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

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Ed Dolan
Ed Dolan

What do the Gulf oil spill and the recent financial crash have in common? Both involve risk taking gone bad.

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Free 際際滷s from Ed Dolans Econ Blog http://dolanecon.blogspot.com/ What Oil Spills and Financial Crashes Have in Common: Gambling with Other Peoples Money Post prepared , June 6, 2010 Terms of Use: These slides are made available under Creative Commons License AttributionShare Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics , from BVT Publishers.
All Business is Risky All business is risky Entrepreneurs do not try to avoid all riskmanaging risk is an essential part of their job Public policy cannot protect everyone from risk, but it should encourage people to manage risk responsibly Post P100606 from Ed Dolans Econ Blog http://dolanecon.blogspot.com/ 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 Post P100606 from Ed Dolans Econ Blog http://dolanecon.blogspot.com/
Recreational Gambling If you buy lottery tickets or otherwise gamble for fun you may prefer a different kind of risk Small chance of huge prize Limited maximum lossnot more than you can afford Expected 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 Post P100606 from Ed Dolans Econ Blog http://dolanecon.blogspot.com/ Source: pdclipart.com
Gambling with Other Peoples Money If you have a chance to gamble with other peoples money, you may choose a third kind of risk Make a small gain almost all the time Run 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 Post P100606 from Ed Dolans Econ Blog http://dolanecon.blogspot.com/ Source: pdclipart.com
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 Post P100606 from Ed Dolans Econ Blog http://dolanecon.blogspot.com/
Negatively Skewed Risks and Executive Compensation In the world of business, executive compensation plans often create incentives to take negatively skewed risks Most 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 Post P100606 from Ed Dolans Econ Blog http://dolanecon.blogspot.com/ Source: pdclipart.com
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 Post P100606 from Ed Dolans Econ Blog http://dolanecon.blogspot.com/
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. Post P100606 from Ed Dolans Econ Blog http://dolanecon.blogspot.com/ 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 Post P100606 from Ed Dolans Econ Blog http://dolanecon.blogspot.com/ Source: pdclipart.com
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 dont? Should BP have spent more to plan for a worst-case spill even though the probability of such a spill was small? Post P100606 from Ed Dolans Econ Blog http://dolanecon.blogspot.com/ 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 regulationsbut 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 dont insist on these thingsand often they do notcan government regulations really be effective? Strict legal liability for lossesbut 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 Post P100606 from Ed Dolans Econ Blog http://dolanecon.blogspot.com/

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

  • 1. Free 際際滷s from Ed Dolans Econ Blog http://dolanecon.blogspot.com/ What Oil Spills and Financial Crashes Have in Common: Gambling with Other Peoples Money Post prepared , June 6, 2010 Terms of Use: These slides are made available under Creative Commons License AttributionShare Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics , from BVT Publishers.
  • 2. All Business is Risky All business is risky Entrepreneurs do not try to avoid all riskmanaging risk is an essential part of their job Public policy cannot protect everyone from risk, but it should encourage people to manage risk responsibly Post P100606 from Ed Dolans Econ Blog http://dolanecon.blogspot.com/ Source: pdclipart.com
  • 3. 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 Post P100606 from Ed Dolans Econ Blog http://dolanecon.blogspot.com/
  • 4. Recreational Gambling If you buy lottery tickets or otherwise gamble for fun you may prefer a different kind of risk Small chance of huge prize Limited maximum lossnot more than you can afford Expected 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 Post P100606 from Ed Dolans Econ Blog http://dolanecon.blogspot.com/ Source: pdclipart.com
  • 5. Gambling with Other Peoples Money If you have a chance to gamble with other peoples money, you may choose a third kind of risk Make a small gain almost all the time Run 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 Post P100606 from Ed Dolans Econ Blog http://dolanecon.blogspot.com/ Source: pdclipart.com
  • 6. 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 Post P100606 from Ed Dolans Econ Blog http://dolanecon.blogspot.com/
  • 7. Negatively Skewed Risks and Executive Compensation In the world of business, executive compensation plans often create incentives to take negatively skewed risks Most 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 Post P100606 from Ed Dolans Econ Blog http://dolanecon.blogspot.com/ Source: pdclipart.com
  • 8. 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 Post P100606 from Ed Dolans Econ Blog http://dolanecon.blogspot.com/
  • 9. 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. Post P100606 from Ed Dolans Econ Blog http://dolanecon.blogspot.com/ Source: pdclipart.com
  • 10. 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 Post P100606 from Ed Dolans Econ Blog http://dolanecon.blogspot.com/ Source: pdclipart.com
  • 11. 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 dont? Should BP have spent more to plan for a worst-case spill even though the probability of such a spill was small? Post P100606 from Ed Dolans Econ Blog http://dolanecon.blogspot.com/ Source: www.whitehouse.gov
  • 12. 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 regulationsbut 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 dont insist on these thingsand often they do notcan government regulations really be effective? Strict legal liability for lossesbut 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 Post P100606 from Ed Dolans Econ Blog http://dolanecon.blogspot.com/