The New York Times yesterday featured an article by Yale economist Robert Shiller in which he discussed how financial reform had fallen short of addressing the conditions that caused the crisis. He focused on the failure to implement effective pay reform at the large financial firms that too big or otherwise too crucial to fail:
The issues facing us are complex. Let’s look at just one of them: the provisions in the Congressional bills on executive compensation.
Certainly, executive pay has grown enormously in recent decades, and there has been much suspicion that it contributed to the crisis. But it’s not the high level of executive salaries that helped cause the financial collapse. Efforts to reduce executive salaries have perversely created the wrong incentives. A 1993 law discouraging companies from paying their chief executives more than $1 million a year appears to have led to a de-emphasis of salaries and an increase in stock options.
So here is one of those epiphanies: Those stock options didn’t lower total compensation. And they probably encouraged C.E.O.’s to expose their companies to more risk, because options’ value grows as risk does. In fact, legislators’ misunderstanding of the law’s true incentives may have contributed to the severity of the crisis.
Yves here. Um, so how exactly does this little discussion disprove Shiller’s aside, that the level of pay did not contribute to the crisis? Answer: it doesn’t. He instead shows that not-fully-thought out reform created results the reverse of what was intended: it allowed pay levels to escalate when the level of executive compensation had already become worrisome, and worse, in a way that encouraged undue risk taking.
Now some readers will argue that financial services industry pay is market determined and therefore virtuous. That’s a misconstruction. Compensation in the financial services is a classic example of market failure.
The big banks and broker dealers ALL went into the crisis badly undercapitalized. Why? Because the industry engaged in a variety of practices that allowed them to rely on what amounted to fictive capital. For instance, credit default swaps allowed them to hedge risk with undercapitalized counterparties like AIG and the monolines. When the hedges failed, the banks showed spectacular losses. Similarly, banks shifted assets into structured investment vehicles and other off balance sheet entities, but earned fees both for setting them up and providing services to them. When these entities started showing serious losses, the banks discovered they weren’t so “off balance sheet” and tool losses.
If the banks had accounted for these risks properly, they would have had to carry higher capital levels and would therefore have had to retain more in the way of earnings and pay less to employees. And the idea that escalating pay levels was needed to retain “talent” was dubious. The threat was that the best staffers would leave for hedge funds. But let’s face it, they did regardless, and hedge funds employ comparatively few people in comparison to the banks and broker dealers.
Another reason compensation across the firms was excessive was that earnings are what economists call pro-cyclical. Banks and broker dealers are structurally long. Even Goldman, which endeavored to short subprime, was still long mortgages and credit instruments generally. When interest rates fall and risk spreads narrow, banks and brokers will show profits if they do absolutely nothing. They will show profits on the rise in the value of their assets. This has nothing to do with employee actions, yet they were paid bonuses on profits that would have shown up regardless. And those profits turned quickly to losses when risk spreads widened, but no one was forced to disgorge what amounted to undeserved compensation.
In 2007, John Whitehead, former co-chairman of Goldman, debunked the idea that the current levels of pay were warranted (mind you, 2006 bonus were dwarfed by 2007 and 2009 levels):
“I’m appalled at the salaries,” the retired co-chairman of the securities industry’s most profitable firm said in an interview this week. At Goldman, which paid Chairman and Chief Executive Officer Lloyd Blankfein $54 million last year, compensation levels are “shocking,” Whitehead said. “They’re the leaders in this outrageous increase.”
Whitehead, who left the firm in 1984 and now chairs its charitable foundation, said Goldman should be courageous enough to curb bonuses, even if the effort to return a sense of restraint to Wall Street costs it some valued employees. No securities firm can match the pay available in a good year at the top hedge funds.
“I would take the chance of losing a lot of them and let them see what happens when the hedge fund bubble, as I see it, ends.”
More support comes from Andrew Haldane of the Bank of England, who in a March 2010 paper compared the banking industry to the auto industry, in that they both produced pollutants: for cars, exhaust fumes; for bank, systemic risk. While economists were claiming that the losses to the US government on various rescues would be $100 billion (ahem, must have left out Freddie and Fannie in that tally), it ignores the broader costs (unemployment, business failures, reduced government services, particularly at the state and municipal level). His calculation of the world wide costs:
….these losses are multiples of the static costs, lying anywhere between one and five times annual GDP. Put in money terms, that is an output loss equivalent to between $60 trillion and $200 trillion for the world economy and between £1.8 trillion and £7.4 trillion for the UK. As Nobel-prize winning physicist Richard Feynman observed, to call these numbers “astronomical” would be to do astronomy a disservice: there are only hundreds of billions of stars in the galaxy. “Economical” might be a better description.
It is clear that banks would not have deep enough pockets to foot this bill. Assuming that a crisis occurs every 20 years, the systemic levy needed to recoup these crisis costs would be in excess of $1.5 trillion per year. The total market capitalisation of the largest global banks is currently only around $1.2 trillion. Fully internalising the output costs of financial crises would risk putting banks on the same trajectory as the dinosaurs, with the levy playing the role of the meteorite.
Yves here. So a banking industry that creates global crises is negative value added from a societal standpoint. It is purely extractive. Even though we have described its activities as looting (as in paying themselves so much that they bankrupt the business), the wider consequences are vastly worse than in textbook looting.
Yet its incumbents tout their ‘talent” and insist on their right to mind-numbing pay because their services are allegedly so valuable to the economy.
Yet after applying a wrecking ball to the global economy, the banks got big handouts, and like Fannie and Freddie pre crisis, the banks get to borrow at cheaper rates than would otherwise apply because investors understand full well that governments stand behind big financial firms. Haldane again:
It is possible to go one step further and translate these average ratings differences into a monetary measure of the implied fiscal subsidy to banks…The resulting money amount is an estimate of the reduction in banks’ funding costs which arises from the perceived government subsidy..
