naked capitalism

This came via e-mail from a savvy past client with the sign off, “Frustrated on a plane.” I like all his suggestions, and I particularly call readers’ attention to his recommendation regarding compensation reform. One thing that is striking is that the media (and pretty much everyone in DC) has fallen in with the industry-flattering party line that pay is a third rail issue, that touching it is socialist, when our current taxpayer-subsidization of capital markets firms is tantamount to Mussolini-style corpocracy. By contrast, most people I know in financial services who are over the age of 45 believe that the only hope for a return to a financial services sector that has a healthy respect for risk is to return to something that approximates the old general partnership, where liability was unlimited, or greatly defers payouts, since many trades and activities involve long-tailed risks.

From a recovering derivatives trader:

I have to confess that I have officially crossed over to curmudgeon status. I long for the days when bankers actually cared about relationships, when transactions were used to service customers, and when the word fiduciary meant something. It seems that granularity of a relationship is now defined as a single transaction and the time horizon of both buyers and sellers is limited by the conclusion of the deal.

Aside from whining about being old, I am deeply saddened by the debate or more precisely the lack of intelligent debate about how to properly reform the financial sector. The wise old men of Wall Street (Volker et al) have more or less all said that we need some significant reform to create a value added financial service segment, and that we must return to an environment that is less about risk taking and more about service.

While I agree with their sentiments, I don’t actually agree with the prescription that the answer (or even part of the answer) lies in separating proprietary trading from “customer servicing”. The days when pure brokerage can be separated from proprietary financial intermediation and risk transformation are LONG gone. Further the issue is not really with taking excess risk in the banks’ prop trading desk. Instead I would suggest the fundamental causes of the crisis and the current state of the financial segment are fairly simple namely too much leverage, too much credit exposure, not enough transparency, and of course pay practices that encourage speculation on the firms, and worse, the taxpayers, balance sheets.

Of course these three things are interconnected as well, but let me do my best to put forward a segmented argument

Too much leverage – We all know that the prop trading books are not the proximate cause of the meltdown. Rather is is the loan book and the inventory left on the shelf from a clogged securitization pipeline. We have all seen the numbers of the dramatic increase in leverage of all banks – whether Investment or Commercial – so the issue is not a return to Glass Steagall separation. Rather is is about charging properly for capital use, mandating that off balance sheet item be put back on the balance sheet (as in the final analysis these off balance sheet items are not off balance sheet) and encouraging the use of exchange and other standardized mechanisms to reduce net exposure, and increase transparency. While we all understand leverage caused the crisis we seem not to be able to agree on a solution.

Further what I find lacking in the debate is recognition that even the management of these financial institutions did not understand their real exposure (go ask Marcel Ospel of UBS, if you doubt the truth of this statement) It seems absurd to me that if the management of the financial institutions didn’t understand the real risks that any regulator has a snowball’s chance in hell of understanding (and regulating) our way out of this mess. Too little of the debate has focused on the fact that financial instrument complexity coupled with the federally mandated power of certain rating agencies masked the real financial risk form both the internal mgmt team and to investors. So we need to attack the root causes of this excess leverage and lack of mgmt understanding of the real risks, i.e too much complexity.

Too much credit exposure – There was a reason the industry created mutually owned clearing firms and why the government exempted them from the cherry picking. We need to use these institutions to eliminate excess credit exposure that makes it impossible for mgmt, investors and regulators to actually understand the net exposure of one institution to another, let alone understand systemic linkages. We need to make more use of these institutions and penalize transactions that bootleg around these institutions.

Not enough transparency – This is a complex subject, but by transparency I don’t just mean the old notion of reporting prices of each transaction. I also mean enough transparency around contract specification and the modeling that justifies such complex transactions that everyone involved as a real understanding of what they are buying, selling, rating, intermediating or have somehow touched. The chief issue is balancing innovation with the real charge to the system of superfluous complexity. Off exchange contracts are less standardized than on exchange contracts. hence they are harder to understand (less transparent). So we need to charge for this complexity in a manner that still allows for financial innovation but insures the system against excess complexity increasing the systemic risk. Similarly OTC transactions that are significant deviations from ISDA or other recognized industry consortiums are more complex than standardized contracts, so charge for this complexity. Think of this as a complexity tax designed to encourage transparency and understanding for all

Asymmetric pay practices – Enough has been written on this topic, but a heads I win and tails you lose (whether it is the firm or the taxpayer, doesn’t really matter) should be corrected. I would simply note that none of these practices existed when firms were general partnerships with all of the personal liability that business form entails.

So what should we do?? I propose a FEW simple changes.

1. Variable capital and insurance charges – Part of the problem is that as a society we need to balance the role of legitimate financial innovation with need for a robust system. Most binary solutions, such as Glass Stegall prohibitions do not adequately balance these important objectives. Rather than general prohibitions, excepting my number 2 below, I would suggest variable capital charges. Capital charges should be designed to incentivize people to trade on exchange (where transparency, standardization and clearing firms eliminate or reduce much of the risk of complex instruments – after all in economic jargon the very complex instruments have a negative externality of confusing mgmt, the buyers and the investors who back such institutions, so we merely need a tax to incorporate that externality back into the market). Perhaps something like four times charges for any OTC transaction not executed through and exchange and double charges for anything executed OTC but cleared through a central clearing house. While we are a it the moral hazard issue of too big to fail could also be addressed through variable insurance charges – perhaps something like a stepped INCREASING charge for complex instruments. The rate could be set by an FDIC type insurance program for too big to fail banks – that funded an actual bailout fund. All of the clever details like have an organized liquidation plan etc now discussed could simply be the mechanism to help determine the actual insurance charge to the specific institution. Consider it the way to charge in advance for the bail out insurance the taxpayers have implicitly given every large financial firm

2. Make it illegal for financial institutions to transact off balance sheet. These transactions all seem to find their way back to the parent institution in a crises so we should just recognize that fact upfront and make prohibit this upfront (yes I know this violates my rule above, so maybe I haven’t thought this through enough) Yves here. I think the disconnect here is in 1. he meant more narrowly OTC trading of various sorts, while this prohibition fits if you think of it as applying to off balance sheet vehicles. The FDIC’s proposed restrictions on “true sale” (what you have to do to have a securitization be treated as a true sale, and hence moved off balance sheet) actually solves many of the problems of securitization, which is why the industry is trying to kill it. Back to the e-mail message:

3. Get rid of “mandated” rating agencies. Instead encourage the use of more open source type rating agencies that actually published and allowed others to comment on the models and model assumptions that underly their ratings

4. Change the incentive system so that “excess pay” is subject to clawback upon a firm meltdown. The issue is not just bonus and it is not just executive. So how do we define excess? I propose something simple like anything above 2 times the average income of a family in the US be escrowed and only available after some period of years (think of it as a rolling bonus escrow in which you slowly vest). To those that would comment this is impossible or unfair, then fine. Force all financial firms to become general partnerships and remove the limited liability shield for all individuals that make more than XXX. given this choice, I expect most managers, trader, employees of these firm would opt for an escrowed comp plan that rolled off through time

OK . So the above wouldn’t fix everything. But it would go a long way to correcting the system and the incentives to go in the wrong direction. Most importantly, it is simple, it is understandable and it attempts to reincorporate the proven mechanisms of past era into a more modern financial landscape