naked capitalism

By Marshall Auerback, an investment strategist and analyst who writes for New Deal 2.0.

How appropriate that with Halloween just around the corner, the Fed and Treasury have announced a coordinated effort that will put the central bank at the forefront of pay regulation on the zombie firms now kept alive courtesy of US government largesse. Trick or treat for the US taxpayer?

The new pay regulations are ostensibly designed try to align the financial incentives of managers with the longer-term performance of their firms. The Federal Reserve will have direct oversight over the pay of tens of thousands of executives, bankers, and traders. The oversight is being justified as a “safety and soundness issue“, according to Fed Chairman, Ben Bernanke.

Had the Fed and Treasury demonstrated similar concerns about the overheating housing market, the degeneration of lending standards, and the proliferation of dangerous Over The Counter (OTC) derivatives during the past 10 years, it could have done much to alleviate today’s still profound financial instability.

This measure, by contrast, reeks of bogus populism. In the words of Reuters’ columnist, Jeffrey Cane:

By making executives at seven companies wear hair-shirts, some of the populist anger over bonuses and Wall Street may be assuaged – anger that should rightly be channeled into calls to prevent banks from engaging in risky activities. There’s no reason that banks that are back-stopped by the government should be in the securities business. Taxpayers – voters – should ignore the media fascination with pay and urge that Congress heavily regulate and tax such risky activities.

As Cane acknowledges, the curbs only apply to the newest wards of the state, the likes of AIG, Chrysler, GM, Bank of America, and Citibank. The more than 700 banks and other companies that have directly benefited from the government’s largesse are not affected – even those who are minting profits from credit markets propped up by trillions of dollars of the taxpayers’ money, and who continue to benefit as a consequence of the FDIC guarantees of their commercial paper, which substantially reduced borrowing costs at a time of uniquely high financial stress. Yet we’re still neither proposing any kind of serious regulation, nor any kind of resolution mechanism to deal with the problem of “too big to fail” banks.

The Fed has other big ideas: Federal Reserve Chairman Ben S. Bernanke has also called on Congress to ensure that the costs of closing down large financial institutions are borne by the industry instead of taxpayers. He has called for a “credible process” for imposing losses on the shareholders and creditors, saying “any resolution costs incurred by the government should be paid through an assessment on the financial industry.” That would be the very same financial industry that has already received trillions of dollars in financial guarantees and aid by the Federal Government, wouldn’t it? The left hand giveth, and the right hand taketh away. It’s all a big shell game. Given the absence of structural changes in the industry, this will simply increase the cost of credit, so the taxpayer will end up paying again.

What’s with the Fed’s new-found populism? It’s as if Ben Bernanke has started to channel his inner Huey Long. There could well be other motivations at play here.

The Federal Reserve, as we know, is now under uncomfortably high public scrutiny and its hitherto secretive actions are being subject to the greatest degree of Congressional and press scrutiny that the institution has experienced in its 96-year history. True, in the 1970s, the then-Chairman of the Committee of Financial Services, Henry Reuss, sought to challenge the constitutionality of the Federal Open Market Committee’s ultimate decision-making power on monetary policy, but he was denied standing. The Supreme Court never ruled on the issue. But now, like so many other things, the Fed’s privileged status in our society is again being queried. A healthy dose of skepticism in regard to their actions is well merited.

And what of the Obama Administration itself? It demonstrates a similar kind of cognitive dissonance evinced by the Federal Reserve. Having left open the gates of the asylum, the President and his main economic advisers profess shock, (”shock!”) that the sociopaths who run our investment banks are back to their old tricks, daring to gamble in a totally uninhibited manner with the taxpayers’ dollars. These are the same dollars which have been all but guaranteed by Treasury Secretary Geithner, who promised that there would be “no more Lehmans”. These are the very same tax dollars now being deployed to lobby against financial reforms, which will mitigate the practices that created the mess in the first place. The next time, these same banks are likely to leave a catastrophe far scarier than any Halloween costume. Having been duped, the President now seeks to deploy a cheap political trick. He is attacking an easy political target, but as usual, doing nothing concrete to ameliorate credit conditions. Indeed, his actions will likely increase the cost of credit.

