Smart Guys on Wall Street: The Trillin Theory

By James Kwak

According to Calvin Trillin (or, more accurately, the probably-at-least-semi-fictional interlocutor he meets at a bar in Midtown), the financial crisis was caused by smart people going to work on Wall Street. In the old days, the story goes, it was the lower third of the class that went to Wall Street, and

“by the standards that came later, they weren’t really greedy. They just wanted a nice house in Greenwich and maybe a sailboat. A lot of them were from families that had always been on Wall Street, so they were accustomed to nice houses in Greenwich. They didn’t feel the need to leverage the entire business so they could make the sort of money that easily supports the second oceangoing yacht.”

Then, however, as college debts and Wall Street pay grew in tandem, the smart kids started going to Wall Street to make the money, leading to derivatives and securitization, until finally:

“When the smart guys started this business of securitizing things that didn’t even exist in the first place, who was running the firms they worked for? Our guys! The lower third of the class! Guys who didn’t have the foggiest notion of what a credit default swap was.”

It’s a cute story. But there may be an element of truth to it. In their well-known paper, “Wages and Human Capital in the U.S. Financial Industry: 1909-2006,” Thomas Philippon and Ariell Reshef measured the relative wage and relative educational levels of workers in the financial sector over the last century. The picture looks like this:

The relative wage I knew about — that’s something we also charted in our Atlantic article. The relative education I did not know about (although there was lots of anecdotal evidence).

Now, Philippon and Reshef calculate relative education using the share of workers with more than a high school education; the left axis is the difference between this share in the financial sector and in nonfinancial industries. So all college students are treated equally — there’s no differentiation by where you went to college or how you did there. But there’s no reason not to think that, as finance became more complicated and required more math aptitude (see Figure 3 in the paper), the level of academic achievement went up as well.

I read somewhere that of the CEOs of the largest banks, only Vikram Pandit at Citi was a true “quant,” and he only came in when Citi (C) bought his hedge fund in 2007, after the bulk of the damage was done. (I’m not endorsing Pandit’s job as CEO, only saying that the mess was there before he arrived.) So there probably was this situation where the executive ranks were filled with old-style relationship-builders and dealmakers, and the increasingly quantitative traders were doing things they didn’t understand. A similar story has been told about Salomon under John Gutfreund in the 1980s (and LTCM under John Meriweather in the 1990s).

Technology firms also face a similar problem. In technology, as in most businesses, the way to make it to the top is through sales, so you end up with a situation where the CEO is a sales guy who has no understanding of technology and, for example, thinks that you can cut the development time of a project in half by adding twice as many people. I have seen this have catastrophic results. Even when you don’t have the generational issue that Trillin talks about, the problem is that the sociology of corporations leads to a certain kind of CEO, and as corporations become increasingly dependent on complex technology or complex business processes (for example, the kind of data-driven marketing that consumer packaged companies do), you end up with CEOs who don’t understand the key aspects of the companies they are managing. And the underlying problem is that, for all the blather that CEOs and boards spit out about succession planning and the importance of people, the fact remains that the market for CEOs is deeply flawed, as shown for example by Rakesh Khurana.

Comments

[PastTense:]

No. I think everyone at those firms knew there was a possibility that everything would blow up. But they ran the numbers looking at solely at their own personal financial situation: exactly how much salary and bonuses they would get vs how much they would lose if their stockholdings in the firm went to zero.

As it turned out everything turned out beautifully for them anyway: they got the massive salary and bonuses were times were good, and when times were bad the losses were transferred to the Federal government (or actually the average taxpayer and future generations) and now they are back to making the big bucks.

Oct 14 03:45 PM

[Roger Knights:]

Past Tense: Maybe it's half-and-half.

Oct 14 03:56 PM

[Robert0713:]

Trillin isn't the first, or most interesting (I was), to put forward this notion. The flight from engineering, science, and the like follows the Decline of the Roman Empire analogy. The brain folks go for the quick buck, because the rules allow the quick buck to be bigger than the slow buck.

