9

Picking Up Nickels

Let’s return to the metaphor of the poker table. As a player sitting at the table drawing a salary based on your performance and able to enhance the measure of your performance by leveraging the money of your investors with borrowed money, what is the ideal investment?

A high-risk, high-return investment has drawbacks. If you draw to an inside straight with borrowed money, you will sometimes win a very big pot. But most of the time, you’ll lose and be unable to pay off your loans. Then you’ll lose your seat at the table, be unable to draw a salary, and have a harder time getting a seat in the future. And if creditors believe that their ability to be repaid depends on the reasonableness of the investments to which they lent money, a player who keeps drawing to an inside straight may have trouble attracting funds.

A much better approach is to look for investments that have a small risk of failure (even though the consequences of failure are catastrophic) and a small return. No one loves a small return, but leverage improves the overall return of such a portfolio. That was part of the appeal of mortgage-backed securities.1

On Wall Street, the practice of making small amounts of money on a lot of transactions while knowing that eventually the whole thing can fall apart and you might get flattened is called “picking up nickels in front of a steamroller.” Picking up nickels in front of a steamroller is a very appealing game.2 True, the steamroller might get you. Your firm might die. But you live to earn another day (especially if everyone else was doing the same thing). And while you’re picking up the nickels, you look like a genius. Year after year you make excellent rates of return justifying a very large salary and bonus. The ideal bet for the poker player playing with other people’s money and drawing a salary isn’t just a risky bet. It’s a risky bet with a low chance of disaster and high chance of a modest return.

Long-Term Capital Management’s strategy was picking up nickels—making very small amounts on arbitrage opportunities with very high leverage. The steamroller did get them in 1998. But they made a lot of money along the way for their executives and for their creditors who got rescued or at least partially rescued—and that was just one firm picking up nickels. When everyone is picking up nickels in front of the steamroller, the odds of a complete rescue are higher. So when a bunch of firms got flattened, Uncle Sam came to the rescue, using taxpayer money to cover the hospital bills.

As in the Fannie and Freddie story, the real financers of the salaries associated with picking up the nickels aren’t the firms. The taxpayers are ultimately funding the picking up of the nickels, and the taxpayers get flattened. The executives at the firms that manage to pick up just the right number of nickels and stay ahead of the steamroller (Goldman and J. P. Morgan) make ridiculously enormous amounts of compensation. The executives at the firms that get steamrolled (Bear Stearns, Lehman, Citibank, etc.) just make an enormous amount of money. The real risks are borne by you and me.

NOTES

  1.  See Macroeconomic Resilience, “A ‘Rational’ Explanation of the Financial Crisis,” working paper, 2009, http://www.macroresilience.com/wp-content/uploads/2009/11/A-Rational-Explanation-of-the-Financial-Crisis.pdf, for an explanation of the attractiveness of negative skewness—payoffs where there is a high probability of a small positive return and a small probability of catastrophic losses. Small returns are unpleasant, but enough leverage makes them tolerable. And as long as the catastrophe doesn’t materialize for a while, you can look prudent and respectable playing the game.

  2.  This helps explain the seemingly absurd explosion in the synthetic CDO market and the credit default swap market. Once Wall Street figured out how to manufacture AAA-rated securities, it was inevitable that someone would get flattened.