For UK banks, the average annual subsidy for the top five banks over these years was over £50 billion – roughly equal to UK banks’ annual profits prior to the crisis. At the height of the crisis, the subsidy was larger still. For the sample of global banks, the average annual subsidy for the top five banks was just less than $60 billion per year. These are not small sums…
On these metrics, the too-big-to-fail problem results in a real and on-going cost to the taxpayer and a real and on-going windfall for the banks.
Barry Ritholtz in a post today, correctly takes apart Shiller’s recommendation (deferring a substantial portion of pay, which would be forefit if a company were bailed out or failed) and recommends a superficially appealing solution, returning to a partnership model:
The thought process behind this is that risky corporate activities should also become a risk to the firm’s executives…The hope is that “this will transform executives’ thinking about risks — and may help prevent another disaster.”
I sincerely doubt it. Similar disincentives were already in place — and they failed miserably.
At each and every one of the companies that went bust due to their excessively risky speculations — from AIG to Bear to Citi to Fannie Mae to Lehman to WAMU — every executive had huge amounts of stock, stock options, and future salaries at risk. Lehman’s Dick Fuld reputedly lost over $500 million dollars in stock value, and a few of Bear Stearns execs lost close to a $ 1 billion dollars each in asset value.
The mere threat of future losses has already proven insufficient to moderate behavior. Holding back $100s of 1000s of dollars — or even millions of dollars — is a meaningless inconvenience to the people whose net worth is measured $100s of millions or billions of dollars.
Barry then offers partnerships as a model:
I did discover one group of Wall Street firms whose senior management took a very measured approach to managing risk..
The group? Wall Street partnerships…
Partners have “joint and several liability.” Every partner is fully liable, up to the full amount of the relevant obligation, for the actions of every other partner. This has the effect of focusing the minds of management on exactly what the worst case scenario of their behavior can wreak….the creditors can proceed to recover losses from the personal assets of every partner. Bank accounts, Houses, boats, vacation property, 401ks, cars, jewelery, watches, etc. are all fair game for creditors.
Not surprisingly, none of the Wall Street partnerships got into trouble…
Yves here. While I agree 100% that Barry’s proposal is superior to Shiller’s it’s not the panacea he makes it out to be. First, partnerships were reckless in the 1920s and many failed in wake of the Great Crash. Ironically, Barry cites Brown Brothers as an example of a modern partnership that has behaved prudently, but the current Brown Brothers was born of the merger of the teetering Brown Brothers & Co. into the stronger Harriman & Co. in 1931. There was another large wave of partnership failures and mergers in the wake of the 1960s back office crisis, but because these firms got into trouble as the result of operational problems, as opposed to the misuse of borrowed money, it did not have wider economic fallout.
Second, there are a lot of ways that executives can slip the leash, from putting assets in countries where it would be hard to repatriate, or even locate them (there is a reason Jews fleeing persecution used to sew diamonds into their clothing, it is a compact and portable form of wealth) to quitting at the first sign of business troubles, to only taking risk in very long-dated exposures (again, to shift responsibility for any blowups on to successor management) And who would want to take on that sort of liability unless he could an exhaustive audit of the banks’ exposures? Thus, if someone were to turn down a high level position, rumors could easily start that the bank was in trouble, which in a worst-case scenario would precipitate a run.
Third, how would you draft regulation to deal with sales of severely weakened firms? Look at the sale of Merrill to Bank of America, which was lauded as a coup by John Thain (in terms of the value received by Merrill shareholders). It sure was, Bank of America later cut a deal with the government to cover Merrill losses. And this sort of partnership liability concept would lead the authorities to write waivers to firms like JP Morgan that step in to buy troubled firms like Bear.
One of the reasons that Barry forgets that partnerships led to more caution wasn’t simply the prospect of unlimited losses. It was also that partners had most of their wealth tied up in the firm, and could withdraw it only gradually after they retired. This led them to take a long-term perspective and also prevented the pursuit of a lavish lifestyle. And it further lessened mobility among junior staff. Partners would only take people into the partnership that they had observed over long periods of time. Unless he was exceptionally talented, someone who came in mid-career to a firm would be at a disadvantage relative to those who had spent their career there.
But the focus on executive pay divers attention from the fact that pay levels across the big players is wildly out of line, given their ever-growing government guarantees. n a paper by Piergiorgio Alessandri and Haldane, “Banking on the State” (hat tip reader Scott), they describe how support to the financial system has ratcheted up in the wake of crises, which only makes it more attractive for banks to gamble. They note:
This is a repeated game. State support stokes future risk-taking incentives, as owners of banks adapt their strategies to maximise expected profits….the latest incarnation of efforts by the banking system to boost shareholder returns and, whether by accident or design, game the state. For the authorities, it poses a dilemma. Ex-ante, they may well say “never again”. But the ex-post costs of crisis mean such a statement lacks credibility. Knowing this, the rational response by market participants is to double their bets. This adds to the cost of future crises. And the larger these costs, the lower the credibility of “never again” announcements. This is a doom loop.
The “St Petersburg paradox” explains how a gambling strategy which starts small but then doubles-up in the event of a loss can yield positive (indeed, potentially infinite) expected returns. Provided, that is, the gambler has the resources to double-up in the face of a losing streak. The St Petersburg lottery has many similarities with the game played between the state and the banks over the past century or so. The banks have repeatedly doubled-up. And the state has underwritten any losing streak.
Yves here. In other words, given the inability of bankers to avoid crises, this destructive pattern will continue until the banks break their backers, meaning the state, or we find a way to stop the game. Loudly contesting the idea that the pay levels at the major capital markets players are in any way warranted is part of the process of bringing the industry to heel.