What's up guys and welcome back to wall street millennial on this channel, we cover everything related to stocks and investing in previous videos. We've seen many cases of companies being destroyed or suffering significant reputational and economic damage due to the actions of individual employees. Sometimes leadership makes business decisions that put companies at inordinate amounts of risk or employees are incentivized to engage in behaviors that are exactly opposite of the company's interests. For example, in 2008, the japanese technology and industrial conglomerate toshiba was hit hard by the great recession.

As a result of the deteriorating financial environment and pressure to maintain the company's 100 year, history of profitability, a corporate environment that encouraged anything necessary to meet quarterly financial expectations set in eventually, this led to an embarrassing disaster for the company in top level management that the Company has still not yet fully recovered from another example is the case of jerome kerviel, the french trader for the investment bank society generality. He was described by his lecturers as a mediocre student who was not particularly outstanding. He started his career in finance. Doing middle office work but had ambitions to move up the company's ranks and pay grades.

In his case, that meant maximizing his own trading profits by taking on inordinate amounts of company risk in the end that taking cost the bank more than five billion dollars. It might seem like these are just one-off cases where the companies got unlucky with certain employees, but these kinds of situations happen all the time in business. This is the issue of the perverse incentive, a phenomenon that shows up all over politics and economics. A perverse incentive is any incentive structure that leads to undesired and unintended results.

The term was first coined by economist horse cyber when he described a made-up occurrence in india under british rule. Supposedly, the sea of new delhi had a problem with having too many venomous. Cobra snakes and the colonial government wanted to find a way to control their numbers. They came up with a program whereby citizens were paid for each cobra that they killed and brought to the authorities.

While this initially worked, eventually, people started raising their own cobras to turn in for the cash incentive. The colonial government thus paid out larger rewards than anticipated without solving the problem of reducing the wild cobra population. That's because the incentive structure produced an optimal way for citizens to act. That was not in line with the intended outcome.

Although this story is fictional, the same mechanics apply in real life. In the 1970s and 80s, the company waste management experienced extreme growth and profitability. Although its business was more like a utility shareholders came to expect year after year of top and bottom line growth by the 1990s, the company had begun to saturate its own market and growth slowed the ceo at the time, dean buntrock felt pressure from shareholders and analysts To find any way necessary to keep their financial results, growing analysts continually projected quarterly revenue and profit growth, and the investors gave the stock a high price to earnings multiple, reflecting their expectations of organic growth, but that level of growth was simply not possible anymore. Garbage disposal is a pretty simple business, with little room for innovation or any other means of increasing revenue per customer.

It's also not a business that is very easy to find areas for cost cutting once waste management had expanded across the country into every major market growth. Inevitably slowed but the way that financial reporting works, incentivized waste management, not necessarily to do what was best for shareholders and the growth of the company, but instead to meet quarterly expectations for the headline numbers. The company ended up doing that by increasing the amortization period of their garbage trucks by 50 from 8 years to 12 years. This allowed them to record significantly lower amortization expenses and inflate their net earnings.

There was no justification for increasing the amortization period, and an internal company study of the useful life of the trucks did not support the increase, but because what wall street really cares about is quarterly revenue and earnings before anything else and total compensation for upper level management Is often tied to financial results in stock prices, this behavior was incentivized. The company was incentivized by the financial markets to report results, not necessarily in line with the interest of the company or its shareholders. The perverse incentive issue can also be produced from within a single company in the early 2000s jerome kerviel started working at the french investment bank society generality, although in his first few years he worked middle office roles, doing compliance work, he was eventually promoted to a junior Trader position due to his performance as a trader within the investment bank, his job was to make arbitrage trades on behalf of the bank's own trading accounts. Bonuses paid to traders were linked to the profits generated by their trading after just a year or two as a trader.

His annual bonuses nearly exceeded his base salary, but he knew that other more senior traders that he worked with were earning bonuses many times even what he was being paid, and he wanted more that caused him to place huge trades taking on enormous positions throughout 2006. He made hundreds of thousands of dollars for the company by shorting. Certain parts of the market as his profits grew so did his confidence by 2008. He had racked up more than a billion dollars in profits for the bank for this trading.

However, that also attracted the attention of the bank's compliance and risk management officers who he lied to about how much risk he was taking on. In order to reduce his own scrutiny, he deliberately placed some trades that he thought would lose money specifically by going net long. In a market that was just starting to free fall due to the recession, but the magnitude of his losses far exceeded what he expected and he ended up losing the company more than 5 billion dollars, because the bank incentivized its traders to generate profits for the company. Through profit, sharing in the form of bonuses, curvier took on too much risk to the bank.

