Words of wisdom (on bank compensation)

…this really [is] a pretty odd situation. Wh[y] doesn’t the market take care of
this problem itself? It really seems like investors would be reluctant
to deal with financial institutions that are organized this way. It
seems like there was a reason the major investment banks were
traditionally organized as partnerships–partnerships don’t have these
incentives, and people should prefer to do business with institutions
that don’t have these incentives. But the market’s not working like
that. And it’s worth trying to understand why. If regulators start
playing cat-and-mouse with compensation shenanigans, the mice are
probably going to wind up winning. But if there’s some specific thing
that’s preventing market discipline from adequately aligning
incentives, we ought to be trying to find out what it is and what can
be done about it.

Here is more.

Comments

It is a mistake to think of finance as market based. It is really an extension of government but with only the laxest of oversight. It is really little more than minimally regulated utilities where competition is meant to keep them honest but often only drives them to commit the same errors at the same time.

Some fleecing machines had bad compensation incentives, the market tried to work by making those companies bankrupt, but the government stopped the market from working and you said it was "better than nothing". That "nothing" was the market.

The idea that somehow bankruptcy may have aligned banker incentives with shareholders is almost laughable. I just don't know what to even say to people who are so willing to ignore what actually happened over the last decade.

The guy who blew up AIG is still sitting on a few hundred million dollars.

I don't have numbers, but you can estimate there are probably 30 guys at Bear who were directly involved in businesses that ended up blowing up Bear. They probably walked away with somewhere north of 10 million each.

Propping insolvent banks up, and having the government guarantee banks' liabilities, are two government interventions that are "preventing market discipline from adequately aligning incentives."

"Too big to fail" distorts moral hazard. We need to make these guys "small enough to fail" -- but under Bernacke/Geitner we are going the wrong way.

If bondholders are bailed out, where is the incentive? A money manager told a family member to buy bonds several years ago because the government would bail out the company. I'm sure they were surprised when the government DIDN'T bail them out. They were GM bonds. The prospect of a government bailout is not a laissez-faire system.

And by the way, are the liberals ever going to work on anything that doesn't look like bonus envy on its face?

Several people above have hit upon what i think is important, there is no symmetrical down side risk for people managing other's money. The potential benefits are huge, the down sides small. Going back to partnerships or some other way of insuring personal risk for CEOs and traders is a way to cure this. One should still have the ability to earn bazillions of dollars, but you should also risk personal bankruptcy and loss of personal assets.

Steve

Debt guarantees I think are the problem, the equity holders know they get big returns if those traders make big money.

The bondholders allowed excessive leverage because they knew the government would bail-them out. I think that's where it breaks down, the bondholders. IF the bondholders were at-risks (lehman being the exception), they wouldn't let the equity/traders use the same kind of leverage.

Many good points above and I think there is an important issue to be studied regarding executives' understanding of their firms' actual risk profile. Note that Ken Lay also held substantial Enron stock until the end. Perhaps the issue is less with "aligning incentives" (if that means "vesting equity ownership") and more with understanding how to manage complex financial businesses. Perhaps we don't yet have the tools to really do so, unless the people managing the book are also managing the business.

Thinking about trader, as opposed to executive, compensation, here is a hypothesis offered freely to the world (without evidence) for testing: banks do not want traders to think too much about risk-adjusted returns. Rather they want traders to source and close deals with the highest paper profit. Banks have separate risk management systems that are supposed to detect and void transactions that are dangerous. The skills that banks seek in traders are different from the skills that banks seek in risk managers, so it is logical for banks to divide these functions into two groups of people.

Because traders are associated with paper profit and not risk-adjusted or realized cash returns, they are able to differentiate themselves to prospective buyers of their services based on incomplete performance data. Banks (especially when the rising tide is lifting all boats) are in a prisoners' dilemma-type equilibrium, wherein they bid for traders based on the trader's associated annual accounting upside, because annual compensation is the unit of measure in the labor market, but the impact of associated liabilities take much longer to develop (and the risk management tools are imperfect). (If this is true, one argument for compensation regulation is that it could force banks into a different equilibrium. There are many arguments against such regulation.)

I heard somewhere (possibly from unreliable sources) that Berkshire Hathaway pays out based on net realized profits from deals executed 3-7 years previously. If true, I wonder why this is not widely replicated in the industry. Perhaps because traders don't think/understand/care about downside exposure and rejected this model at firms without the Buffet halo?

Am I being too mean to traders?

@Ned

I agree entirely.
Also, Florida has quite a bit of housing regulation due to hurricanes and such. Also a lot of florida land is federally or state owned so there isn't as much room to expand.

I also predict that in real terms, housing prices will begin falling again soon, as house production technology gets better.

Last fall, Henry Paulson told the country the financial sector needed a bailout or else the economy would fail.

After TARP was approved, and they shoveled money out the door faster than the shuttle at take off, the economy failed.

Yet the people at AIG and Goldman Sachs and Merrill Lynch and most other firms on Wall Street (Lehman excepted) got their bonuses.

What would that bonus have looked like if the feds hadn't bailed them out?

The survivors on Wall Street know they're too big to fail - they know the feds will pay them their bonuses no matter what. What's the impetus for change if you get your bonus no matter how your company performs?

The market DOES take care of these problems, why do you think they have things called "market corrections."

Comments for this post are closed