Oil spills, financial crashes, and gambling with other peoples money

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What Oil Spills and Financial Crashes Have in Common: Gambling with

Other People’s MoneyPost prepared , June 6, 2010

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Post P100606 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/

All Business is Risky

All business is risky Entrepreneurs do not try to

avoid all risk—managing risk is an essential part of their job

Public policy cannot protect everyone from risk, but it should encourage people to manage risk responsibly

Source: pdclipart.com


Risking your Own Money as an Entrepreneur

Suppose you are entrepreneur risking your own money on a project.

What you want is a project that has an expected value of revenue that is greater than the estimated cost

Sometimes your investment will pay off, sometimes not, but on average, over time, you will earn a profit from this kind of venture


Recreational Gambling

If you buy lottery tickets or otherwise gamble for fun you may prefer a different kind of riskSmall chance of huge prizeLimited maximum loss—not

more than you can affordExpected value of prize

less than cost of ticket In money terms, you lose on

average, but you enjoy the game and the dream of a pot of gold



Gambling with Other People’s Money

If you have a chance to gamble with other peoples’ money, you may choose a third kind of riskMake a small gain almost

all the timeRun a small risk of a

disastrous loss You know that if a disaster

does occur, the game is over, but you hope to go home with past winnings in the bank, and stick someone else with the loss



Symmetrical and Skewed Risks

Each kind of risk has a name Symmetrical risk —

balanced gain and loss Positively skewed risk —

small chance of very large gain

Negatively skewed risk —small chance of very large loss


Negatively Skewed Risks and Executive Compensation

In the world of business, executive compensation plans often create incentives to take negatively skewed risksMost of the time, the company

makes money and the executive earns an annual bonus

If a huge loss comes, the executive is fired, but may collect a “golden parachute” retirement bonus

There is rarely any “clawback” of previously earned bonuses even when risky decisions later turn out to produce big losses


Example of incentive to take negatively-skewed risk

Strategy A 5 quarters of $100 million profit 5 quarters of $10 million loss 10-quarter net for shareholders:

profit of $449.5 million 10-quarter result for executive:

total bonuses of $500,000

Strategy B 9 quarters of $200 million profit 1 quarter of $2,000 million loss 10-quarter net for shareholders:

loss of $201.8 million 10-quarter result for executive:

total bonuses of $1.8 million

Negatively skewed strategy B has higher payoff for the executive but lower payoff for shareholders

Assume a bonus plan that pays 0.1% of net profit each quarter



Not Just Top Executives

Top executives are not the only ones who may have incentives to gamble with other peoples’ money

Mid-level managers, traders, analysts, even engineers and production workers may earn bonuses or promotions if their work results in short-run profits for the company

If they take hidden risks that later result in huge losses, often the worst that can happen is that they are fired. Source: pdclipart.com


Negatively Skewed Risks and the Financial Crisis

Before the financial crisis, Wall-Street was full of opportunities to gamble with other peoples’ money

Selling credit default swaps on complex securities backed by subprime loans

Risky trading strategies “Gaming” federal regulations in order to

increase leverage of banks and other financial institutions

Manipulating ratings to put “AAA” seal of safety on risky securities



Negatively Skewed Risks and the Gulf Oil Spill

Investigators are trying to find out if BP

or its contractors made decisions

in the interest of profit or cost-cutting

but with small risks of large losses What kind of technical decisions were

made in the last days and hours before the blowout?

Blowout preventers usually work, but are fail-safe systems needed in the rare occasions when they don’t?

Should BP have spent more to plan for a worst-case spill even though the probability of such a spill was small?

Source: www.whitehouse.gov


What can be done?

What, if anything, can be done to protect against

the temptation to gamble with other peoples’ money at the risk of disaster? Stricter regulations—but who will regulate the regulators? Who will

prevent “capture” of regulators by special interests? Improve executive compensation—fewer short-term bonuses, more long-

term stock ownership, more “clawback” mechanisms. But if shareholders don’t insist on these things—and often they do not—can government regulations really be effective?

Strict legal liability for losses—but the law is slow and costly, and the individuals who made the bad decisions may not be the ones who pay even when their corporations are found liable

Oil spills, financial crashes, and gambling with other peoples money

Education

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