Monday 17 March 2014

The hidden cost of employing boy geniuses is the symptom of Partnoy's Complaint

To lose $377m in one day's trading may still be a record. It was set by a bright young man in Merrill Lynch's New York office, who took a view about principal-only mortgage strips (don't ask - no one else did) and guessed wrong.

"It just goes to show," said Stani Yassukovich, chairman of Merrill Lynch Europe, "that the cost of employing boy geniuses is higher that it seems."

In the fifteen years that have followed, repeated attempts have been made on this record, with higher qualifications being brought to bear on new financial technology. Long Term Capital Management went so far as to use Nobel prizewinners, whose trading strategies, so they believed, would see the universe out. The universe outlasted them.

Now Warren Buffett, the sage of Omaha, suggests that the record is there to be broken. Misplaced ingenuity, he says, has enabled companies to arm themselves with financial weapons of mass destruction. Worse still, these weapons are easily disguised or moved around, so the inspectors, toiling after them, may never spot them.

Professor Frank Partnoy agrees with him. Companies' accounts have become so complex, he says, and the values in them so arbitrary, and so much is simply left out that neither the regulators nor the shareholders can follow what is happening.

So senior managers and star performers learned how to manipulate the figures to their own advantage, and learned again from each others' example. Looking back, Alan Greenspan found the words for it: "An infectious greed," he told the Senate banking committee, "seemed to grip much of our business community."

Mr Partnoy's account* charts the course of the infection, which might be called Partnoy's Complaint.

It began innocently enough. None of these new markets in new kinds of financial instruments could have grown up unless companies wanted to use them to measure and limit their risks. A new troupe of performers sprang up to meet the demand, and some of them came to earn fortunes, or were paid them.

At JP Morgan, Sir Dennis Weatherstone would give his bright young men three chances to explain what they were doing - but if they could not make him understand it, they were not allowed to do it.

Other bankers, with less reason, were less modest. Peter Baring believed that Nick Leeson's operations were essentially risk-free and very profitable. He was as wrong as could be, on both counts, and the misjudgment broke Barings.

Enron lived by financial ingenuity and perished by it. Helped by resourceful advisors and blessed by complaisant auditors, it aspired to be world's greatest company and made fortunes for those who were close to it - though not, in the end, for its shareholders.

Partnoy's Complaint had spread from the financial markets to their corporate customers. At the height of the frenzy, a successful share-pusher could expect $100m a year, but the chief executive of the company whose shares he was promoting could have salary and options worth as much.

One measure of the chief executive rewards was given by William McDonough, president of the Federal Reserve Bank of New York. In a single business generation, he said, these rewards had grown 10 times as fast as the average level of earnings in America.

Today's chief executives might be better than their predecessors but they certainly were not 10 times as good.

They were made to look good by the growth in their company's earnings, and they were rewarded by stock options tied to the share price. On one view, this was their incentive to fiddle the earnings so as to keep the price rising. The higher it rose, the harder it fell.

In that bygone era, values were driven forward by a general will to believe. A rising share price served, in itself, as an answer to doubters. This circular argument was dignified by the name of "momentum investment". It showed that investors, too, could catch Partnoy's Complaint.

They have now been cured, or at any rate immunised. "Public trust in stock market investment, either directly held or indirectly held through pension funds and insurance policies, has fallen in parallel with the markets," says Alastair Ross Goobey, who could claim to be the thinking man's investment manager.

He asks whether better behaviour by company executives and investment professionals could put matters right and restore trust. It can, so he told the Securities Institute - so long as the professionals ask the right questions. They should raise their eyes from the next set of quarterly earnings and focus on strategy and on the people in charge of the company.

The analyst who summed up one of Robert Maxwell's companies with an acronym - Can't Recommend A Purchase - saved his followers a lot of money.

In a new era such old-fashioned virtues as good character and hard-earned reputation would count for as much as a manipulable set of numbers. Cash would continue to tell the truth.

As for the price of chief executives and boy geniuses, that, too, would find its own level.

*Infectious Greed. Frank Partnoy. Profile Books, £20.

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