The Power of Nothing to Lose — William Silber
The Power of Nothing to Lose — William Silber
What would you do if you had nothing to lose? In The Power of Nothing to Lose, William Silber explores what happens when people find themselves in situations with big upsides and limited downsides. But big risks don’t always yield big rewards — at least, not without consequences … In this episode, Silber discusses the Hail Mary effect, risk management and other themes from his latest book with host Charles Mizrahi.
- An Introduction to William Silber (00:00:00)
- Hail Mary Effect (00:04:09)
- Upside vs. Downside (00:10:21)
- The Volcker Rule (00:22:50)
- Leverage Kills (00:30:07)
- Preventing Bad Behavior (00:39:09)
- History Repeating Itself (00:45:55)
- Flattening the Skew (00:48:17)
William Silber is a bestselling author, former professor and senior advisor at Cornerstone Research. Silber was a Marcus Nadler Professor of Finance and Economics at New York University’s Stern School of Business. And he was a three-time winner of the Professor of the Year award at Stern.
In addition, Silber has written eight books about financial history and economics. His latest book is below. It details the Hail Mary effect and how people are incentivized to take abnormal — and potentially dangerous — risks.
Before You Leave:
WILLIAM SILBER: The Hail Mary strategy allows people to take normally abnormal risks. In fact, they prefer big risks because the big payoff at the end — winning the game — dominates the downside — which is another interception.
CHARLES MIZRAHI: My guest today is William Silber. Bill is the former Marcus Nadler Professor of Finance and Economics at New York University’s Stern School of Business. He’s a three-time winner of the Professor of the Year award at Stern. And he’s currently a senior advisor at Cornerstone Research.
CHARLES MIZRAHI: He’s also a bestselling author and has written eight books about financial history and monetary economics. His latest book is, The Power of Nothing to Lose: The Hail Mary Effects in Politics, War, and Business.
CHARLES MIZRAHI: I recently sat down with Bill, and we talked about what happens when people find themselves in situations where there’s a big upside and limited downside. How can triggers of gambling behavior — like a Hail Mary — lead to terrible decision-making?
CHARLES MIZRAHI: Bill, thanks so much for being on the show. I greatly appreciate it. I really enjoyed your book. The name of the book is, The Power of Nothing to Lose: The Hail Mary Effect in Politics, War, and Business. Thanks so much, Bill.
WILLIAM SILBER: It’s my pleasure to be here, Charles.
CHARLES MIZRAHI: OK, Bill. Until we spoke last week, I didn’t know that you and I might have crossed paths close to 40 years ago on the floor of the New York Futures Exchange.
WILLIAM SILBER: That is correct. I was a professor at NYU. And I had done a whole bunch of research on how market-makers make a living. I was on the floor of the New York Stock Exchange, and I went to the Bankers Trust trading room — where half of my students were. I sat down and watched what they did. And finally, I said: “I think I can make a living doing the same thing!” So, when the New York Futures Exchange opened — I think it was 1982.
CHARLES MIZRAHI: That’s right, it was.
WILLIAM SILBER: I took my $15,000 — which was close to my entire net worth at the time — and said: “Let me go down there and see if I can trade.” I quickly learned that I didn’t know what I was doing until some guy said: “Hey, listen. Don’t think you know which way the market is going. What you have to do is quote a bid and an offer. Let it live for about 12 or 13 seconds. Buy at your bid. Sell at your offer. And if you can’t do that, let the trade go away. Wash the trade.” And once I learned not to think that I knew which way the market was going, I made a nice living.
CHARLES MIZRAHI: Yeah, that’s great.
WILLIAM SILBER: Goldberg Brothers was a big clearing firm on the Chicago Board of Trade.
CHARLES MIZRAHI: When did you leave? You left in May of 1982?
WILLIAM SILBER: I started within a month of when the [New York] Futures Exchange opened. About a year later, I went to COMEX. And then, I went to the to the New York Merc. At COMEX, I traded gold and gold options. And on the Merc, I traded crude oil options.
CHARLES MIZRAHI: All right. I remember I was down there in May of 1982. That’s when I started.
WILLIAM SILBER: We definitely crossed paths. We might have been yelling at each other.
CHARLES MIZRAHI: It could be. Maybe I hit your bid one day. But all right. Who knows?
WILLIAM SILBER: If you hit my bid, I would have liked you.
CHARLES MIZRAHI: You said you made a nice living. And I was definitely not a grate floor trader when I got there. That’s for sure. All right, Bill, you put together a book about the Hail Mary effect. So, before we go on any further, what is the Hail Mary effect?
