Thus, in "quiet" periods...writers of options will make what appear to be positive excess returns...However, in relatively infrequent, "active" periods, the writers will suffer large losses...
Even if top management wants to maximize long-term bank value, it may find it difficult to create incentives and control systems that steer subordinates in this direction. Given the competition for talent, traders have to be paid generously based on performance. But, many of the compensation schemes paid for short term risk-adjusted performance. This gave traders an incentive to take risks that were not recognized by the system, so they could generate income that appeared to stem from their superior abilities, even though it was in fact only a market-risk premium. The classic case of such behavior is to write insurance on infrequent events such as defaults, taking on what is termed tail risk. If a trader is allowed to boost her bonus by treating the entire insurance premium as income, instead of setting aside a significant fraction as a reserve for an eventual payout, she will have an excessive incentive to engage in this sort of trade.
Andrew Lo, a professor at the MIT Sloan School of Management, imagines a confrontation in 2004 between the head of Lehman and its chief risk officer. Forseeing a catastrophe ahead, the risk officer proposes shutting down the mortgage business, but his boss threatens to sack him on the spot. He suggests cutting back, but the boss counters that his competitors are expanding and his best people would be poached. He mentions hedging the risk, but his boss retorts that in the next two years that will cost hundreds of millions of dollars of lost profits.
The individuals who were running large financial institutions had an opportunity to pursue strategies that resembled, in terms of their reward structures, going short on extreme market volatility. Those strategies paid off for years, but ended in disaster. Until the volatility actually arrives, this trading position will appear to yield supernormal profits, and indeed, the financial sector was enormously profitable until the asset pricing bubble burst.
Indeed the financial sector had incentives to take risks that combined a large probability of an above normal return with a small probability of disaster. If things could be designed to make it likely that the disaster would occur sometime in the distant future, so much the better. The net return could even be negative, but no one would know it until it was too late. Modern financial engineering provided tools to create products that perfectly fit this description.
An example may illustrate. Assume that one could invest in a safe asset with return of 5 percent. The finance wizards designed a product that yielded 6 percent almost always-say 90 percent of the time. Magically, they seem to have beaten the market, and by an amazing 20 percent. But in the remaining 10 percent of the time - everything was lost. The expected (average) return was negative (-4.5 percent), far below the 5 percent of the safe asset. But, on average, with the bad returns occurring only one year out of ten, it will be a decade before the disastrous outcome occurs - a long time during which the financial wizards can reap ample rewards from their amazing ability to beat the market.
The disaster that grew from these flawed financial incentives can be, to us economists, somewhat comforting: our models predicted that there would be excessive risk-taking and shortsighted behavior, and what has happened has confirmed these predictions. ...The misalignment between social and private returns was clear: financial marketeers were amply rewarded but had engaged in such egregious risk-taking that, for the economy as a whole, they had created risk without reward.
Don't blame the quants: Steve Shreve
The financial meltdown Philip Protter
Variable Annuities : A great way to book short term profits (and get paid large bonuses) and let your shareholders take the losses.
The Credit Crunch of 2007: What Went Wrong? Why? What Lessons Can Be Learned: John Hull
Comments on the financial sector Luigi Zingales, Chicago