By gnawing through a dike, even a rat may drown a nation.
Edmund Burke
Against the background of Charlie Munger’s memorable remark that Wall Street traders “have all the social utility of a bunch of rats admitted to a granary,” we now have more information about the counterparties of JPMorganChase’s disastrous trades by Bruno Iksil in its Chief Investment Office. If JPMorganChase [JPM] has lost somewhere between $2 billion and $5 billion from these trades, others must have won. Who are these "winners"?
Nice work if you can get it: Government-backed gambling
The Wall Street Journal has reported that some of the winners in these gambles are none other than Government-backed banks, including Goldman Sachs [GS] and Bank of America [BAC]. They have have scored profits that collectively could total $500 million to $1 billion.
When JPMorganChase was selling credit default swaps in large quantities, it had gone way beyond any sensible definition of “hedging its investments”: it was pure and simple gambling of the Las Vegas variety. As a result, we not only have the interesting spectacle of the US Government backstopping JPMorganChase’s habit of large-scale gambling, and undertaking to bail out the firm out if it ever gets into any deep trouble. Even more interesting, the US Government is also backstopping the other gamblers, so that the game can go on forever, no matter how badly anyone ever loses. Moreover the individuals involved are able to pocket huge personal bonuses if the bets pay off, and not lose anything personally if they don’t.
The bottom line is a gambler’s paradise: heads you win, tails the US taxpayer picks up the tab.
Banned card player wins big on Wall Street
A prime example of the phenomenon is another winner in the JPMorganChase debacle: Boaz Weinstein, who is highlighted in a stunning article by Azam Ahmed in the New York Times. An ardent gambler, Mr Weinstein has been banned from the opulent Bellagio casino for counting cards while playing blackjack, but his gambling continues on Wall Street.
“Mr. Weinstein was a pioneer in complex credit derivatives, latching onto them early in his tenure at Deutsche Bank, before they became the financial weapons of mass destruction that worsened the financial crisis. He was a profit machine at the bank, notching earnings in 10 of his 11 years trading there. At 27, he became one of the youngest managing directors in the bank’s history. He exploited price discrepancies and piled leverage into his trades. Then his team at Deutsche Bank lost $1.8 billion during the 2008 financial crisis.”
A loss of $1.8 billion might be big problem for the US economy and the US taxpayer, but no problem for Mr. Weinstein. In the good years before his gambles blew up, he was reportedly earning about $40 million a year. Having gotten rich helping bring Deutsche Bank—and the global economy—to the brink of collapse, he left the bank and, along with 12 of his colleagues, set up his hedge fund. Mr. Weinstein started it with $140 million and now controls more than $5.5 billion.
Surely a similarly lucrative future now awaits Mr. Iksil, the “London whale” at JPMorganChase who masterminded the multi-billion dollar loss there. He will likely be taking with him the extravagant bonuses he obtained in the good years when his gambles paid off while leaving JPMorganChase to clean up the massive losses he leaves behind him, now that his bets have gone sour.
Slum lords in pin-striped suits
Keep in mind that the kind of gambling now occurring on Wall Street does nothing for the economy. JPMorganChase selling credit default swaps does no more for the economy than a bet placed in the roulette table of a Las Vegas casino. It doesn't grow the economic pie. No businesses are created and no houses are financed by it. The income generated is simply the extraction of rents in zero-sum gambling, ultimately backed by the US taxpayer.
John Cassidy, writing in The New Yorker in an article entitled What Good Is Wall Street? quotes Gerald Epstein, an economist at the University of Massachusetts:
These types of things don’t add to the pie. They redistribute it—often from taxpayers to banks and other financial institutions.
Lord Adair Turner, the chairman of Britain’s top financial watchdog, the Financial Services Authority has described much of what happens on Wall Street and in other financial centers as “socially useless activity”. Cassidy suggests that these traders are the financial equivalent of slumlords or toll collectors in pin-striped suits: if they retired to their beach houses en masse, the rest of the economy would be fine, or perhaps even healthier.
Professor Mihir Desai, the Mizuho Financial Group Professor of Finance at Harvard Business School–puts the issue more harshly in the March issue of Harvard Business Review. These people are not merely socially useless they are positively harmful to the economy, creating:
“the twin crises of American capitalism: repeated governance failures, which lead many to question the stewardship abilities of American managers and investors and rising income inequality.”
Even worse, the skewed incentives and huge unearned windfalls have given rise to righteous but unwarranted belief in entitlement: the individuals “now consider themselves entitled to such rewards. Until the financial incentives bubble is popped, we can expect mis-allocations of financial, real and human capital to continue.”
Rethinking the purpose of business
The root cause of these disasters is that “dumbest idea in the world”: the view that the purpose of a firm is to maximize shareholder value, i.e. make money. Once making money becomes the goal of a firm, companies and their executives start to do things that not only lose money for the firm but cause problems for the economy. It is time to eliminate this pervasive nonsense from business thinking and re-devote the energies of business to what Peter Drucker recognized in 1973 as "the only valid purpose of a firm", namely, creating customers.
Roger Martin calls this different thinking “customer capitalism.” Ranjay Gulati calls it ‘organizing for resilience.’ Richard Florida has called it “the creative economy.” I have called it radical management. Whatever we call it, it’s very different from the money-driven management currently being practiced on Wall Street. It’s fundamentally about orienting firms to do what is good for the economy that supports them.
Read also:
Berkshire Hathaway: Wall Street "Rats In A Granary"
HBR Blows The Lid Off C-Suite Compensation
The Dumbest Idea In The World: Maximizing Shareholder Value
The Big Five Surprises Of Radical Management
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