WILLIAM SILBER: Well, almost every American knows the Hail Mary — even if they’ve never watched a football game. My wife knows about the Hail Mary, and she never watches football. I use Aaron Rodgers because he’s quite famous for the Hail Mary pass. At the end of a football game, when the Green Bay Packers are losing by less than a touchdown, are on the 50-yard line and there’s no chance that they can that they can get a touchdown in a normal way, Aaron Rodgers gets in the huddle and says: “Everybody run into the end zone, and I’m going to throw a pass.” And hopefully, one of those people would catch what is now known as the “Hail Mary” pass.
WILLIAM SILBER: It became known as the “Hail Mary” pass in the early 1970s with Roger Staubach. Roger Staubach was a quarterback for the Dallas Cowboys. In one of the playoff games, he was losing, and they threw a pass into the end zone. Drew Pearson caught it. And the reporters gathered around at the end of the game and asked: “What happened?” [Staubach] said: “I got into the huddle, threw a pass, got knocked down and said a few Hail Marys.” And it became an American icon. It was an act of desperation that allowed someone to take what is normally an unthinkable risk.
WILLIAM SILBER: Aaron Rodgers and Roger Staubach didn’t throw the ball up in the air. They didn’t like getting intercepted. But at the end of the game, they had what I call “downside protection.” What does “downside protection” mean? They’re going to lose anyway. So, what if they have an interception? It’s meaningless. The big upside is that they can win the game. The Hail Mary strategy allows people to take normally abnormal risks. In fact, they prefer big risks because the big payoff at the end — winning the game — dominates the downside — which is another interception.
CHARLES MIZRAHI: Basically, you just described an option — which is an asymmetrical bet or lottery ticket where you have minimum downside. You buy a lottery ticket for $1. And if it hits, your maximum upside is a zillion dollars. And if it doesn’t, you would never do that with your whole paycheck. But you’re doing it with a small amount because the risks are against you. And really, what’s the worst that could happen? You lose $1.
WILLIAM SILBER: Perfect, Charles. You read the book and understood it better than I did when I started. Actually, the way this got started was during part of a class I was teaching on investments. How do you choose between stocks, bonds, real estate and so on? And then, I wanted to introduce options — which is normally a tough topic. There’s a lot of math.
WILLIAM SILBER: So, I designed a fun contest. And this was after the students were all beaten up by math. I designed a contest that said: “Look here, guys. I’m going to give you a list of 10 stocks/bonds.” I said IBM back then. I said crude oil, Treasury bonds and so on. “I’ll give you a list of 10. If you pick the winner — the one that has the biggest profit at the end of the semester — you’re going to get 1.5 points added to your final grade. And if you pick a loser, nothing happens. Except, you get sympathy.”
WILLIAM SILBER: So, the question is: “How should you choose?” Most students think they know something. They say: “I think this. I think that.” They guess. You and I know that guessing is a very bad strategy. But there’s an optimal way to approach this. And that’s by looking at the asset — which is the riskiest. What’s riskiest? The biggest upside and downside — like crude oil back then and Bitcoin today. Why do you choose the riskiest? Well, the upside gives you 1.5. The downside costs you nothing. The payoff is skewed.
WILLIAM SILBER: There’s big upside — 1.5 points — and zero downside. Therefore, the optimal strategy is the riskiest security. You and all your listeners know that this is why the premium on an option with the biggest volatility of the underlying asset is the biggest. It’s attractive because you get upside without downside.
CHARLES MIZRAHI: OK. Let’s not even get into deltas, gammas, betas and all things options.
WILLIAM SILBER: I forgot everything you just said.
CHARLES MIZRAHI: Outstanding. Good. Let’s put it this way: When the chips are down — and they have nothing to lose — people behave in ways that they wouldn’t on a regular Monday morning. Agreed?
WILLIAM SILBER: That’s a perfect way of saying it succinctly.
CHARLES MIZRAHI: OK, excellent. That’s why they pay me the bucks. By the way, when my kids were in school, they would have stock market contests. Over X period of time, you’d pick a stock, win and they’d give you a certificate or something. They always used to come and say: “Dad, you do this for a living. You manage money. You know stocks. Give me a stock.” And I refused to give them stocks. I said: “This is encouraging terrible behavior.” They asked why. Then, I started to explain that stocks were pieces of a business. They didn’t want to hear any of that.
CHARLES MIZRAHI: But my point is that these so-called contests encouraged behavior that could lose you a fortune in the real world. You’re going to go for the maximum upside without caring about the downside. And you’re playing a game — literally — about getting the most in the shortest amount of time. So, it teaches you nothing. It will teach you nothing about stocks. As you mentioned with the example — If I were in your class today and picking in a contest, I’d pick Bitcoin, Ethereum or any of the other small ones because those could move 30% to 40% a week. What’s my downside? What did it teach me? It taught me to take risks.
