In the wake of the economic scandals of 2008-2009 and more recent events like the JP Morgan’s “London Whale” losses the media has directed substantial scrutiny at trader compensation and the role it plays in trading losses. This discussion has focused on one point: traders who are paid primarily via bonuses are paid both for performance (which is arguably good) and for volatility (which can cause havoc).
Consider a trader managing a $100M portfolio who is paid $300K per year plus 15% of each year’s profits. Clearly this trader has what amounts to a cash settled call option on the portfolio. If the portfolio makes money, he gets 15%. If it loses money, he loses nothing. It’s easy to see how this could warp the trader’s behavior in the direction of taking excessive risk anytime the portfolio was close to break-even as the year end approached. Taking a 20% coin flip at the end of a break-even year would result in an expected profit of $1.5M for the trader (half the time he wins $3M, half the time he gets no bonus) and an expected loss of $1.5M for his employer/investors (who would win $17M after fees half the time, and lose $20M the other half of the time).
This phenomenon is undeniably real, and anyone designing the compensation packages for traders would be wise to take it into account. But I would argue the media discussion of the topic misses one central fact: traders don’t like to get fired. This rather common-sense aversion on their part goes a long ways towards explaining certain market events. More importantly it can directly put money in your pocket once you know what to look for.
The obvious question of course is what causes traders to get fired. And the answer is losses in their portfolio/book. But not all losses are created equal. Size matters of course – losing 1% of the portfolio value isn’t near as bad as losing 30%. The nature of the loss matters too – losses where you had a lot of company or could plausibly blame the loss on some other person or unexpected outside event are much less likely to generate a pink slip than losses where the blame cannot be shifted.
This can create absurd situations wherein traders are eager to take “good” losses before they can turn into “bad” losses. I’m not referring to the general practice of cutting losses short with a stop order here. I’m referring to a trader being more willing to take a loss when there’s a pink-skip-proof excuse than when there isn’t. A great example of this behavior can be seen in the bonds of British Petroleum during the Deepwater Horizon oil spill crisis. The yield on their medium term bonds spiked to over 6% above zero risk rate. Some municipals BP had insured spiked to as much as 8% above zero risk. They had been trading at less than 1% above zero risk prior to the accident. The post-spill yields are notable because at no time was there any realistic chance of a bond default. Certainly the accident has cost BP a lot of money, and will cost them a lot more before all the litigation is resolved. But the equity share of the company and the high liquidation value of their equipment, oil leases and the like insured that there was no way a default could occur.
Given that information, BP bonds should have been nearly as valuable during the spill as they were before. Yet as previously mentioned their yields spiked precipitously. So what happened? The answer is that before the spill you could not be fired for holding BP bonds. After the spill, you could be. In order to understand what changed, you have to know a little bit about BP’s bonds and who was buying them.
In the world of corporate bonds, there are a few favored companies whose bonds trade at only a tiny premium to the zero risk of return. In the US bond market right now, the most notable example is IBM. BP was the same for the London markets before the spill. It’s interesting to note that these favored firms are mostly selected for longevity, not for perceived risk. For example any rational assessment would say that the technology sector is unusually prone to the decline of apparently monolithic firms. DEC, anyone? Yet IBM remains one of the chosen few.
What makes these bonds useful to money managers is perception: they are perceived as being so gold plated that, were something to go wrong with them and losses occur, the portfolio manager could claim he had been beset by unpredictable bad luck and likely avoid being fired. From the perspective of a portfolio manager, especially the less adventurous types that infest pension funds, this sort of bond is invaluable regardless of yield. Earning more yield does not get one a salary increase, but buying higher yielding bonds could get you fired. That’s a no-brainier decision. Of course, once the spill occurred the perception changed. BP was no longer gold plated, and the smart manager had to sell (and buy IBM or T-bonds instead) lest he take further losses that could not be blamed on bad luck. From the manager’s perspective, the price at which he sold BP bonds was almost irrelevant – what mattered was that they were sold ASAP, so the loss could be blamed on the freak wellhead explosion rather than the portfolio manager.
If pension fund managers have incentives to sell when a bond loses its luster, you might imagine that various institutional traders with more balanced compensation schemes would be eager to buy. After all, a trader with a profit incentive bonus has every reason to buy BP bonds at an 8% yield, because when they go back to 4% his firm will make a killing and via the bonus he will make a sub-killing. Yet this happens less often than you might think. While this type of trader has incentives for doing the right thing, the disincentive of potentially being fired is still there. And traders at major institutions are supremely attached to their jobs – I’ve heard it described as “the only job worth having” more than once. Hyperbole or not, the attachment is real. And a big bet on a “distressed” asset that goes sour is one sure way to find yourself without the only job worth having. The typical result is that trading decisions about distressed assets get deferred or kicked up to management who wants even less to do with it than floor traders do. Thus the killing all too frequently goes un-made.
This is where independent and retail traders can and should step in. The nice thing about being a retail trader is that no one can fire you. You can run out of money, but that’s not the same thing, especially if trading is a side job rather than your primary source of income. So whenever you see an asset class that looks bad enough fund managers could be fired for continuing to own it, you should seriously look into buying. This isn’t a substitute for due diligence of course – some things really are so toxic you should want no part of them at any price. But you owe it to yourself to look, because as a retail trader you have an advantage the big boys can’t match. In general the opportunities are more plentiful in the bond market than they are in stocks. BP bonds were WAY more mispriced during the crisis than BP stocks. This is because bond fund managers are way more conservative than stock fund managers.
So when the press around a previously high-flying firm gets remarkably bad, look to see if they’ve got some once gold-plated bonds that are now inexplicably cheap. You might just make a killing of your own.