naked capitalism

I for one enjoy it when those well versed in Wall Street lingo and logic go to the trouble of using it to demonstrate that the market for what passes for talent in the securities industry is very inefficient. And the Financial Times is more willing to challenge how the Masters of the Universe are paid than its US counterparts are.

One sighting came in August, courtesy the FT’s John Dizard:

As is customary, the risk managers were well-prepared for the previous war. For 20 years numerate investors have been complaining about measurements of portfolio risk that use the Gaussian distribution, or bell curve. Every four or five years, they are told, their portfolios suffer from a once-in-50-years event. Something is off here….

The “tails risk” ….becomes significant over longer periods of time. Traders who maintain good liquidity and fast reaction times can handle tails risk….Everyone has known, or should have known, this for a long time. There are terabytes of professional journal articles on how to measure and deal with tails risk….

A once-in-10-years-comet- wiping-out-the-dinosaurs disaster is a problem for the investor, not the manager-mammal who collects his compensation annually, in cash, thank you. He has what they call a “résumé put”, not a term you will find in offering memoranda, and nine years of bonuses….

Today, Raghuram Rajan, University of Chicago professor and former IMF chief economist, gives a longer-form treatment of what is wrong with how bankers are paid. The big issue is that owners of capital (think shareholders investment bank stocks as well as investors in funds) should pay a premium for alpha, or manager skill, and not beta, or market returns. But a lot of people are paid for what Rajan calls “fake alpha,” which is basically taking undue but hidden risk, or finding chumps (which can lead down the road to litigation, another hidden risk) rather than creating value for investors.

But what Rajan misses is that everyone in these firms is conspiring together to create the impression that they are all generating real, risk adjusted, excess return. Think I am making this up? I know plenty of people who complain bitterly that they are underpaid when they are making will over a million dollars a year. And none of them could go off and start a boutique business in the same field and generate the same level of income.

A small but telling example: remember Joseph Jett? He was a government bond trader at Kidder Peabody who exploited a defect in the firm’s accounting system and used it to create the impression that he was generating tremendous profits (note that unlike other forms of trader mischief, Jett was not covering up losses, merely producing phantom earnings. It also isn’t clear whether Jett understood that he was taking advantage of a bookkeeping flaw; to this day, he maintains his profits were real, which is a convenient position if you want to escape a sanction for fraud).

Now anyone with an operating brain cell should have realized, pronto, that something was amiss. The government bond markets are way too efficient for there to be opportunities to reap enormous trading profits. Jett was either taking massive risk (which he wasn’t; his positions were matched) or something didn’t add up.

So what was the result of this debacle? GE, embarrassed by the need to write down previously reported profits, shuttered Kidder. Jett was fined $200,000 for a “books and records” violation and made to disgorge $8.21 million in bonuses. But his immediate boss, Edward Cerullo, made $20 million in bonuses thanks to Jett’s results, was not sanctioned or investigated in connection with l’affaire Jett and got to keep all his dough.

The Street is full of people like Cerullo who will maintain the fiction that their units are generating real value when there are other factors at work.

From the Financial Times:

Banks have recently been acknowledging enormous losses, yet those losses are barely reflected in employee compensation. For example, Morgan Stanley announced a $9.4bn charge-off in the fourth quarter and at the same time increased its bonus pool by 18 per cent. The justification was that many employees had a banner year and their compensation should not be held hostage to mistakes that were made in the subprime market. The chief executive, John Mack, however, assumed some responsibility and agreed to take no bonus for 2007 – although he got a $40m payout for 2006.

Even so, most readers would suspect something is not right here. Indeed, compensation practices in the financial sector are deeply flawed and probably contributed to the ongoing crisis.

The typical manager of financial assets generates returns based on the systematic risk he takes – the so-called beta risk – and the value his abilities contribute to the investment process – his so-called alpha. Shareholders in asset management firms, such as commercial banks, investment banks and private equity or insurance companies are unlikely to pay the manager much for returns from beta risk. For example, if the shareholder wants exposure to large traded US stocks she can get the returns associated with that risk simply by investing in the Vanguard S&P 500 index fund, for which she pays a fraction of a per cent in fees. What the shareholder will really pay for is if the manager beats the S&P 500 index regularly, that is, generates excess returns while not taking more risks. Hence they will pay for alpha.

In reality, there are only a few sources of alpha for investment managers. One of them comes from having truly special abilities in identifying undervalued financial assets. Warren Buffett, the US billionaire investor, certainly has it, yet this special ability is, by definition, rare.

A second source of alpha is from what one might call activism. This means using financial resources to create, or obtain control over, real assets and to use that control to change the payout obtained on the financial investment. A venture capitalist who transforms an inventor, a garage and an idea into a fully fledged, profitable and professionally managed corporation creates alpha.

A third source of alpha is financial entrepreneurship or engineering – creating securities or cash flow streams that appeal to particular investors or tastes. As long as the investment manager does not create securities that exploit investor weaknesses or ignorance (and there is unfortunately too much of that), this sort of alpha is also beneficial, but it requires constant innovation.

Alpha is quite hard to generate since most ways of doing so depend on the investment manager possessing unique abilities – to pick stocks, identify weaknesses in management and remedy them, or undertake financial innovation. Such abilities are rare. How then can untalented investment managers justify their pay? Unfortunately, all too often it is by creating fake alpha – appearing to create excess returns but in fact taking on hidden tail risks, which produce a steady positive return most of the time as compensation for a rare, very negative, return.

For example, an investment manager who bought AAA-rated tranches of collateralised debt obligations (CDO) in the past generated a return of 50 to 60 basis points higher than a similar AAA-rated corporate bond. That “excess” return was in fact compens ation for the “tail” risk that the CDO would default, a risk that was no doubt perceived as small when the housing market was rollicking along, but which was not zero. If all the manager had disclosed was the high rating of his investment portfolio he would have looked like a genius, making money without additional risk, even more so if he multiplied his “excess” return by leverage. Similarly, the management of Northern Rock followed the old strategy of taking on tail risk, borrowing short and lending long and praying that the unlikely event of a liquidity shortage never materialised. All these strategies essentially earn the manager a premium in normal times for taking on beta risk that materialises only infrequently. These premiums are not alpha, since they are wiped out when the risk materialises.

True alpha can be measured only in the long run and with the benefit of hindsight – in the same way as the acumen of someone writing earthquake insurance can be measured only over a period long enough for earthquakes to have occurred. Compensation structures that reward managers annually for profits, but do not claw these rewards back when losses materialise, encourage the creation of fake alpha. Significant portions of compensation should be held in escrow to be paid only long after the activities that generated that compensation occur.

The managers who blew a big hole in Morgan Stanley’s balance sheet probably earned enormous bonuses in the past – Mr Mack certainly did. If Morgan Stanley managed its compensation correctly those bonuses should be clawed back and should be enough to pay those who did well this year without increasing the bonus pool. At the very least, shareholders deserve better explanations. More generally, unless we fix incentives in the financial system we will get more risk than we bargain for. Unless bankers offer these better explanations, their enormous pay, which has been thought of as just reward for performance, will deservedly come under scrutiny.