WILLIAM SILBER: You’re absolutely right. And in fact, I tell a story about a contest at TD Ameritrade in this book. [There were] holds among all college students. They had 500 teams. And the team that won in 2015 chose the riskiest portfolio. Why? They said: “The biggest upside is the risk. The downside? Who cares if we lose money?” So, it’s a bad lesson for investments. However, it’s a good lesson for things that have optionality and skewed payoffs.
WILLIAM SILBER: When you have a skewed payoff — it’s like the end of a football game. I’ll give you another sports example. It’s not just at the end of a football game. When a batter has a 3-0 count in baseball, what does the manager sometimes do? They give the batter a green light. What’s the green light? You have the option to swing at the next pitch, but you don’t have to. Mike Trout, who was a three-time MVP winner, said: “When I get up there, it’s 3-0 and I get the green light, what do I do? I swing as hard as I can. Why is that? I want to belt that out of the park. What’s the downside? A strike.”
WILLIAM SILBER: So, when you’re confronted with a skewed payoff, the best strategy is to choose the riskiest outcome. And if all of the costs of the downside are borne by you, there’s no problem. The big problem occurs when there’s collateral damage because others bear the costs of your reckless behavior. And there are many instances in history where that has caused huge destructive effects.
CHARLES MIZRAHI: Let’s talk about huge destructive effects because at the end of this conversation, we’re going to try and discuss how to harness this — when it should and shouldn’t be used. Because if you don’t know the difference, you could cause a hell of a lot of trouble.
CHARLES MIZRAHI: In 2005, 2006, 2007 and 2008, most investment banks were getting paid by producing instruments of mass destruction — derivatives — that they manufactured for investors, institutions or what have you. They got paid huge amounts of commission. And when it blew up, there was no damage to the person who put it together. He got paid his commission. He was probably out of there by then. It almost took down whole financial systems when the risk for the individual was zero.
CHARLES MIZRAHI: So, I want to formulate a question about that. When dealing with other people’s money, what types of circuit breakers can you put in place so you don’t put people in a tempting position? Heads, they win. Tails, they win a little less. You want them to have heads, they win, and tails, they lose.
WILLIAM SILBER: All right, Charles, let me broaden that a bit. And we’ll come back to your basic question. Whether it’s an investment or commercial bank, the distinctions are almost nonexistent. But if you look at a trader for a bank, they normally have a small salary. They also get a bonus. A bonus for doing what? They earn a big profit for the bank. This produces the same identical skewed payoff that we’re talking about. Why? Because if the trader puts on a risky position and there’s a run-up in the asset that they bought, they get a big bonus. But what happens if the stock price or asset goes down? He loses money, but he never has to repay the bank for the losses.
CHARLES MIZRAHI: So, how do you prevent that? We know this, right? We know that when you put people in a position where they get enormous rewards for the Hail Mary pass and there are no repercussions — well, sometimes there are. The guy might get fired. But then, he’d get another job somewhere else.
WILLIAM SILBER: That’s exactly right.
CHARLES MIZRAHI: So, what sorts of deterrents do you put into place that prevent this type of behavior? Because it could create a reckless environment. It could create the collateral damage you mentioned. They almost brought down the financial system in 2008. And it will rear its ugly head again when we keep offering these types of incentives. Tell me how to put the brakes on this.
WILLIAM SILBER: Let me give you the first line of defense. The first line of defense is the company itself. The bank itself knows that traders are incentivized to take big risks because they have asymmetric payoffs. So, they don’t let any old jerk sit a trading desk and do whatever they want. They’ll be bankrupted before they turn around. So, they monitor. Management always has an incentive to monitor traders. To do what? Take prudent risks. When you’re about to lose too much money, take the position off. Banks want to stay in business. And if they want to stay in business, they’re going to monitor their traders.
CHARLES MIZRAHI: Let me stop you right there. The first thing you’re telling me is pretty common sense. Every institution that gives people discretion to trade money in capital markets has a system for monitoring risks. We’ve seen the way this doesn’t work. And most of the time, it doesn’t work — especially if that particular trader happens to be a tremendous earner. You close your eyes to it.
CHARLES MIZRAHI: We had Jim Campbell on the show a few weeks ago. He wrote the book Madoff Talks. He was the guy who had access to Bernie Madoff — the Ponzi scheme emperor. No one ever did what this man did. And he was monitored by so many — especially by J.P. Morgan. They were the guys handling these assets. And if they would have checked, they’d have seen it was impossible. Yet, since Bernie was providing so many fees for the bank, there were internal memos that said: “Lay off the guy.” So, what happens when the incentive to make more money for the institution gets in the way?
