Proofiness - Charles Seife [30]
In the world of finance, risk and reward are flip sides of the same coin. A safe investment—one with extremely little risk—will earn an investor very little money. To make big profits, you have to be willing to bear substantial risks; you have to accept that your gains might never materialize and that you might even lose the money you invested. Successful investors aren’t people whose bets always pay off; Warren Buffett regularly loses money when some of the risks he takes don’t pan out. Successful investors are the people who have a knack for squeezing the most reward out of the risks they’re willing to take. They’re the people who maximize the upside, the return on an investment, while keeping the downside, the risks they bear, to a minimum. Conversely, if you want people to give you money—to invest in you—you have to give them a large return with a minimum of risk. The less risk you seem to represent, the more money people are going to give you. This is why risk mismanagement is such big business. If you can understate the risks in your business, if you can hide them or shuffle them around or pawn them off on someone else, you can make billions.
In the late 1990s, the energy firm Enron was rolling in money. Its officers were millionaires many times over; at one point founder Ken Lay was worth $400 million. Enron was producing enormous profits for its investors, and quickly became a Wall Street darling. In 1995, Fortune magazine named it the most innovative company in America. In 1996, it won the title again—and in 1997, 1998, 1999, and 2000. But it was all a façade of risk mismanagement. Lay and his colleagues were making their money, in part, by moving risk from place to place in an attempt to shield it from outside scrutiny. They had created a whole slew of shell corporations (many of which, such as Chewco, Obi-1 Holdings, and Kenobe, had Star Wars-inspired names) to hide how risky an investment Enron really was. These corporations assumed much of Enron’s debt, taking it off the books. As a result, Enron looked squeaky clean when it was in fact saddled with billions in debt—and was joined at the hip to dozens of dubious corporations that were on the verge of bankruptcy. When the risk mismanagement came to light, investors fled and the whole house of cards collapsed, taking along with it the savings of many investors who had no clue that Enron was a risky investment.29
If you move money around in clever enough ways, you can camouflage risks and make an absolute mint. Bernard Madoff was worth more than $800 million at his peak—by shuttling money from client to client, he managed to hide just how risky his investment firm really was (and that he was making himself rich by stealing his clients’ money). Through his manipulations, Madoff managed to deflect attention for more than a decade—until the markets collapsed, suddenly exposing the fact that his coffers were empty. In making himself rich, he managed to lose more than $50 billion of his clients’ money, earning him 150 years in prison.
The Ken Lays and the Bernie Madoffs of the world are able to make their money by hiding risk and moving it from place to place, deceiving their investors. When their criminal enterprises collapse, the malefactors rightly get a lot of press attention as they are pilloried and prosecuted. However, as big as these frauds might seem, they’re nothing compared to the risk mismanagement that’s gnawing away at the heart of our economy. Madoff and Lay are rank amateurs in the proofiness game.
There are more subtle ways to make money off of risk. Just as risk can be hidden or moved from place to place, it can be divvied up and sold. Insurance companies are nothing