Investments in innovation do not pay out in the current quarter. Typically, they don’t even pay out in the current year. If you care about your bonus this year, you are directly incented not to make investments in new inventions as you will incur the expense, but reap no profits. – Ben Horowitz
In his post “Why We Prefer Founding CEOs” Ben Horowitz, inadvertently, explains the root cause of Wall Street’s problems. Professional managers with short term outlooks and incentives tend to be far better at maximizing the profits of an existing business model than they are creating new business models and products. The innovation required to create the latter is significant and risky whereas maximizing short term revenue – while its own set of problems – tends to be not only lower risk but also what the professional manager is going to get paid on. If you make a lot of EBITDA/net income in the short term, you get a nice bonus for your contribution. But what if the right answer for the long term prosperity of the business was to forgo some of that short term profit (and therefore some short term compensation) and instead invest in innovation on things that might not work and if they do work, won’t pay off for a few years.
It’s a problem that afflicts many – but clearly not all – companies run by professional managers and particularly those with strong “pay me now” bonus cultures. It was blatantly in effect at the likes of Citi, Bear, Lehman, Morgan Stanley, AIG, Countrywide, WAMU, Merill (but likely not Goldman) during 2006 and 2007 when, despite tremendous evidence that their existing profit centers (creating mortgage related securities) were failing badly, they chose not to innovate on new business models (GS famously reversed course and went short) but rather to maximize their short term profits. In “The End of Wall Street“, Lowenstein gives some shocking examples of banks not only staying the course despite the troubling increase in negative indicators on mortgages (increasing defaults, obvious lower standards on loan grants) and obvious macro risks (rising interests rates, flattening and decreasing home prices, and a preponderance of ARMs) but actually doubling down and going harder to get in while the getting was good. In fact, at Countrywide, when it was finally, belatedly, decided to change the rules on loan standards, the sales force was exhorted – in email – to get their remaining – substandard – loan applications in for approval before the rule change went into effect. In so doing, the people in these financial institutions destroyed not only “their” (people like Bob Rubin at Citi actually owned very little of the equity – he was by no means an owner the way a Bill Gates is/was) “businesses” but wrote trillions of dollars of loans to people who had no prospect for paying them and left the American taxpayer (typically responsible folks who did not overextend themselves on mortgages) on the hook to pay the bill. Of course, while the rest of us are paying the bill – and in particular hard working, responsible, younger Americans who don’t benefit from entitlement programs – these “bankers” (a real banker actually provides a useful purpose to society) kept the bonuses they paid themselves on their 2006 and 2007 “profits”; screwing the actual shareholders in the banks, the traders paid themselves bonuses in the here and now based off of calculations for the expected lifetime profit of deals they did; it probably goes without saying that those future profits did not exactly materialize. Having taken their loot from the ship that is the American economy, these modern day pirates, have sailed off to their literal and figurative islands to enjoy themselves with their ill gotten gains. The American economy is, unfortunately, showing the wear and tear that these selfish individuals inflicted on her.