WILLIAM SILBER: Let me broaden it a bit. The bank could surely monitor as deeply as it wants. It could cut you off. Do not take that position. What’s the problem? The problem is the bank likes the upside and doesn’t want the downside. But it will indulge a great trader. It will indulge a great trader to capture the upside, and it believes it can monitor the downside — even though there are occasions when it can’t. It can’t, won’t do it or gets caught before it’s able to monitor it.
WILLIAM SILBER: And by the way, this has undone many. Barings was a 200-year-old bank that helped Thomas Jefferson finance the Louisiana Purchase. It was undone by a rogue trader — Nick Leeson — in 1995. They monitored, but they liked his profits too much. And therefore, they were slack and let it get out of hand.
CHARLES MIZRAHI: Okay, so how do you solve that problem?
WILLIAM SILBER: There are two solutions. One, you can tell bank management: “If you lose more money than your total capital this year, we’re going to put the CEO in jail for 20 years.” If you did that, I guarantee the CEO would put a manager in place on the government bond trading desk — on the proprietary trading desk — who would monitor. Or, the CEO would say: “Guess what? No more proprietary trading. The only thing you can do is quote bids and offers. And you’d better go flat.” Flat means what? No positions at the end of the day. If you punish the CEOs enough, I guarantee you they will find a way to be effective monitors.
CHARLES MIZRAHI: OK. Maybe that works in Disneyland. But in the real world, tell me how we’re going to do it.
WILLIAM SILBER: In the real world, Congress will never pass a law that puts CEOs in jail for 20 years if they lose too much money. But it sometimes has the guts to pass a law that says: “Banks are forbidden from proprietary trading.”
CHARLES MIZRAHI: That’s the Volcker Rule.
WILLIAM SILBER: They did under the Volcker Rule. The Volcker Rule says that banks can’t do proprietary trading. Does that mean proprietary trading disappears? The answer is no. It goes to an unregulated sector where everybody knows the risks — like hedge funds. So, you push the really dangerous trading to an area where there are both upsides and downsides.
WILLIAM SILBER: The people who put their money into hedge funds — Bill Hwang, who managed Archegos, lost the family jewels. And he also caused big losses at major banks that lent him money. And they, in fact, suffered the consequences of wanting the upside.
CHARLES MIZRAHI: OK, let me interrupt for a second to get our listeners [up to speed]. He was a trader who lost $20 billion in a heartbeat. He lost $20 billion in a pretty short span of time — I think was a couple of days or so. He was going to banks and borrowing money for them. The banks were on the hook because they wanted this guy’s business. They make money on fees, interest and so on and so forth. And they indulged him even more.
CHARLES MIZRAHI: While his bets on the market didn’t pay off, they got caught holding the bag. And here’s what’s amazing, Bill. I’m not telling you anything you don’t know. This was not the first time he burned people. This was the second time he burned people. He has a history of doing it. But the incentive — on behalf of institutions — to make more money overrides rational thinking.
WILLIAM SILBER: I wrote a biography on Paul Volcker. And I was around when he was talking to Congress about the Volcker Rule. In fact, when it was passed, there was screaming and yelling, “This is un-American! How could you let this happen?” At the time, I thought his answer was overkill. You can’t let them do anything? The answer is: “Push it to a sector that is not subsidized by the government.”
CHARLES MIZRAHI: But here’s my point. I hear what you’re saying, and I am totally with you — in theory. By the way, didn’t Paul Volcker’s son go to NYU — where you taught?
WILLIAM SILBER: Yes, he was in my class.
CHARLES MIZRAHI: There you go. OK, good. Hope you gave him a good mark. His dad is Paul Volcker.
WILLIAM SILBER: Nah, he didn’t do so well. But go ahead.
CHARLES MIZRAHI: Oh, goodness. All right. And Paul Volcker is a big guy. What is he? Is he 6’7 or so?
WILLIAM SILBER: Yeah, he’s a big guy. But you know what? He doesn’t interfere. He says: “You’ve got to stand on your own two feet.”
CHARLES MIZRAHI: Wow, you’re some professor. I only went to college for a couple of months — and definitely not at NYU. I went to Brooklyn College for about a year.
WILLIAM SILBER: That’s a good school.
CHARLES MIZRAHI: I didn’t stay. This was there in 1979 and 1980. Inflation was running rampant. Stagflation was crazy. And a professor was sitting there in our lecture hall speaking about how the economy should change. And I said to myself: “What am I doing in this class? I’m listening to some guy who’s a professor. He’s not doing this but talking theory. Let me go out into the real world.” And then, I started trading. I realized that everything I learned went out the window. But OK. Put that all aside. I digress.
WILLIAM SILBER: I’m not going to hold any of that against you.