Oct 14 04:55 PM

[alajac:]

Old IT proverb:

"To err is human, but,
to REALLY screw things up,
you need a computer."

Oct 14 10:09 PM

[punk_ash:]

what do you expect an engineer to do when you have your boss's boss's boss's boss's boss is a moron with an MBA. When engineers are looked down upon and morons with who do the deciding are revered.

Oct 15 12:05 AM

[dcb:]

there are times when the sum total of data in a very small amount of time proves how illegitimate the American government is, and what a huge ponzi scheme the system is. When it is shown without a doubt that the wealthy took a big hit last year and all government efforts are designed to get their money back your your expense with additional wealth disparity. When it is shown how corrupt the system is. That in fact the entire system is figged and designed to benefit the few, but marketed as something to help us all. I had my coffee today, seven folks there. I was the only person who even owned stocks or bonds. Yet the government is helping us. Let me be very clear. We are talking about the Fed, congress, White house. All are not legitimate representatives, and we do not have a representative democracy, but a corporate oligarchy that makes the rules and drives the discourse to ensure their continued wealth. I'll just let you read the articles, and you
decide.

JP Morgan profits lift Dow above 10,000
$3.6bn net income best figure since 2007
Investment banking arm provides boost
By Francesco Guerrera in New York
The Dow Jones Industrial Average climbed above 10,000 for the first time in more than a year yesterday after JPMorgan Chase kicked off the US banks’ third-quarter results season by reporting its biggest profit since 2007.
The $3.6bn in net income earned by JPMorgan in the three months to the end of September easily beat analysts’ expectations and has set the bar for rivals Goldman Sachs, Citigroup and Bank of America, which report later this week.
The unexpected results from JPMorgan, coupled with relatively resilient US retail sales, and better earnings than expected from Intel on Tuesday, sparked a broader market rally.
The Dow rose 144.80 points, or 1.47 per cent, to 10,005.86, finishing above the 10,000-point mark for the first time since October 3 2008, the day the troubled asset relief programme was approved by Congress and signed into law.
JPMorgan’s performance highlighted the contrast between Wall Street’s resurgence and the continuing weakness of US consumers. Analysts said they expected the divide to be evident as other financial groups report, with securities houses such as Goldman Sachs and Morgan Stanley expected to do better than banks with huge retail operations such as Citigroup and BofA.
“Wall Street is picking up quite smartly, while Main Street continues to suffer,” said Bart Narter at Celent, a research and consulting group. “Rising unemployment and declining house prices will cause continuing pain on Main Street and the banks that serve it.”
JPMorgan’s investment banking arm, which ousted its cohead Bill Winters last month, accounted for more than half of group profits, driven by strong revenues in its fixed-income arm and other trading divisions.
The securities unit also benefited from a $400m gain on its leveraged loans and mortgage-backed assets – the first time a US bank has disclosed a significant “write-up” on the value of securities that have caused huge losses to the sector.
JPMorgan’s net income of $3.6bn compared with $527m last year. It was the bank’s best profit since the second quarter of 2007. Earnings per share were $0.82, up from $0.09.
Yet its US consumer businesses continued to bleed, with its credit card unit losing $700m in the quarter and its retail bank, which was augmented by the purchase of the regional lender Washington Mutual last year, barely breaking even.
Jamie Dimon, chief executive, said he had seen “initial signs of consumer credit stability” but warned it was too early to call the end of the downturn.





