Many years ago MIT’s Andy Lo made a simple point (weirdly, I haven’t been able to track down the paper) about the distortion of incentives inherent in financial-industry compensation. Suppose you’re a hedge fund manager, getting 2 and 20 — fees of 2 percent of investors’ money, plus 20 percent of profits. What you want to do is load up on as much leverage as possible, and make high-risk, high return investments. This more or less guarantees that your fund will eventually go bust — but in the meantime you’ll have raked in huge personal earnings, and can walk away filthy rich from the wreckage.

But surely, you say, investors will see through this strategy. They can’t consistently be that stupid or naive, can they?

Hahahaha.

What brings this to mind is a new Center for Public Integrity report on the lifestyles of the rich and infamous — finance honchos who brought down their companies and much of the world economy with them. So, Lehman’s Dick Fuld gets to ruminate on what went wrong in his Greenwich mansion or his 40-acre ranch, or maybe his 5-bedroom house in Florida. Jimmy Cayne of Bear Stearns plays bridge from his $25 million apartment in the Plaza Hotel. And so on down the line.

So it really was heads they win, tails we lose, with all the incentives being to take maximum risks and let the taxpayers clean up the mess.

Luckily, it won’t happen again, because we’ve had comprehensive financial reform. Right? Right?

http://krugman.blogs.nytimes.com/2013/09/14/heads-they-win-tails-we-lose/