CHARLES MIZRAHI: You don’t have to — especially with the tuition NYU charges today. Here are my thoughts on that. When you do that — when you push it to an unregulated area of the market — it’s not your problem, right? It’s not my problem. It wouldn’t bring down the system. Is that what you’re trying to tell me?
WILLIAM SILBER: It won’t bring down the system. Let me interject right here. What’s the problem? The problem is that a sector — like the banking system — has a claim on the central bank and government to remain in business because they are essential to everything. So, that industry is subsidized by a put.
WILLIAM SILBER: In other words: If things are really bad, the government is going to come in and bail you out. If the government is going to come in and bail you out, it has the right to prevent you from doing things that will cause big bailout bills.
WILLIAM SILBER: On the other hand, if we push all that into the hedge fund industry — and the people who invest in hedge funds know full well that they can lose everything — and the hedge fund monitors know they can lose everything, the damage isn’t zero. I didn’t say it was zero. But it won’t have as big a bill for taxpayer bailout.
CHARLES MIZRAHI: OK, let me stop you there. In 1998: Long-Term Capital. These were professionals. These were the smartest people in the room. And just for our listeners, there’s a fantastic book by Lowenstein. It’s called: When Genius Failed. I highly recommend it. It’s about 150 pages. It’ll educate you on how smart, brilliant people do stupid things. So, you won’t feel that bad.
CHARLES MIZRAHI: There, you had more brainpower and higher IQs than any place in the world. You had a couple of PhDs sitting there. And you had traders and managers who worked at Salomon Brothers. They were not in the men’s clothes business. They were in this business. They started this new company. At one point, they leveraged 250 to one — and they were inches away from taking down the financial system. If it wasn’t for the New York Fed getting them all in a room and closing the door among the investment banks so they worked it out … The system was in peril.
CHARLES MIZRAHI: So, let me circle back. Let’s go to Paul Volcker. Paul Volcker basically said: “Let’s move the problem away from where it’s subsidized — in a sense — by the taxpayer and U.S. Government and put it in a place where, if it blows up, rich people lose money. But in reality, it doesn’t happen that way.
WILLIAM SILBER: When you say, “in reality, it does it happen that way” you can point to the fact that there were no federal funds used to bail out Long-Term Capital because all the major banks bailed them out. Hold it.
CHARLES MIZRAHI: I’m not saying anything.
WILLIAM SILBER: It was in their best interest to help Long-Term Capital not destroy the entire financial system.
CHARLES MIZRAHI: Okay, but my point is this: If the Fed didn’t hold a gun to their heads and say: “You guys work this out” and locked the door…
CHARLES MIZRAHI: And by the way, Jimmy Cayne of Bear Stearns was the only guy who held out. Bear Stearns did not pony up. And they got paid back in 2008. When they were asking for money, everyone just slammed the door on them. Wall Street has a long memory. So, they got kicked in the ass for what they did back in 1998 — when they should have been bailed out.
CHARLES MIZRAHI: Let’s move aside for a second. If the Fed didn’t lock them all in a room and say: “You guys work this out,” the blank could hit the fan in a huge way. The point that I’m trying to make is this: How the heck did we get so close to the cliff? We looked over into the abyss. And all of the sudden, we got pushed back by chance. That breeds moral hazard. We saw that they thought the same thing in 2008. “Don’t worry. We can work this all out.” And it brought down the system.
WILLIAM SILBER: I have a one-word answer: Leverage. I said a one-word answer, but then, there’s a little commentary.
CHARLES MIZRAHI: It’s one word with a paragraph attached.
WILLIAM SILBER: That’s right. Leverage is the answer. And that means leverage kills when people are induced. It’s other people’s money when taking big risks. It’s the same principle. When you are highly-leveraged and have a big, positive outcome, you get to keep it all. When you have a negative outcome, you declare bankruptcy. It’s never possible to reduce the risk to zero. It is not possible — unless you outlaw leverage.
WILLIAM SILBER: If you outlaw leverage you will never have this kind of problem. Leverage produces an incentive to take risks. It’s done in corporate America. It’s done in financial institutions. Leverage kills. What’s the attraction to leverage? Big leverage allows me to get big returns when I’m right. So, you put out more leverage. And of course, there are guidelines for leverage. There are guidelines for leverage among financial institutions that have a claim on government resources. And presumably, stockholders worried about highly-leveraged business.
WILLIAM SILBER: There are all sorts of clauses in debt financing that prevent doing things that are not in the interest of shareholders. But none of that eliminates every risk. As soon as you have leverage, you have an incentive. You have a skewed payoff with an incentive to take on big risks — which is why investors must monitor companies that are highly-leveraged. Monitoring will be incomplete. But you have to be aware that leverage is dangerous.
