Infectious Greed: How Deceit and Risk Corrupted the Financial Markets
by Frank Partnoy is a fascinating book. Partnoy describes how the ever raising performance-related bonuses for brokerage bankers in the 1980s lead the brokers to create a succession of schemes to inflate bonuses.
The early waves of this phenomenon was in the dervatives business. Derivatives are financial instruments the payoff of which is determined by other factors. The stated purpose of a derivative is to sell the risk related to something to someone who is better prepared to handle it.
Dervatives can be linked to everything like from the price of a stock (options), the future price of a commodity (futures), the relative exchange rates of two currencies, or interest rates. Derivatives can even be linked to things like the weather. Now, weather derivatives may sound like nothing more than gambling, but in fact, industries like hydro power plants, farming, and travel depend critically upon the weather.
The real problem comes from the fact that when you sell risk, it is very hard to find someone who is really in a better position to handle it. As all derivatives are null-sum games, this means that it is in practice a gamble that big financial insitutions are allowed to make with the money they hold. Examples include mutual fonds, pension fonds, insurance fonds, and municipal authorities.
Around 1990, derivatives were made more and more complex. Buyers of derivatives were making money, but no one could predict how changes in for example the federal interest rate would affect people. Around 1992, the tables turned, and many investors learned the hard lesson of gambling: The house always wins. The house was the brokerage banks. The losers included for example Orange County, California, which went bankrupt from its investments in derivatives linked to the federal interest rate.
So, in the mid-90s, investors were scared off of derivates, and the brokers needed a new scheme to get their multi-million bonuses. What had made derivatives good was this: It was extremely difficult to assess their risk and value. Investors considered the only safe bets to be in stocks. So, the brokers wanted stocks whose value and risk was very hard to assess. Enter .com.
Partnoy provides a convincing explaination of the .com-phenomenon, which is very sobering to technologists: No-one never believed we could produce the values we thought they believed in. No-one never believed in us. We were just pieces in the game to deceive investors with financial instruments whose risk and value were hard to assess.
The book is depressing, sobering, and upsetting. The attitudes Partnoy describes are disturbing and sickening. The book is very well written, and reads easily. I guess the moral of the story is: There is no such thing as a free lunch. You always pay in the end.