Just over the weekend, the President again lambasted the banks for failing to enhance credit availability. During his weekly address, the President said banks should “return the favor” of their recent taxpayer-financed bailout by lending more money to small businesses. As a taxpayer, I don’t recall ever granting this “favor”, but that aside, the President still demonstrates huge conceptual confusion when it comes to the economy. Under the guidance of Larry Summers and Timmy Geithner, policy has continued to preserve the interests of big financial companies, rather than implementing government programs that directly sustain employment and restore states’ finances. To make matters worse, the Obama Administration is already preoccupied with “paying for” additional spending through tax hikes or spending cuts elsewhere. It does not appear to be willing to let the fiscal position of the federal budget grow as needed to meet current challenges.

All of which collectively will serve to cause incomes to stagnate and personal balance sheets to deteriorate, thereby diminishing creditworthiness. Repeat after me, Mr. President: “Enhance creditworthiness and improved credit conditions will follow; personal balance sheets before bank balance sheets.” You improve aggregate demand, and incomes will rise, as will the borrowers’ capacity to borrow. All of which makes it easier for lenders to lend.

It’s so simple that even a banker can figure it out.

And here is why the whole model of securitization itself precludes improving credit conditions. In the words of L. Randall Wray and Eric Tymoigne in “It isn’t Working: Time for More Radical Policies“,

When a commercial bank makes a loan, the loan officer wonders “how will I get repaid”. Because the loan is illiquid and will be held to maturity, it is the ability to repay that matters-and it is most prudent to rely on income flows rather than potential seizure and forced sale of the asset at some time in the possibly distant future and in unknown market conditions. On the other hand, when an investment bank makes a loan, the loan officer wonders “how will I sell this asset”. The future matters only to the degree that it enters the value of the asset today because it will be sold immediately.

It’s Halloween at the end of this week, so it wouldn’t be right to conclude this post without a bit of Halloween imagery. Last week, I described the bankers as vampires (with full tribute to Matt Taibbi ) and the banks as zombies. I have also noted (as has my colleague, Anat Shenker) the tendency of many deficit terrorists (many of whom are the largest beneficiaries so far of taxpayer bailouts, but who still claim we “can’t afford” to help the vast majority of Americans) to deploy imagery relating to our government spending as something unnatural or unhealthy. We hear characterizations of the budget deficit as a “national cancer” (former Illinois Senator, Paul Simon), or government spending as something akin to a heroin addiction (a description I heard last week at a Financial Forum in Denver, Colorado). True to my love of Hammer Film horror classics, I prefer a different image to describe our government spending. It’s a necessary blood transfusion, without which the patient (in this case, the US economy) dies.
But like any blood transfusion, you want to give it to a sick patient who has a chance to get better, not a terminally ill one (i.e. like our TBTF banks), who are being propped up by phony accounting (what we might call a life support system, where the government steadfastly refuses to pull the plug).

Unfortunately, these “blood transfusions” have hitherto been misallocated. No amount of populist grandstanding by the President or the Fed can change that. When we aid banks in this way, it is like using our blood to feed vampires instead of giving that blood to people who could genuinely use a transfusion. This causes those vampires, in turn, to prey on the rest of us. By the same token, introducing pay restrictions on the likes of AIG, BofA, or Citi is akin to complaining about the quality of the clothing being worn by the zombies as they rampage and munch away on the living.

Happy Halloween everybody.

The Wall Street Journal reports that the pay czar, Kenneth Feinberg, is going to cut executive comp at 7 TARP recipients for the 25 most highly paid employees.

Does this really mean anything? The press will noise it up as significant (and some outlets will no doubt finger wag at this “interference”) but the short answer is no.

First, recall Feinberg’s hollow mandate. He is limited to only TARP recipients, not the beneficiaries of other forms of government largesse. And as anyone who has an operating brain cell knows, the number of firms on the dole and the degree of subsidies is much greater than the TARP. Have a look at the Fed’s balance sheet for a reality check. Even Larry Summers said,

There is no financial institution that exists today that is not the direct or indirect beneficiary of trillions of dollars of taxpayer support for the financial system.

So let us look at the list of companies affected. AIG, Bank of America, Citigroup, General Motors Co., GMAC Inc., Chrysler Group LLC and Chrysler Financial. AIG is effectively nationalized but is allowed to operate as a private company, a simply bizarre state of affairs. Pay cuts falls well short of the oversight the government should be exercising (any private owner with that big of a stake would have thrown out the board and installed new management, for starters, and be all over AIG like a cheap suit). So this is an overdue, token measure to appease the public over the AIG retention bonuses that were also extended to clearly non-essential support staff, which is a clear tipoff that they were also extended to non-essential management.