Geithner aides had made millions of dollars
‘Counsellors’ worked on Wall St
Advisers escaped Senate hearings
By Tom Braithwaite in Washington
Obama administration officials now working on fixing and regulating the financial system were beneficiaries of several million dollars in pay from Wall Street and private equity companies, it has been revealed.
Financial disclosure forms show that before joining the government, Gene Sperling, a senior Treasury adviser, was paid $887,727 by Goldman Sachs and $158,000 for speeches to companies that included Stanford Group, the company run by Sir Allen Stanford, who has since been charged with fraud.
Mr Sperling’s compensation from Goldman was for work on a philanthropic project. His overall pay, including for his main job at the Council on Foreign Relations, totalled $2.2m in the 13 months to January.
The forms, first obtained by Bloomberg, showed that Matthew Kabaker, another adviser in the Treasury, earned $5.8m at Blackstone, the private equity firm, in the two years before joining the administration to work on plans to support banks and spur lending. Much of the package was in stock.
Lewis Alexander, another adviser, was chief economist to Citigroup before joining the administration; he was paid $2.4m in the past two years.
Even though some of the officials whose previous salaries were disclosed are senior, many were appointed as “counsellors”, so escaped Senate confirmation hearings that could have highlighted their past remuneration and employment at a time of heightened animosity towards the financial industry.
This month the release of the telephone call logs of Tim Geithner, Treasury secretary, showed that he had numerous conversations with a number of Wall Street executives, sparking allegations that the administration was too close to the industry.
Officials argued, then and yesterday, that it was important to have skilled people working for the government as it crafted complicated financial rescues and for Mr Geithner to communicate with financial sector executives. Mr Geithner, former president of the Federal Reserve Bank of New York, has never worked on Wall Street.
Mr Obama, however, has hit out at the culture that he said prevailed before last year’s financial crisis – at a time when many of the Treasury officials were working on Wall Street and related businesses.
“We will not go back to the days of reckless behaviour and unchecked excess that was at the heart of this crisis, where too many were motivated only by the appetite for quick kills and bloated bonuses,” he said at a speech in New York last month.
Previous releases of disclosure forms revealed the $5.2m paid to Lawrence Summers, chief economic adviser to the White House, by DE Shaw, the hedge fund, in the two years before he joined the administration.
The disclosures come during a complicated time for the relationship between the Obama administration and business, with officials accused of being too close to companies on the one hand and encountering increased criticism from business lobby groups on the other.
The US Chamber of Commerce yesterday launched its “campaign for free enterprise”, arguing the private sector was under threat from various over-reaching government plans, including for a Consumer Financial Protection Agency and a cap-and-trade scheme to reduce carbon emissions.

Dollar falls to 14-month low after Fed signals no rise in rates soon
Minutes show support for new asset purchases
By Krishna Guha in Washington
The dollar fell yesterday after minutes from the Federal Reserve’s last policy meeting showed that some committee members favoured increased purchases of assets such as mortgage-backed securities to speed recovery.
While the committee simply agreed to keep open the option of either expanding or reducing the purchases if the economic outlook changed, only one policymaker made the case for scaling back buying – leaving an overall doveish skew.
This tone was echoed in the discussion of inflation. Most Fed officials “anticipated that slack in both labour and product markets would be substantial over the next few years, leading to subdued and potentially declining wage and price inflation.”
They agreed that inflation expectations needed to be “carefully monitored” but indicated that they would seek to manage these expectations by building confidence in their exit strategy, rather than by raising rates preemptively.
With inflation fears muted and forecasts of protracted high unemployment, the minutes suggest that the Fed is still a long way from raising interest rates. This undermined the dollar, which fell to a 14-month low on a trade-weighted basis.
The minutes confirm that the US central bank is examining “reverse repurchase agreements on a large scale, potentially with counterparties other than the primary dealers” as a possible way to mop up excess liquidity when the time comes to tighten policy. The other counterparties envisaged prominently include money market mutual funds.
The minutes also show that the Fed viewed the decline in Treasury yields as “puzzling” given the improved economic outlook. Fed staff economists raised their forecast for the second half and projected that growth would strengthen further in 2010 and in 2011. They “forecast core inflation to slow somewhat further over the next two years from the pace of the first half of 2009.” They thought unemployment would be about 9.25 per cent at the end of 2010 and about 8 per cent at the end of 2011.
The minutes show that many Fed policymakers also raised their growth forecasts. But many still expected the recovery to be “quite restrained” – in part, because credit “remained difficult to obtain and costly”.
They also “expressed considerable uncertainty about the likely strength of the upturn” once government supports were withdrawn.


