.
3 Correction, 27 Feb 2009: A kind reader has gently reminded me that gold is priced in troy ounces, whereas humans are priced weighed in avoirdupois pounds. At approximately 14.583 troy ounces per avoirdupois pound, my previous calculation overpriced said trader by $262,145, for which you could purchase a couple of decent analysts or the services of a Ukranian hooker for a couple weeks. This sort of error is inexcusable: I abase myself before you for epistemic ignorance.

© 2009 The Epicurean Dealmaker. All rights reserved.