Four of the companies are auto bailout related, so we can exclude them as far as implications for big financial firms are concerned.

Citigroup is an obvious ward of the state too, and he AIG argument applies there. The government should have more control there too, which does NOT mean micromanagement. When the Swedish nationalized their banks, they replaced management and set strict goals and targets, but did not interfere in operations. Bank of America may look like a borderline case, but it would be dead now had it not gotten emergency infusions. Given its credit card losses, Merrill, and Countrywide (for starters) combined with the sudden exit of Ken Lewis, it may well be in worse shape than is now perceived.

The point is that the collection of these scalps will do nothing to comp levels ex these firms. The companies that also enjoy implicit government guarantees are free to do the “heads I win, tails you lose” game of privatized gains and socialized losses. And Ken Lewis is the poster child of why these measures are completely meaningless. He sacrificed his 2009 pay, but will still collect $125 million when he departs Bank of America.

If the government is going to backstop the industry (and this isn’t an “if” anymore), it needs to limit those firm’s activities to what is socially valuable and regulate them heavily to contain risk taking. As we have said, reining in executive pay (and note there is no will to do that anyhow) is not an effective approach. Those employees who don’t like that are free to decamp and raise money in ways that do not involve the regulated firms in any way, shape, or form, save perhaps counterparty exposures on very safe, highly liquid instruments.

I was on the Andrew Hall/Phibro beat for a while and must confess I dropped it in the finish-the-book crunch. I neglected to follow up on and important aspect of the story that is still germane.

Readers may recall the brouhaha: Hall, a high stakes oil trader, had received nearly $100 million in 2008 at Citigroup (Phibro, his unit, was a subsidiary) and had the potential to earn that much this year. His pay deal looked unseemly even by Wall Street standards. As we noted in our first post on this matter (where we took issue with the Wall Street Journal’s posture):

No where is the asymmetry of this arrangement mentioned: that Hall and his team get the upside (30%, more than a hedge fund success fee, more than even LTCM in its glory days, which got a 25% upside fee), but the taxpayer gets stuck with the losses. Hall and his bunch have the richest option deal going. Nor does it bother to point out that Hall would find it hard to get access to as much capital as Citi provides him on such rich terms from the outside. Citi not only provides him with more equity than he is likely to be able to raise (certainly for a 30% upside fee) and his cost of funding is sure to be considerably lower than if he were to operate on his own.

The indefensible aspect in our new bailout era was that taxpayers should be backstopping or funding activities only if they are essential parts of the financial infrastructure. Principal trading is not on the list.

What was intriguing was as things rolled forward was that is was increasingly obvious that Hall would not be able to replicate the conditions he had at Citi anywhere else. After some initial resistance to the pay czar pressure, Hall started negotiating with Citi. Huh? If he was such a hot item, he should have been able to decamp and raise money, or find a happy home in another bank. Contrary to conventional wisdom, not all banks in the world are walking wounded. The Japanese, who are keenly interested in oil thanks to their need to import a ton, would be candidates. Some Eurobanks are not on the government drip feed (Sandater, Deutschebank, although their regulators could have curbed a deal). And there was always the option of a joint deal, say a bank plus a deep pockets investor, private equity firm, or sovereign wealth fund (they took a hit, but should be showing some improvement as equity markets rebound).

But what did we see? Hall wound up at….Occidental Petroleum. Maybe the company has changed, but I had some very limited dealings with them in the 1980s (they were pedaling an utter garbage barge of an oil shale deal, and were so eager to foist it on the chump Japanese that I got to meet all the top brass. To put it politely, they were not nice people, and I see that some that I met are, ahem, still in positions of considerable influence. My dim views then were confirmed by commodity traders).

Now the Journal in particular put up a series of articles that finger wagged at government interference (see here, here, and here for a few examples, with a qualified exception here).

Whoa. Phibro earned an average of $351 million a year for the last 5 years. Oxy paid $250 million, the current value of Phibro’s trading positions. There was NO premium, zero, zip, nada, for the earning potential of the business. Zero. Oxy bought the business for its liquidation value.

