We lose in Greed Game
I’ve spent much of the past few months investigating the causes and likely consequences of the credit crunch for a BBC2 documentary, Super Rich: the Greed Game, which will be broadcast at 9pm on Tuesday.
And as scheduling chance would have it, a radio documentary I’ve made on British attitudes to business, Britain’s Business Problem, will be transmitted on Radio 4 this Saturday at 8pm, in the Archive Hour slot.
As it turns out, the programmes are complementary.
At the heart of the television film – for which we interviewed some of the most influential players in global finance, including George Soros, Stephen Schwarzman, Michael Hintze, Jim Chanos, Sir Ronald Cohen, Mervyn Davies, John Moulton, Terry Smith and Paul Myners – is an examination of how remuneration practices at private equity, hedge funds and banking encouraged excessive risk-taking.
The first important point to grasp is that bankers, the private-equity partners, the hedge-fund managers were all using other people’s money for their deals.
Investment bankers invested the capital of the banks for which they worked. Hedge-fund and private-equity executives invested their backers’ funds.
And they topped this up – they “leveraged” their deals – by borrowing enormous sums.
In some cases, they put modest amounts of their own wealth at risk. But their personal exposure to these deals was usually paltry.
The structure of their remuneration represented – in many cases – a rigged bet for them: heads they won, tails everyone else lost.
As for those winnings, when the going was good rewards were on a scale that were beyond most people’s wildest imagining: millions of pounds, tens of millions, hundreds of millions.
Of course, not all private-equity or hedge-fund players earned quite such fabulous rewards. And their activities can help the process of allocating capital in an efficient way - which ought to stimulate economic growth and should be of benefit to all of us.
But they created a system of remuneration whose consequences do not appear to have been benign.
Here are the rules of what one hedge fund manager called the “greed game.”
The partners of the private equity and hedge funds would receive 20% of the gains made on investing their backers’ funds (and 2% of the value of the funds as an annual management charge).
And if there were no gains, only losses, the backers – which could be other financial institutions such as US pension funds or wealthy individuals – would feel all the pain: there would be no sharing of the losses with the partners of the private-equity firms or hedge funds.
That is what’s known as an asymmetric reward system. And it’s very nice work if you can get it.
Thus if a private-equity firm or hedge fund generated a capital gain of £1bn – and in the boom conditions of the past few years, that wasn’t unusual – the partners in the relevant fund would trouser 20%, or £200m.
But if there was a loss of £1bn, well only the backers would lose.
Why did the backers of these funds agree to be so generous? Because the better private-equity firms or hedge funds had provided them with good returns, even after paying the managers so much, for many years.
Also in the early years of this century, with interest rates very low and asset prices surging, most investors were carried away on a dangerous wave of euphoria that the good times could never end.
One consequence of this mouth-wateringly attractive remuneration system was a massive exodus of the brightest and the best from the investment banks and commercial banks into private equity and hedge funds.
That in turn prompted the banks to put in place analogous remuneration schemes in their own firms, to persuade their putative stars not to quit.
So the annual bonus for clever bankers became – in effect – 20% of the notional profit on the deals they carried out with their banks’ money. And it became commonplace for bankers to pocket millions and tens of millions of dollars every year.
Again it was a one-way bet for the bankers. If the deal went right, they received the enormous bonuses. If the deal went wrong and the banks made losses, what was the worst that could happen? The bankers wouldn’t receive a bonus for that year and might lose their jobs. But how much of a worry was that to those who had already earned many millions, more than enough than they could ever spend?
The remuneration system therefore encouraged those in charge of trillions of dollars of other people’s money to take much greater risks with that money than they would have done if their own money had been seriously at risk.
And, as we now know, the risks they took were – in many cases – crazy, and on a scale that has wreaked havoc on the global financial system, pushed the US economy into what many economists are already describing as a recession and is precipitating a serious slowdown in the UK.
If, for example, individual investment bankers’ own money had been invested alongside their banks’ and their clients, would they have been quite so enthusiastic to convert subprime loans into investments for sale to financial institutions around the world – and wouldn’t they have looked a little more closely at whether the borrowers of these subprime loans really could repay?
But with none of their own money on the line and the potential to generate colossal bonuses from selling these investments, many were seemingly seduced by their own propaganda: they apparently believed that structured finance was revolutionary financial technology for transforming poor quality loans into high quality investments.
There was an epidemic of Nelsonian Eye Syndrome on Wall Street and London. And bankers, private-equity partners and hedge-fund partners acknowledge – or at least some do – that the cause was good, old-fashioned greed induced by a turbocharged remuneration system that promised riches in return for minimal personal risk.
Reform of this dangerous remuneration system probably ought to be a matter of some urgency for shareholders in banks, the backers of hedge funds and private-equity firms, financial regulators and politicians – though right now their priority seems to be weathering the current financial crisis rather than pre-empting the next one.
As for the reputation of the City, Wall Street and the global banks that underpin our economy, that’s taken a serious knock.
Which brings me back to my Radio 4 documentary on why the British appear to be no more in love with business than they were 30 years ago, even though we’d all be a lot poorer if there hadn’t been a serious improvement in the productivity and competence of our wealth creators over the past 30 years.
My primary thesis is that the widespread unease of many Britons with the profit motive and their wariness of the private sector – especially of our biggest companies – is not conspicuously founded on reason. But my case hasn’t really been helped by the irresponsible way many bankers and financiers played the Greed Game over the past few years.