CHARLES MIZRAHI: I don’t think you go far enough here. And I want to tell you why. I’m a shareholder of a company. The board of directors represents the shareholder in the boardroom. They should be monitoring the CEO to make sure he or she doesn’t do anything that’s stupid or could put the company out of business. So, what does the board of directors do? It gives incentives to the CEO in order to be reckless at times.
CHARLES MIZRAHI: For example, as Charlie Munger — Warren Buffett’s partner — says: “If you want to find a crook, look for the incentive.” So, if you’re going to compensate the guy based on increased revenue growth, guess what all the cheating is going to take care of. It’s going to be [in] phantom sales. It’s just the nature of people. And I could go on and on. If you want to do it in earnings, you have this…
CHARLES MIZRAHI: Here’s my suggestion. And it’s not really my suggestion. It’s Warren Buffett’s suggestion. I want to hear how you’ll respond to this. You live in both the world of academia and the real financial world. Those boards of directors get about $250,000 to show up to four meetings a year, smile and vote in the way of the CEO. The CEO appoints them. You can’t get a better job. Just keep your mouth shut.
CHARLES MIZRAHI: I forget who said it, but someone said: “When they invited me to the board, that was the last thing they ever asked me.” So, that’s it. You just sit there and give a “yes” vote. It’s like voting in the Soviet Union back in the day.
CHARLES MIZRAHI: If a company does something reckless and destroys shareholder value to such an extent where it can be determined that it was reckless — by giving the CEO license to do ABC. What AOL or Time Warner did when the AOL merger destroyed shareholder value…
CHARLES MIZRAHI: Other than taking the board of directors out and shooting them, you can bankrupt each one of them. How much of that do you think would go on — in terms of taking crazy, insane risks — if it was above the heads of the board of directors?
WILLIAM SILBER: Well, you didn’t like it when I said: “Give them a 20-year jail term.” You didn’t like it when I said that. But that would do it. Instead of giving the CEO a 20-year jail sentence, put the board of directors in jail. You say: “Bankrupt them.” This is an important point from the book. You get collateral damage when the perpetrator doesn’t bear all of the costs. And that’s what puts the limited downside. If you impose costs on the downside, you say: “Bankrupt them.” I say: “Put them in jail.” I said it before, and you didn’t like it. But now you’ve come half way. You want to bankrupt them. I want to put them in jail.
CHARLES MIZRAHI: I tell you what.
WILLIAM SILBER: No, no. Let me finish. I want the payoffs to not be skewed when there’s huge collateral damage.
CHARLES MIZRAHI: OK, so let’s say I want to take them out and shoot them. How about that?
WILLIAM SILBER: We’re now in the middle between shooting them and bankrupting them. It’s 20 years in jail.
CHARLES MIZRAHI: I think the jail thing is hard. It’s hard to do. How are you going to prove that they broke a law? And you’re going to make up your own laws. I’m with you. Let me put that aside. Let me not debate that for a second.
WILLIAM SILBER: We have financial penalties. Financial penalties put people in jail. If you are guilty of fraud, you go to jail.
CHARLES MIZRAHI: But this is not fraud. This is bad judgment. Bad judgment is not fraud.
WILLIAM SILBER: What is looking the other way?
CHARLES MIZRAHI: To prove fraud, it’s a lot harder. So, here’s what I’m saying. And I know that we’re making the same point. We’re trying to discuss which incentives you could put in there that curtail bad behavior. And we could joke all about it. Shoot them. Bankrupt them. But the point is: We both agree that when there is zero, you create the Hail Mary effect. And that’s what your book is talking about.
CHARLES MIZRAHI: I’m going to give you a perfect example. If you have a school where cheating is punished by sitting in detention for a half hour. You just created a moral hazard. You create reckless behavior. The upside is: “If I get a higher mark, I could go to Harvard.” The downside is: “I spend a half hour in detention.” Perfect! Expel the guy — like in West Point. If you’re caught cheating, you’re expelled. And you’re out of the service. You never overcome that.
CHARLES MIZRAHI: I don’t know what cheating is at West Point. But I think they had some recently. I think what we’re doing here — and what your book does in a laid-out, thought-out way — is identifying the problem. I think your next book should be ideas on how to rein in this problem. This book is phenomenal.
CHARLES MIZRAHI: Folks, I want to tell you: I read this in one sitting. There are two things I like about Bill’s writing. He tells great stories. You’re a great storyteller. I could listen to you all day. He footnotes everything. Everything has footnotes. I looked back and said: “Get the heck out of here,” and “Holy smokes.” I went on the internet and found some of these things. I said: “I can’t believe it.” And it leaves me wanting more stories. So, this is great as a case to study. I think you do a tremendous service to the financial community and people in general. Other than shooting people — which was my idea — if you could come up with how to minimize or blunt the Hail Mary effect…
WILLIAM SILBER: Can I give you one reference in the book that’s fairly controversial? There is a chapter on suicide bombers. And in the chapter on suicide bombers, one answer to deterring them is giving them something to lose. Give them something to lose that they care about. And I’m not going to go through the entire discussion. But one of the examples I give is when the Israeli government destroys the home of someone who is a suicide bomber. And the international outcry is collective punishment.