Hall’s travails had been in the paper for months. The usual routine if you want to get offers for a division is to let the world know it is for sale (the usual code is “exploring strategic options” but more blatant forms like front page business section stories work fine too). Hall most certainly would have put out feelers; presumably Citi did as well. This was the best deal they could scrounge up.

So what does that say?

A LOT of Hall’s performance was due to cheap funding from Citi, and probably massive leverage too, conditions he could not replicate anywhere else. A risky, highly geared operation should pay an interest rate appropriate to the hazards it is taking, not the borrowing costs of its parent (this basic premise is widespread in financial firms, embodied in approaches like RAROC (Risk Adjusted Return on Capital), the Basel I and II rules, and Economic Value Added models.

Hall could not have been a balance sheet hero unless his pay deal did not adjust for the riskiness of his borrowings. Since Phibro acquired Salomon Brothers (which then came out on top in a palace coup) which was later acquired by Travelers and then merged into Citi, it is possible that Hall’s arrangement was grandfathered and the internal accounting made to correspond to it rather than the conventional metrics in use today.

It is impossible to know for certain, but the deal Citi cut with Oxy struck strongly suggests that Phibro’s preformance was in large measure the result of amped up leverage that no one outside Citi was able or willing to provide. Future financial reports from Oxy may shed more light.

An interesting contract in reporting today. Reader (Tom C) sent me the Wall Street Journal version of this story, by Michael R. Crittenden and Liam Pleven, titled “AIG Execs Returned Only $19M Of $45M In Pledged Repayments.” I decided to look at Bloomberg as well, as found one on the same subject, “AIG Should Trim $198 Million in Awards, Feinberg Says,” by Hugh Son. But the Journal has now fallen in line with Bloomberg and has a similar finger-shaking-at-government-interference headline, “U.S. Wants AIG Retention Pay Cut.”

Now look at the difference in emphasis via the headlines. The first highlights that AIG did not live up to its promise to return bonuses, while the Bloomberg version puts the focus on the presumed interference of the pay master, Kenneth Feinberg. But even the Bloomberg version contains a doozy:

American International Group Inc., the insurer that gave bonuses to the derivatives staff blamed for its near-collapse, was advised by the Obama administration to reduce a pending $198 million payment to the employees.

The order from Kenneth Feinberg, President Barack Obama’s special master on compensation, was revealed today in a report by Neil Barofsky, special inspector for the Troubled Asset Relief Program. Feinberg didn’t specify how much the payments for New York-based AIG should be reduced, Barofsky said.

AIG sparked a national furor in March after awarding about $165 million to employees in the unit that sold credit-default swaps. Obama called the bonuses an “outrage.” The bailed-out insurer has said the pay is needed to keep staff unwinding the derivatives. Payments included $7,700 to a kitchen assistant and $87,500 for an administrative assistant, according to the report.

“It is unclear whether Federal Reserve Bank of New York officials knew that thousands of dollars in payments would go to non-essential AIG Financial Products support employees, such as the kitchen and mailroom assistants,” Barofsky’s report said.

We had noted earlier:

In the waning days of the Bush Administration, AIG kept brazenly enlarging the number of recipients of retention bonuses. At one point, it added 2700, who received much lower amounts on average than earlier recipients. I speculated at the time that this was done for the sole purpose of lowering the average amount received to make it less offensive.

The Wall Street Journal story focuses, as the headline suggests, on the proposed bonus cut, without giving the reason why (aside from suggesting the reasons were political, as opposed to AIG is a ward fo the state and should be treated as such):

The U.S. Treasury is pressing American International Group Inc. to reduce $198 million in scheduled retention payments as company and government officials continue to wrangle over pay packages that set off a political firestorm earlier this year.

A report from the special inspector general for the government’s $700 billion financial rescue plan said the Obama administration’s pay czar has informed AIG management that the retention payments for AIG’s financial products division should be reduced. Kenneth Feinberg, Treasury’s special master for executive compensation, has not indicated to AIG management what figure would be acceptable, according to a copy of the report obtained by The Wall Street Journal.

AIG management has previously said it would try to reduce the pending payments by “at least” 30%.

The Journal does include this tidbit:

The report by Special Inspector General Neil Barofsky found that only $19 million, or less than half, of the $45 million in pledged repayments had been received by the end of August. Company officials told investigators that receiving the additional $26 million could hinge on how Feinberg and AIG negotiate the second set of repayments.

