Media coverage would have us believe that detrimental activity in the capital markets – including criminal behavior – is limited to individuals who are different than us. Many of us, as onlookers, believe that illicit, unethical or illegal acts are beyond us, and that we would absolutely behave differently were we in the shoes of those we hear and read about.
Thanks to the concept of risk and return decision-making, we are not as quick to accept that conclusion.
Critics are quick to vilify (as they should) individuals and managements that should stop questionable and illegal market activities. Bernie Madoff, SAC, JPMorgan Chases London Whale and the Libor scandal provide ready examples. The fascinating thing about these over-the-top activities is that they are almost always grounded in the same fundamental decision-making practices Wall Street professionals use every day – at least at the outset.
Professionals make decisions every day. Some result favorably, while others turn out unfavorably. Unfavorable results are acceptable and expected. These routine decisions, individually, usually do not have a material impact on on-going business. Some decisions may be questionable or inappropriate, but as the cautionary tales above illustrate, the payoffs can be greater than for routine decisions. Therein lies the temptation.
No trader sets out to fail, let alone be fitted for handcuffs.
Risk and Return in Decision-Making
The concepts of risk and return are familiar to everyone in capital markets. While they have obvious and direct implications in investment management and trading, so called risk-based decision-making can be a formal, defined, conceptual process, or one that is hardly noticed. In most cases, it depends on the perceived magnitude of the matter at hand.
In its most basic form, risk based decision-making involves two factors: Potential Gravity (acuteness of the decision) and Outcome Probability (probability associated with favorable or unfavorable outcomes).
There is a wealth of academic research on these matters and behavioral finance and economics are becoming increasing important. However, it is clear that risk weighting decisions in a logical and methodical manner elucidates the impact of a range of potential outcomes. This assists the decision maker in taking optimal action.
Making Decisions In a Pressure Cooker
Most industry professionals do not set out to defraud clients or create systemic events that destroy their company. On the contrary, they spend years, if not decades, establishing reputations, demonstrating their abilities and building successful careers. The leap from bad decision-making to recklessness and illegality can occur subtly. It could start as simply as a bad split-second calculation made under stress. A trader may pursue an excessively risky proprietary trading position outside normal limits in an organization with a weak control structure. A successful trader may make the mistake of overestimating his or her capabilities or underestimating the market forces arrayed on the other side. A portfolio manager might impulsively act on non-public material information.
These decisions appear low-risk to the transgressor at the time because the potential upside is far more tangible than the seemingly remote – but very real – element of loss or punishment. Once a step over the line has been taken, and the rewards tasted, the prospect of continued success often propels further action. Gains act like an addiction, compelling the transgressor to accept the delusion that the questionable activity is risk free. When the losses inevitably come, they instill a sense of desperation to get flat before the inappropriate actions are found out.
In the context of risk-based decision-making, the transgressor over-weights the immediate and visible upside against the more remote and, to his or her thinking, almost non-existent downside. In their frenzy to claim credit for the unexpected – and undeserved – success, transgressors may not even recognize downside as a possibility.
A pair of in different realms of finance illustrate: Madoff and the JP Morgan London Whale.
For many years, Bernie Madoff ran a securities business which by all accounts was legitimate and prosperous. Bernard L. Madoff Securities began as a market maker for pink sheet securities and later grew to become the largest market maker on the Nasdaq. His infamous investment advisory business began in the early 1970s using low-risk arbitrage strategies surrounding his market making business. After the crash of 1987, unsettled clients pulled substantial investment capital, forcing Madoff to unwind hedges on unfavorable terms. Madoff then developed an index options strategy that required market volatility to work but markets at the time were flat. According to Madoff, he borrowed client capital as a stopgap to perpetuate his consistently high previous returns and keep his business going. That unexpectedly resulted in a huge influx of new investor capital.
To keep up appearances, and because the high profiles of his new investors fed his ego, Madoff continued the Ponzi scheme that resulted in his downfall. Once his scam was established, he deluded himself into seeing only the tangible aspects of wealth, materialism and inflated ego, all the while ignoring the downside of shame, punishment and prison that awaited.
In April and May 2012, JPMorgan’s Chief Investment Office incurred large trading losses based on transactions booked through its London branch by Bruno Iksil, the London Whale. A series of outsized derivative transactions involving CDSs were entered into allegedly as part of the bank’s hedging strategy. The bank announced a $2 billion loss with expectations the figure would significantly increase.
Iksil made huge bets on thinly-traded indices which caused irregularities in value versus market expectations. The positions stood to benefit if the credit markets improved or stayed the same. Not only were the bets bad, but given the relative illiquidity of the indices, it soon became clear who was trading in what direction.
Jamie Dimon attributed the loss to “egregious mistakes” in trading. He called the strategy “flawed, complex, poorly reviewed, poorly executed and poorly monitored.”
We, like many others, doubt the Whales bets were made in the true spirit of hedging. It appears Iksil suffered the sin of hubris, vastly overestimating his ability to succeed and underestimating the potential downside to the bank. While not criminal, his activities resulted in embarrassing losses for JP Morgan. That ego drove a colored and faulty view of his strategy is illustrated by the fact that Iksil and his team were literally able to shout down and bully the relatively inexperienced risk manager overseeing the groups activities.
Thus we see that decisions to break the law, or less severely step over the line, are simply extensions of the same decision-making that occurs in the normal course of business. Individuals weigh risks and returns. However, when extreme decisions are made – to cheat, or make a substantial ethical breach – the downside is willfully clouded.
Time, pressure and desperation may cause transgressors to leap from the relatively benign blue boxes to the more serious red boxes. Once in the red, the candy of the gain (or desperation associated with a loss) can be tangible and overwhelming. This is often sufficient to permit continuation of the questionable or illegal activity.
Acting in ones own interest in the role of a fiduciary offers examples of fertile ground for questionable decisions. There is considerable legal ambiguity regarding fiduciary responsibility. It is therefore possible for a fiduciary to make some decisions in their best interests while not specifically breaking a law. Misuse of soft dollars is an illustration. An asset manager has latitude to interpret expenses that are Securities Exchange Act of 1934 Section 28e eligible and may charge a client for something that is not in that clients interest.
There are also decisions which have ramifications of criminal or civil liability. Insider trading is a clear example. One chooses – at the risk of fines and civil or criminal action – to trade on non-public proprietary information for virtually certain gain.
The continuum illustrates that decisions that result in criminal activity are but an extension of the day-to-day business decision making process. The risks are higher, as are the returns.
Decision-making consciously or unconsciously is a risk-based process. The temptation to step into the realm of inappropriate, unethical or illegal is arguably within all of us. In most cases, the individuals dont set out to be rule-breakers. They are confronted by situations in which they may be under pressure, not have the time or focus, or delude themselves into believing that a legal transgression is not really a line in the sand. Once the transgression has been made, the pull from the immediate benefits, and lack of immediate negative implications, can incite continued behavior in the same vein. Thats when the risks overwhelm the rewards, and lives are ruined.
Matt Samelson is a principal and director of equities for market research firm Woodbine Associates.