WILLIAM SILBER: You then have to make a judgment: Do you want to discourage suicide bombers? The only way to discourage them is to give them something to lose. And you say: “Will destroying the homes of their parents to discourage them?” And my answer is: “I don’t know for sure. But I do know something. They care about what their families think. They care about damage caused to their families.”
WILLIAM SILBER: So, it is not an outrageous practice to destroy the family homes. It is precisely along those lines that we are talking about in the financial system. So, you ask me: “Why don’t I write a book?” I have a chapter that deals precisely with this question and draws on examples from the U.S. prison system. Prisoners who are in jail for life do not have nothing to lose — which would make them extra violent. Why is that? They have something to lose — namely, air-conditioned cells and so on and so forth. You give them privileges. Well, these are the antidotes to try to internalize the collateral damage and eliminate the incentive to take bigger risks because of the skewed outcome. Change the skewed.
CHARLES MIZRAHI: All right. So, bankrupting CEOs and boards of directors is kind of tit for tat. Here are people who love money and are in it to make money. By the way, with the Israelis, I asked a friend of mine who recently came from Syria: “Is that a real deterrent?” And he said: “You don’t realize it. In the Arab world, owning a home is a sign of pride. Being homeless is a very big shame.”
CHARLES MIZRAHI: So, it wasn’t that the suicide bombers cared about their parents — which they may or may not have. Sleeping with 72 virgins might have overcome that. But causing your parents shame — which is the exact opposite of what suicide bombers are doing. They want to be martyred. And they made streets out of them in Palestinian territories and Gaza. By destroying their homes, you’re basically shaming the family. And that was a very big deterrent. It absolutely worked.
WILLIAM SILBER: I promoted that argument. And there are many suicide bombers who tape messages to their families saying that they are bringing honor. But if you eliminate their homes … I don’t say it will eliminate everything. But we’re trying to reduce the incentives given by the skewed payoff.
CHARLES MIZRAHI: Right. I’m definitely with you on that. I think in the business world — especially when you’re dealing with the too-big-to-fail. The problem is that we’re going to have something every 10 to 15 years because that’s our memory. People who were sitting on the desk were 40 or 50 [years old]. And they’re now retiring at 65 [years old]. You have a whole bunch who never knew what 2005 or 2008 was — now that we’re 12, 13 and 15 years away from it.
CHARLES MIZRAHI: So, they totally forgot it. All those old timers moved on. You have a whole bunch of new guys who think that markets only go up and you never have any types of risk. So, you’re going to keep having this. I know that it’s just a matter of time before it manifests itself in another shock to the system. Hopefully, we can recover from it. The deterrence hasn’t been there.
WILLIAM SILBER: Charles, I’m going to use a cliché. I haven’t used the cliché the whole time because I worry about them. But the cliché is: This is why history repeats itself. People’s memories are short.
CHARLES MIZRAHI: Yeah. We keep going over the same thing again. People don’t remember history because it’s convenient not to remember it.
CHARLES MIZRAHI: Let me get back to this. I didn’t do it justice. We’re running out of time. But your book deals with lame duck presidents. Now that people have heard what type of skewed results there are — the upside is asymmetrical. With the downside, you have limited risk.
CHARLES MIZRAHI: Lame duck presidents’ second term. You outlined how Woodrow Wilson got us into World War I because there was no downside. There were asylum seekers — Rosa Parks even. No downside. Huge upside. Adolf Hitler in the battle of the Bulge. All of these things. I think you did a tremendous service to not only the business community but anyone who studies behavioral finance or anything that deals with how people act during certain situations.
CHARLES MIZRAHI: If our kids are caught speeding, you don’t pay off the ticket or ground them for a week. In New York City, if you were caught driving under the influence, they impounded your car. That’s a tremendous [downside]. It’s no longer just going to court, paying a fine or getting jail time. You lost your car. That was a pretty big deal. I don’t know how that worked.
WILLIAM SILBER: It’s all about flattening the skew.
CHARLES MIZRAHI: Yeah, that’s all it is.
WILLIAM SILBER: You’ve got to flatten the skew in order to get people to internalize the collateral damage. It’s no longer collateral. It belongs to you. That will incentivize you to behave. It’s not easy. And it’s not foolproof. But that’s the way you have to think.