But the story only gets to how widespread the supposed “retention” bonsuses were towards the end. Recall that the rationale was to keep employees with essential expertise from leaving. Yet the story, remarkably, tries to pass off clearly unwarranted payments as no big deal because the amounts were small:

The report also provides new details on the range of retention payments handed out to employees at AIG’s financial products division. Individual payouts from the $168 million handed out in March ranged from $700 for a file administrator to more than $4 million for one executive vice president, investigators found. Approximately 62% of employees in the financial products division received a retention award of more than $100,000, though some employees — such as a kitchen assistant who received $7,700 — received much less.

Clearly, if staff who were OBVIOUSLY not mission critical got bonuses, it suggests that managers and higher ups who were similarly dispensable were also paid unjustified retention bonuses.

The Financial Times reports that the so-called pay czar Kenneth Feinberg, who is in charge of overseeing compensation at TARP recipients, is going to crack down on some of the bonuses paid at AIG:

The Obama administration’s pay tsar has indicated he will take a tough stance on executive pay at AIG, the state-controlled insurance group that sparked outrage over its bonus payments earlier this year.

Kenneth Feinberg, the “special master” for pay at companies that have received government support, has raised concerns inside and outside AIG by putting pressure on the company to alter some pay plans.

People close to the situation said regulators had expressed fears that a crackdown on AIG could impel executives to leave, further harming the company’s prospects and the chances of taxpayers’ money being repaid.

While I think the pay levels in the financial services industry are to a significant degree unwarranted, using pay as a quick and dirty way to appease the masses and try to forgo the needed heavy lifting of real reform and meaningful oversight is likely to be ineffective.

First, let’s parse the latest AIG brouhaha. We have the claim made that if the government dares meddle with AIG’s pay, quelle horreur, the US taxpayer might not get its dough back. Sounds like a threat, now doesn’t it?

Reality check, please. In case you were not paying attention, the US is NOT going to get its money back from its little AIG rescue operation. When AIG came to the Federal government a year ago, in desperation, it agreed to a deliberately punitive interest rate (11.50%) because it was confident (or deluded) that it could sell some divisions and pay off the borrowings pronto. Its tune quickly changed, the deal was retraded several times, with the net result that AIG got MORE money and had the terms of its loans made MUCH more favorable.

So let us pause here. If any private sector lender had a borrower pull that stunt, the rates on the old money would have stayed in place and and the incremental money would have been on vastly worse terms. 15%-20% plus even more intrusive oversight would be entirely reasonable.

So let us not forget the first premise: whatever results AIG is reporting are misstated. They reflect an indefensible subsidy from the US taxpayer, one vastly in excess of the already egrigous subsidy of bailing them out without taking control. The extent of government support to AIG means it owns the place from an economic standpoint, yet is perversely loath to act like one.

Second ugly issue: the longer that AIG has been hocking its operations, the more the notion that there is a ton of equity value waiting to be unlocked looks dubious. Yeah, the deal market isn’t what it used to be. But private equity buyers have been sitting on the sidelines, and they need to put money to work to justify their existence. If AIG won’t take the price that PE buyers will offer, that suggests that AIG has an inflated idea of what its subsidiaries are worth (and by the way, this is a pretty common syndrome). Moreover, at least with some operations, it appears that AIG was engaged in reinsurance relationships among its subs, which means in aggregate they may not have been as well capitalized as they seemed.

Third ugly issue: talent? Surely you jest. My one buddy at AIG was terribly circumspect and very senior (responsible for a $100 billion portfolio). He joined shortly before Hank Greenberg departed. He was looking for a new job as soon as Greenberg left. Not that he had a close relationship with Greenberg; he didn’t. But he could see that the place became unmanageable overnight. Greenberg had run AIG like a French court. All decisions of any consequence, and plenty that weren’t, came to him. There was no way to get things resolved in his absence. And there was no one who had his detailed knowledge of the businesses to step into the breach.

My colleague said, “It is like being in a car with both axles removed. The car is still moving forward, but the wheels are about to fall off.” That was two months after Greenberg was history. Anyone with an iota of self preservation instincts and options was looking for a job. (I will concede that there may be some capable individuals that out of a sense of misguided loyalty lashed themselves to the mast of this sinking ship, but at this juncture, they are likely to be exceptions).

