As a finance major in business school, I heard many times how Wall Street finance guys were the pinnacle of humanity and how they were far more intelligent than the rest of us.‚ The ground they walked on was holy and their pronouncements hammered in stone.
After the huge market crash, these former untouchables are now catching a lot of heat and being accused of defrauding investors, hurting America and even stupidity.
So what is the case?‚ I’m not entirely sure, but I have a fairly simple theory.
The supposedly all-knowing finance gurus were smart and probably realized that that their actions would eventually lead to a market collapse, but their incentives were set up in such a way that they could make more money by ignoring risk.‚ Most high finance people get a healthy salary ($150,000 + per year), but their real money comes from bonuses (multiple millions).‚ Bonuses are paid at the end of each year based on the performance of that year… so the finance guys would maximize returns during that year by increasing risk and taking on more debt (leverage).‚ Up until about 25 years ago, this would not happen because the elite financiers were using their money to invest and if they took on too much risk, they could lose everything.‚ However, finance threw its doors open in the 1980s to common investors and a flood of money rushed into the previously staid world of Wall Street.‚ Now the traders in the big investment banks were using other people’s money to gamble with, instead of investing their own capital.‚ The traders lost their incentives to minimize risk and started using enormous amounts of leverage on many esoteric transactions… and eventually lost much of their investor’s capital.
Was it stupidity that led to such an over-reliance on risk?‚ No.‚ The financiers were very smart and took advantage of money they were given to essentially gamble with and took home enormous paychecks for years.‚ Now that the investment banking industry has collapsed and they have lost their jobs, the finance guys are off sailing in the South Pacific in their magnificent yachts paid for with the many millions of dollars in bonuses that they had paid to themselves during the bubble.
How can we prevent this from happening again?‚ Tie the incentives of the Wall Street financiers, board members, credit rating agencies, CEO’s and others directly to the interests of the shareholders.‚ If shareholders lose everything, they should be able to sue the board members and CEO’s and credit rating agencies and take everything that each group personally owns.‚ That will give all those powerful financiers the incentive to minimize risk.‚ Also, do not allow companies to indemnify (insure) their board members.