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Talent Management Column

Gambling on the Financial Crisis

HR leaders may find some food for thought in reading details about employee motivations underlying the financial panic that spurred the ongoing recession. And it may be worth asking whether HR should have played a larger role in those organizations before the crisis spun out of control.

Monday, August 16, 2010
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August seems to be the month when people in business who can still take vacations do so, and at least some of those folks occasionally get a chance to read books.

Even on vacation, it's hard to get away from the fact that the U.S. economy, in particular, but others as well, are still stumbling along in search of a recovery. Even those of us with jobs are reminded that things are still pretty bad.

And that takes us to a summer reading list about the event that caused all these problems, the financial meltdown, which began in Fall 2007 and extended through 2008. The implications of this crisis for employers, for employees and for society are continuing to emerge, and it may be quite a while before we know all of them.

What causes a recession has traditionally been seen as something of a puzzle, but not for this one. This was a full-fledged banking panic, the kind we typically associate with developing countries.

Amazon.com reports that there are already 255 books written about the crisis. I think the most interesting and useful are not the ones written by economists and financial experts but those written by journalists who actually interviewed the people involved and told the story of what happened from an insider's perspective.

There are lots of ancillary factors in regulations that made it possible for the crisis to spin out of control, but the crisis itself was quite clearly bred in the peculiar market for bonds associated with home mortgages.

Here are three very readable and insightful books that tell insider stories about the meltdown from three different perspectives:

Scott Patterson's The Quants: How a New Breed of Math Whizzes Conquered Wall Street describes the rise of hedge funds and how they operate. Hedge funds focus on derivatives, mainly options to buy and sell in the future.

Michael Lewis' The Big Short: Inside the Doomsday Machine gets inside the mortgage market where the meltdown occurred.

And William Cohan's House of Cards: A Tale of Hubris and Wretched Excess on Wall Street documents the rise and fall of Bear Sterns, an investment bank deeply involved in the mortgage business -- and the first of the financial institutions to fail.

These three independent accounts paint a remarkably similar story about how an important part of the modern investment world operates, the part that was also responsible for the meltdown. Those of us who have sat through economics classes learning about the important role of capital allocation in free-market economies -- how the investment industry allocates capital to the most promising opportunities, how financial markets make it possible to spread risk across investors, etc. -- won't see any of that in these accounts.

Here's what you will see:

These guys were basically gamblers. A striking similarity across these accounts, and others as well, is how many of the individuals involved in this financial market got interested in the investment-management industry through gambling.

Scott Patterson traces the rise of the hedge-fund industry to a book called Beat the Dealer, about how to assess the probabilities in the card game, 21. Its author became a hedge-fund manager by developing a similar approach -- assessing probabilities as to how markets will move -- and inspired others interested in card games to move into investing.

The entire operation of Bear Sterns in William Cohan's account seems to have been based around the card game of Bridge. And Michael Lewis' earlier Liar's Poker described the Wall Street addiction to a bluffing card game that the quantitative analysts eventually figured out how to win.

One gets the sense that the participants in these books would have been happier playing cards full time if it paid as well as the investment business.

None of this activity appears to be economically useful. These players were not investing in businesses. They were betting on financial instruments and on whether markets per se would rise or fall.

The markets for derivatives or options, where most of the action was in the meltdown, are actually bets against other people: Someone else has to lose for you to win.

To see this betting against others most spectacularly, consider that the heart of the financial meltdown started with the creation of a new financial instrument (read: card game) known as credit-default swaps, which were basically insurance contracts against the risk that a given set of mortgage-backed bonds would default.

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Insurance sounds useful until we learn that virtually all of this insurance was sold to people who did not own any of the bonds. This is like buying life insurance on a stranger and having some ability to ensure that they are going to have a really bad day. It's just gambling. The insurer is betting you that their guess is better than yours.

The meltdown came because those selling the insurance, such as AIG, made really big, really foolish bets on mortgage-backed bonds and lost. When they couldn't pay, the problem spilled over to others, and -- poof! -- we had a financial panic.

Hedge funds and quantitative investors identify when markets are out of alignment and basically bet that they will come back into alignment. We might think that's useful, leading to better allocations of capital, except that the kind of misalignments we are talking about now are of a truly microscopic level: Adjustments that are delayed by a couple of seconds, for example, generate millions of dollars for hedge funds that can execute trades in fractions of seconds.

Does it really help our economy to have markets move that quickly? All this betting and adjustments seem to have created the potential for volatility in the future that we can't easily estimate.

One of the issues this gambling mentality raises for organizations has to do with risk management. Inside the companies that were engaged in these markets, individuals were placing bets that ultimately destroyed the companies, and no one seemed to be aware that this was not only possible but likely.

How much of this has to do with our reward systems, where there are huge upsides in terms of individual compensation for success and relatively little downside? Not only in the investment world but elsewhere in executive suites as well, to keep one's job it seems necessary to keep winning: If you fail to win by playing it safe, you will quite likely lose your job. 

If you take a big risk and fail, the worst that happens is you lose your job even if the company goes down with you. Maybe this is yet another example of the separation between individual and corporate interests.

Peter Cappelli is the George W. Taylor Professor of Management and director of the Center for Human Resources at The Wharton School. www.talentondemand.org.

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