Now narrowly speaking, one can argue that Feinberg is 100% correct to be scrutinizing AIG pay. In the waning days of the Bush Administration, AIG kept brazenly enlarging the number of recipients of retention bonuses. At one point, it added 2700, who received much lower amounts on average than earlier recipients. I speculated at the time that this was done for the sole purpose of lowering the average amount received to make it less offensive.

But if you widen the lens, the critics are right, for all the wrong reasons. Yes, AIG might well lose people that it doesn’t want to because its pay is not “competitive”. And why is that? Because the whole bloody financial system is getting massive subsidies (super cheap borrowing rates, fancy Fed facilities, now explicit backstopping), but only current TARP recipients are being put through the wringer! Goldman and the others who were allowed to slip the TARP leash should be subject to the same level of scrutiny as AIG. They were every bit as dead as of October 2008, and their current high profits are the result of an engineered super favorable environment and a failure to make them carry vastly more in the way of equity capital.

But that conundrum raises a much bigger issue. Pay is the wrong way to tackle this problem. It’s a lazy, crowd-appeasing, intellectually dishonest approach. The out of line pay is a symptom, and any attempt to treat symptoms as causes is likely to be ineffective, more likely dysfunctional.

The fact is that policy has encouraged and enabled financial firms to run massive risks with way too little in the way of risk reserves. Not only have they gotten good at playing the regulatory game, but they have also become highly skilled at shifting risks onto chumps (AIG being the poster child).

Now why is trying to control this through pay not such a hot idea? First, one hundred years of performance appraisal systems have proven them to be abject failures (aa 1992 paper by
Patrick D. Larkey and Jonathan P. Caulkin, “All Above Average and Other Unintended
Consequences of Performance Appraisal Systems,” did a brilliant job of dissecting why, but it was too heretical to get published. You can read a few key points here in the section “The Illusion of Meritocracy”). Second, comp systems are supposed to solve what is called a principal-agent problem. You the person hiring someone to work on your behalf wants to make sure they are operating in accordance with YOUR best interests in mind, not theirs.

But what did we learn from 20 years of executive rewards schemes that had lots of equity incentives that would supposedly align the interest of top brass with that of shareholders. We got instead an explosion of CEO pay and companies that are so fixated on quarterly earnings that they are reluctant to invest in growth. How did that come to pass?

BECAUSE THE AGENTS AND NOT THE PRINCIPALS DESIGNED THE PAY SCHEMES!  The foxes were running the hen house. Oh, sure, we had some fig leaves, it was the HR department that hired the compensation consultant, and the board (nominated by the incumbent management) that signed off on it, but it is pretty clear that a comp consultant that did not deliver a CEO-wallet-fattening plan was unlikely to get much repeat business.

And is anything going to be materially different? No. The conventional wisdom is that having employees take a high level of pay as equity is a magic solution, conveniently forgetting that Bear and Lehman both featured very high levels of shareholding among its top management and employees. Feinberg is only intervening in outliers, to collect a few scalps. He is in a very difficult position and is trying to make the best of it.

The financial services industry now has an unimaginably rich deal: privatized gains and socialized losses, and with tons of leverage too, which amps up the apparent profits and hence the pay levels these looters can claim they deserve. The way to attack this problem is to constrain the level of risk assumption. That in turn requires understanding the products and the markets, something the authorities have completely abdicated. With so much “talent” looking for jobs, now would be the perfect time to invest in catching up.

The Wall Street Journal has a headline that would warm the cockles of any populist’s heart: “Bankers Face Sweeping Curbs on Pay.” And even more impressive, who is going to rein in banker compensation? The Fed.

That alone should tell you there is less here than meets they eye.

Let’s look at the outline of the idea:

The Fed’s plan would, for the first time, inject government regulators deep into compensation decisions traditionally reserved for the banks’ corporate boards and executives.

Under the proposal, the Fed could reject any compensation policies it believes encourage bank employees — from chief executives, to traders, to loan officers — to take too much risk. Bureaucrats wouldn’t set the pay of individuals, but would review and, if necessary, amend each bank’s salary and bonus policies to make sure they don’t create harmful incentives.

Let’s parse what is happening.

First, despite the bold headline, this is not a done deal. While the Fed does not need approval to implement this idea, the proposal is weeks away from being fleshed out. Expects gnashing of teeth and tons of pushback from industry lobbyists. Whatever has been leaked will probably be diluted. Recall what happened to the stress tests, where the big banks managed to beat back the regulators on many key issues.