So lets put this all together for those who can't actually see the PONZI scheme. The big banks are making huge profits again and folks are getting their bonuses. But they are cutting back giving out credit, so the money is being made by trading. Even though this is happening, it is too early to tighten rates so the big banks would actually have to pay for the money from the discount window to buy assets. This of course allows for huge leverage of asset price purchases for nothing. Thus really only benefiting people who own lots of stocks. In fact even though they are making profits the fed is going to keep buying their toxic assets with your tax money. Meanwhile your dollar in your savings account has dropped to a 14 month low and you aren't getting any interest to make up for it.

Now we add to that a President who said certain things during his election that turned out to be complete lies. Instead he appoints the head of the NY fed, who lies and said he has never worked on wall street (yet working for the NY fed is the same as working for wall street). Well what would you expect he is a tax cheat. To avoid appear as the out right liars they are and to avoid senate confirmation issues he appoints counselors who have made their money on wall street. "Back door appointments".

Lastly with their unlimited financial power and inherent advantage due to lobby money the American chamber of commerce starts a propaganda campaign to ensure that any and all reform efforts that would actually help the majority of people don't get enacted. This way our liar of a president can claim he got the bills done and had to make concessions to the right, when his treasury has been bought and paid for all the time. See the great majority of what you see is theater for your consumption designed to prevent you from putting two and two together. All along the White house was going to give industry what they wanted (because they have been bought and paid for). Industry fights a campaign of extreme positions asking for much more than they want. Then the president can claim victory for the little guy when he is getting nothing.

You see folks, the whole system is designed against you. This isn't democracy. It is a fictional theater designed to make you ever poorer while the wealthy stay in power and get richer at your expense.

For those people who call the folks bringing their fire arms to meet their elected representatives "crazy", well they aren't they are the rational ones who see what is going on and are tired of it. Does anyone really have the balls to say that our government is a legitimate representative democracy. It isn't.

Oct 15 08:53 AM

[dcb:]

Note from the graph above the greatest period af american strenght was when the financial sector siphoned off the least amount of capital

Oct 15 08:54 AM

[dcb:]

If you take a look at this articleyou will see a graph. That graph clearly shows that a decline in united states power is directly correlated to earnings in the financial sector. weaker currency, excessive leverage, excessively cheap credit= excessive profits. The things that help out wall street hurt this country, but because of excessive power and influence you don't hear this. The American people are in conflict with their own government, they just don't know it.

My theory is this meant more money was actually going to productive investment capacity instead of being paid to the folks who just shuffle the money around skimming off what would be other wise better served in productive uses. This is the difference between a financial sector that serves the country and one that serves themselves.

Note also that in both cases we had financial crisis. Look at the years, the pay. This episode and the great depression. Maybe there is something inherently unstable about the system that allows so much excess profits.
The conditions that allow the creation this wealth disparity are inherently unstable. Yet our government wants to bring it back!!!

Note that the pay level distortion took off at exactly the same time as securitisation. When debt to GDP ratios took off and increasing amounts of debt did not increase nominal GDP. An excessively profitable financial sector is inherently unstable and bad for 99% of the country. The conditions that create the profitability create instability. Knowing what you now know is it any wonder these pundits keep saying what they do. All that concerns them is their excessive profitability, not america. They see we need securitisation for growth, the exact opposite is in fact the case. they need securitisation for excessive profitability. This creates instability. Austrian economics understands this, which is why they aren't allowed in our government and you don't see much of them working for corporate controlled media. It doesn't matter if they are fresh or salt water economists because this keeps the liquidity flowing. Of course the mountain economists (Austrian) take it away. Therefore you have a government, media, industrial bias on the information you hear and those that advocate these positions move up the ladder. After all they keep the party going!!!!

Oct 15 09:22 AM

[Harry Tuttle:]

We have become a "Dow Jones centered" society. Peyton Manning would not be a star if nobody cared about Football.

The idea that stock prices are a reflection of our well being is deeply ingrained and transcends Wall Street.

Oct 15 12:19 PM