Managing risk is just as important as maximizing return, but managing risk is much harder to incentivize the spat craze of 2020 and 2021 showcases a situation where the way the financial markets work creates a misalignment of the interests of shareholders and the incentives given to spac sponsors. The spac is at its core a way for public market investors to gain access to private investment opportunities. The sponsors of the spacks often have private equity experience. They raise money through a spec from public investors.

Then they use that money to go into the private markets and buy ownership stakes of private companies on behalf of the spac investors. In return for enabling the investment in these private companies, the sponsors receive a portion of the public company after the deal closes. Normally, this stake in the spec is held in escrow for some time, so that the sponsor cannot dump the shares right after the deal is closed. This way, the sponsor is incentivized to find good private companies for reasonable valuations making money for both themselves and the public investors.

Unfortunately, the exact structures and arrangements of individual specs can vary widely. This creates an enormous amount of confusion and lack of knowledge among shareholders. As to the true incentives of the stacked sponsors, sometimes even knowledgeable market professionals can't seem to figure out what the spac sponsor's true incentive structures are. Take, for example, this interview with chamath pauli habitia, who is a prolific smack sponsor and cnbc's andrew ross sorgen about concerns over the clover health space.

There is no way that i can win unless the stock goes up. There is risk in all of these things, but the reality is that i'm putting my own money and what i'm trying to do is put my people we're going to promote and say you're getting no pro. But what you just suggested was that you're getting no promote. No, that's not what i'm suggesting what i'm suggesting is that you have 16 million dollars, initially plus 160 million dollars on the back total total total i've just told you what we own so you're, saying now that's going up to about 250 million dollars right now automatically Due to the incentive structures of many specs sponsors, frequently get what is called the promote promote refers to pretty much free shares of the spec after the deal closes, which encourages the sponsor to do a good job of seeing the deal through the process.

However, it also creates a situation where the sponsors can still be in the green, even if the stack does poorly in the months. Following the deal. Reuters reports that studies from stanford and jp morgan estimate the average three-month return for stack sponsors at something like 400 to 650 percent. That's a huge advantage over regular retail investors and creates the incentive to just do more deals in the case of chamoth.

He put about 178 million dollars of his own money into the clover spa, but based on the free shares he received from the promote his position automatically goes up to about 250 million dollars according to cnbc as soon as the deal closes. That means has effective cost basis, is about seven dollars and fifty cents per share because of that clover could decline up to 25 percent. He could still be in the green. On the other hand, individual investors who buy in at 10 a share start to have a far inferior risk return profile to be fair to chemoth.

He does put a substantial amount of his own money in so he's actually one of the better sponsors for many stacks. The sponsors can stay in the green, even if the shares decline to as low as three or even two dollars. Although many stacks have made tremendous amounts of money for investors overall, their success is questionable. According to cnbc, historically, space talks have done poorly over the past.

Nine years almost all buy and hold investments and specs would have lost money over a one or three year period. The reasons for this are an ongoing subject of research, whether it be that the valuations or the specs are too high, or that there are simply not enough viable high quality private companies to support as many spaces there are, but with many specs. Even if the stock price goes down, sometimes by as much as thirty percent or even more, the spak sponsors can still make money on the deal. This has led to sponsors becoming fabulously wealthy chamath paul hepatia, for example, has claimed to be worth somewhere in the range of 10 to 20 billion dollars.

Although forbes has him at a little over 1 billion. Unfortunately, the incentive to the sponsors of receiving a significant stake in their specs after the deal is closed, incentivizes them not necessarily to maximize shareholder return, but sometimes just to do as many deals as possible. In this video we've seen two kinds of perverse incentives in today's economy. The first kind is when a concrete incentive is set by an authority figure such as a profit sharing arrangement with traders working for a financial company.

This is the case of society generali, which incentivized jerome kerviel to take on inordinate amounts of risks to maximize trading profits. The second kind is when the way that the markets or economy is set up, inherently incentivizes certain market participants to act, not necessarily in the best interests of their stakeholders. This is the case of waste management, which was incentivized by the reality of wall street reporting that quarterly and annual profit numbers are sometimes more important than true business growth. Let us know in the comments section below, if you can think of any other cases of perverse incentive that fit one of these two kinds.

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