Second, the timing seems awfully sus. Ron Paul’s “audit the Fed” bill now has enough votes so as to be veto-proof in the House. The G-20 meeting are also sure to include discussions on how to curb banks. Europeans are particularly keen to put limits on financial firms, the countries with big financial centers, the US and the UK, predictably less so. Moreover, the Fed can always argue to go for whatever the lowest common denominator is by international standards (resorting to the usual excuse, “if we are more toughminded, the banking ‘talent’ will all leave”). So this looks like a cynical effort by the central bank to burnish its image.

Third, as a result, it is hard to believe the central bank’s heart is in this. The Fed has thrown an extensive safety net under the banking industry and has proposed zero in the way of measures to combat the moral hazard and bad incentives creative by such massive subsidies of risk-taking. They’ve been shockingly unprepared to deal with this issue. Now we have a leak that action on the pay front is forthcoming, but the proof of the pudding is whether the Fed would do anything more than implement a few obvious measures, like mechanisms to claw back pay under certain circumstances.

The problem is, despite the swashbuckling talk in the Wall Street Journal story, the ideas on the table suggest any moves will directed at the most extreme practices, simply to curry the image that the Fed is Doing Something. The proposed measures are not extensive or intrusive enough to deal with the fact that we now officially have a system of socialized losses and privatized gain. That arrangement calls for heavy, intrusive oversight to curb risk-taking of crucial, social valuable banking and capital markets functions, managing them as a utility. Those regulated institutions would also need to be restricted from extending credit for financial or investing activities that were not deemed socially valuable (that means, for instance, no prime broker loans, hedge funds would have to get their leverage via exchange traded instruments or non-bank affiliated creditors).

But what we see instead is:

The U.S.’s largest banks, about 25 in number, would get especially close scrutiny. The central bank intends to compare these banks as a group to see if any practices stand out as unusually dangerous to their firms.

This group is apples and oranges. The risk-taking that was really troublesome and hard to police took place at the big capital markets players; the former investment banks plus Citi. If you believe Gillian Tett’s Fool’s Gold, JP Morgan was more prudent by virtue of having a more conservative culture on risk, and then later, Jamie Dimon, although a cynic might say their caution was due to taking big losses on credit default swaps in the Ford and GM downgrades in 2005 (I think 2005, forgive me if 2004), which was a painful but in the end very valuable reminder. But the same issues apply to JP Morgan.

How is the Fed going to curb risk when for well over ten years, it has refused to understand where risks in complex organizations lie, instead relying on their own risk models (recall in the infamous stress tests, the Treasury asked banks simply to run scenarios, and the Fed has proposed institutionalizing the stress test approach, with NO suggestion that the Fed develop its own models for measuring the risk on bank books). For instance, banks blew themselves up last cycle on AAA rated instruments precisely because regulators allowed banks to carry very little capital against them (Basel II banks even got to assign their own capital, which they generally decided was zero if they hedged the risk with a credit default swap).

To wit:

The proposal will likely push banks to use “clawbacks” — provisions to reclaim the pay of staffers who take risks that hurt their firms — in certain pay packages, among other tools, to punish employees for taking excessive risks with their firms’ money. The central bank could also demand that more pay be offered through restricted stock or other forms of long-term compensation designed not to reward short-term performance.

This all sounds well and good, but the use of restricted stock has proven wildly ineffective in curbing a short-term focus. Bear and Lehman had very high levels of employee stock ownership across the firm, and look how much good that did in curbing their risk taking.

But in a way, that is irrelevant. One of the effects of any rules like this is Morgan Stanley and Goldman will ditch their bank holding company status, pronto. Even this level of intrusion is more than they will want to deal with.

By contrast the risk taking at traditional banks (yes, we do remember that Countrywide, IndyMac, et al blew themselves) could and should have been managed through bank examinations. A lot of the people at those banks, as reports have dribbled out in the media, were kept from reining in the reckless practices at these banks not by being bribed (rich pay) but by the mundane threat of job loss if they did not play along (this in particular applies to roles that are not richly rewarded and are designed to check the sales types, like appraisers and compliance).

So again, we have symbolism and probably some action on a few outliers, but otherwise business at usual wrapped in a reform banner. Welcome to corpocracy in America.