CHARLES MIZRAHI: Yeah. Humans are pretty clever, and they will always figure a way to either move the risk somewhere else where you can’t see it or get around certain guardrails that you put up. Someone who wants to do mischievous behavior or take undue risks will figure it out. It’s not the good people that you have to worry about. It’s those outliers that’ll just blow up any system.
CHARLES MIZRAHI: It’s the whale trader — with J.P. Morgan losing billions of dollars on that. Nobody knew about that either. When you were trading at Goldberg Brothers, we had a P&L every day. I remember one time I was using too much leverage. They had a clerk come down in the middle of the trading session. I think it was during the 12:30 spot. He tapped me on the shoulder and said: Miz, get off the floor until you put up more money.” And that was it! My trades were frozen. And this was a couple hundred dollars. When it measures in the billions of dollars, it doesn’t register how bells and whistles are not going off.
WILLIAM SILBER: I agree with everything you said. If you want me to fight with you, you’re going to have to pay me extra.
CHARLES MIZRAHI: No. Honestly, I don’t. As long as you have human beings involved — and we don’t have straight algorithms cutting things off or turning the lights out — you’re going to have this type of behavior. The question is the integrity of the people you deal with. Warren Buffett says: “You can’t make a good deal with a bad guy.” So, if you hire people who are risk-takers by nature and have things in their pasts that would promote this type of all-or-nothing strategy, you have to avoid them.
CHARLES MIZRAHI: If you put these types of people in situations, it’s really hard to monitor them and stamp it down — especially when a guy has to pay for his sick kid who needs a kidney. And here he is at a trading desk. He could risk money. “All right. I’ll give it a shot. What do I have to lose? I get fired?” It’s crazy.
WILLIAM SILBER: Part of the answer is punishment — but also not promoting reckless behavior by providing the wrong incentives to begin with. It’s the wrong incentives.
CHARLES MIZRAHI: We send kids to college with the incentive to get good marks. Therefore, where are you going to find the cheating and the plagiarism? It’s in getting good marks. If we took away all the marks, and college was for knowledge’s sake, those behaviors wouldn’t manifest. So many times, we put the stumbling block before the blind person. And we say: “Go ahead.” It seems they’re not giving these people a chance. They’re doomed to fail. That’s just my take. I’m going to let you have the last word on that, Bill.
WILLIAM SILBER: It’s the last word is: Watch out when you see people with skewed outcomes. And if you see them, you had better watch out for the collateral damage.
CHARLES MIZRAHI: This morning, I was telling a good friend of mine that I was interviewing you today. I was telling them about the book, The Power of Nothing to Lose, and the Hail Mary effect. There was a guy in our industry. It was the garment industry, but I’m not going to tell you more than that — where they paid the salesman based on sales. So, you can imagine how much money this person made and how many of those sales were not only dubious but sold at a loss. And he won because they were paying him on sales. So, the incentive was not to make money for the company. The incentive was to write orders. And I think the company went out of business. They lost millions.
WILLIAM SILBER: It’s the credit department that you need to have reining him in. The credit department. I want to pay the manager of the credit department the most money in my business because that’s the guy who’s going to save me.
CHARLES MIZRAHI: And then, he goes to the CEO. And the CEOs goes: “You know what? He’s writing a lot of business. We can’t piss him off.” And we’re back to square one.
WILLIAM SILBER: Then the credit department guy says: “You know what? You’re not paying me enough money because you’re not paying attention to me.”
CHARLES MIZRAHI: I hear you. It’s a never-ending cycle of how to figure this out. And I think it boils down to: You have to hire the right people and make sure the incentives are there. But they’re not the wrong incentives that are going to encourage reckless behavior. That’s a very fine line. We aren’t going to come up with a solution today. But I love the way you pointed it out in so many different things.
WILLIAM SILBER: It was a pleasure.
CHARLES MIZRAHI: Bill, thank you so much. The name of the book is: The Power of Nothing to Lose. Go out and get it. It’s a quick read. You’ll really enjoy it. Bill is a great storyteller. And you can see them in your own lives, businesses and the way you raise your kids. When you see an incentive pop up, the first thing you should be asking is: “How can this destroy me?” If it doesn’t today, it will eventually do so tomorrow — if you don’t have the proper guardrails in place. Bill, thanks so much. I greatly appreciate it.
WILLIAM SILBER: It’s been a pleasure. I enjoyed it.
CHARLES MIZRAHI: Thanks for listening to this episode of The Charles Mizrahi Show. If you’re a new listener, welcome! If you’ve been listening for a while, we’re glad to have you back. Either way, we’d love to know what you think of the show. Please leave a review if you listen on Apple Podcasts. Reviews make it easier for others to find the show. You can also see the video of the interview on The Charles Mizrahi Show channel on YouTube.
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