The havoc on Wall Street following the collapse of the subprime-mortgage market boils down to a simple truth: for years, lots of very smart people took lots of very foolish risks, betting borrowed billions on dubious mortgage derivatives, and eventually the odds caught up with them. But behind that simple truth is a more surprising one: the financial whizzes made bad decisions in part because that’s what they were paid to do.

CHRISTOPH NIEMANN

Not literally, of course. The way that hedge-fund managers and investment-bank C.E.O.s get paid is supposed to make them perform better for the investors they serve. Hedge-fund managers, for instance, typically are paid “2 and 20”: they get two per cent of total assets as a management fee, and they keep twenty per cent of their investment gains (above some agreed-upon benchmark). Letting hedge-fund managers keep a chunk of their winnings gives them an incentive to do well for their clients: in theory, they get rich only if their clients do.

In practice, though, things don’t always work that way. Fund managers get bonuses at the end of each year, and they keep those performance fees even if the fund eventually goes south. So if a billion-dollar hedge fund rises twenty per cent in its first year and falls twenty per cent in its second, its investors will have lost money, while the fund’s manager might earn forty million dollars in performance fees. Hedge funds do have a rule that’s meant to deal with this problem: when a fund loses money, it yields no performance bonus until investors get back to even. The catch is that nothing prevents a hedge-fund manager from simply shutting down after a bad year and walking away with the fees he’s already accrued. Sometimes this happens out of necessity: the two subprime-focussed funds at Bear Stearns whose closure precipitated this summer’s market mayhem had seen their assets annihilated. But sometimes it happens because a manager has no incentive to keep supervising a fund that won’t generate a decent performance fee. In either case, the managers keep what they’ve earned and investors are left holding the bag. In short, a hedge-fund manager can do a lousy job and still become very wealthy.

Because fund managers reap large rewards on the upside without a correspondingly punitive downside, they have a much greater incentive to take big risks than ordinary investors do. Hedge funds generally leverage their bets with large amounts of borrowed cash—one Bear Stearns fund, for instance, borrowed ten times its capital—which makes it possible for them to turn small gains into enormous ones. Of course, leverage can also turn small losses into enormous ones. That helps explain why bad bets by hedge funds have been at the heart of the biggest financial-market meltdowns of the past decade.

A similar tendency to underplay risk is at work in parts of corporate America, thanks to the ubiquity of stock options. Options, which give executives the opportunity to buy company stock at a predetermined “strike price” within a certain period, seem like an ideal tool for insuring that a C.E.O. cares as much about the company’s stock price as his shareholders do. The problem is that if a company’s stock price is below the options’ strike price when they expire those options become valueless—and they’re just as valueless whether the stock price is a dollar below the strike price or fifteen dollars below it. To a shareholder, the difference between a stock that’s at thirty dollars and a stock that’s at twenty means a lot. But to a C.E.O. who has a pile of options with a strike price of thirty-one dollars, the difference means much less. As a result, that C.E.O. is likely to embrace projects that promise big rewards, even if they also entail a significant chance of failure.

Not surprisingly, a recent study of almost a thousand companies by the management professors W. Gerard Sanders and Donald Hambrick found that C.E.O.s whose compensation was made up mostly of stock options tended to “swing for the fences,” making investments and acquisitions that were riskier than those made by other executives. As a result, the performance of the companies run by the risk-takers was far more volatile, and not for the good of the companies: the risky strategies were more likely to end in a big failure than a big gain. Generous options grants may also encourage fraud; the business professors Jared Harris and Philip Bromiley, who have made a study of hundreds of firms forced to restate earnings after accounting irregularities, found that companies that paid out most of their compensation in stock options were far more likely to end up restating earnings. And, as with hedge funds, the perverse effects of performance pay are exacerbated by the fact that big bonuses are often based on short-term performance. Stanley O’Neal, who was recently forced to resign as the C.E.O. of Merrill Lynch, made eighty-four million dollars in 2005 and 2006, a figure based in part on the huge profits that Merrill booked as a result of its forays into the subprime market. Last week, thanks to those same forays, Merrill announced giant losses and writedowns that obliterated most of those profits. O’Neal, however, won’t be giving any money back.

One lesson of the current market chaos, then, is that it’s hard to get incentives right. Investors, after all, want fund managers and corporate executives to take reasonable risks—that’s the only way to make money—and many of them do just that. But, in trying to reward reasonable risks, we’ve encouraged unreasonable ones as well. And when you make it rational for people to bet the house, you may end up without a roof over your head. ♦