The Financial Times tonight reports that Goldman CEO Lloyd Blankfein made “startling” remarks in Germany, for instance, that a lot of banking activity is rather thin on redeeming social value. Oh, and he admitted bankers might be paid too much, too.

Gee, with revelations like that, what might he to ‘fess up to next? That some employees have substance abuse problems? That bankers take clients to strip clubs? The mind simply boggles.

Admitting to something that everyone knows is hardly a confession. particularly when it is as watered down as this one:

Mr Blankfein said: “The industry let the growth and complexity in new instruments outstrip their economic and social utility as well as the operational capacity to manage them.”

One senior European banker said Mr Blankfein’s speech was clearly geared to his audience.

Many German banks filled their balance sheets with asset-backed securities bought with cheap short-term funding in a strategy that unravelled spectacularly when funding dried up last year. “Germany has an open wound,” said the banker.

“Blankfein was clearly trying to placate the locals and show some kind of contrition. But I agree with what he said – these were silly bets and they were absolutely useless.”

Acknowledging that some products had become too complex, Mr Blankfein said: “We have a responsibility to the financial system which demands that we should not favour non-standard products when a client’s objective and the market’s interests can be met through a standardised product traded on an exchange”….

The Goldman boss, who himself received total compensation of more than $70m in 2007, said multi-year bonuses should be outlawed and senior staff should receive large proportions of pay in stock, rather than cash.

These are all non-concession concessions. The idea of moving credit default swaps to exchanges (which is the candidate under consideration) is likely to prove to be a non-starter. I was initially a big fan of the idea of either shutting them down or moving CDS to exchanges, but the more I have had to look into them, neither looks like a good option so I am now leaning towards strangling them slowly by regulating them aggressively. It is disheartening that there is no good, simple, surgical solution.

There are very few CDS that trade actively, I am told only about 50 names, and even those are probably not traded enough on a daily basis for moving them to an exchange to be viable (the very fact that CDS aren’t even actively traded enough for them to be included in Bloomberg and Reuters feeds). Skeptics should read Donald MacKenzie’s An Engine, Not a Camera, on how much uneconomic activity by Chicago exchange members was required to get a some financial futures contracts going. And this was a business the community wanted to succeed. Conversely, the dealers have good reason not to make heroic efforts.

Second, even if an exchange were to get going, or ISDA did succeed in creating more standardized contracts, the fact that the reform proposals on the table allow dealers to trade OTC is an exception you can drive a truck through. The profit model is intact, and everyone understands that.

Recall also that Goldman, unlike JP Morgan, did not try renegotiating the repayment terms of its TARP warrants. So Goldman is now trying to play statesmanlike, and will let everyone else engage in more public piggy behavior. All Goldman has to do is look better than its peers, which isn’t hard (well, save the government capture bit, that is kind of hard to disguise).

Churchill once said, “In war, resolution; in defeat, defiance; in victory, magnanimity”. If there was any possibility of real reform, Blankfein would not even go as far as making gracious-sounding but empty concessions. By contrast, it’s cheap, easy, and prudent to make nice noises when you have nothing to lose. So all we have is clever posturing to diffuse some ire, and the FT is treating it with more dignity than it deserves.

Perhaps I place too much emphasis on turn of phrase. However, the fact that the EU officialdom is starting to use feral imagery in describing the posture they intend to take relative to the financial services industry says they have a keen appreciation of what they are up against. The battle lines are being drawn on pay, with EU members increasingly saying that more than enough is too much. But it’s not that hard for most of them to sign up for this program, since few are as finance-centric as the US and UK have become.

What is even more remarkable is G20 members are claiming they are largely in alignment on this issue. I cannot believe Turbo Timmy is on board (it is one thing to take the photo op, quite another to deliver on nice-sounding statements of philosophy), but I would be delighted to be proved wrong. However, the US experience confirms that there is much to be gained by talking a good game without following through.

From Bloomberg:

European Union finance ministers agreed to push for tighter rules on bank bonuses…Authorities need “stronger muscles and sharper teeth,” Swedish Finance Minister Anders Borg, whose nation currently holds the rotating EU presidency…“The bonus culture must come to an end.”…

French Finance Minister Christine Lagarde said she is optimistic that all 27 EU governments will support proposals she brought to yesterday’s meeting to curb bonus pay at banks. She said the options included an outright cap on bonuses, limiting them as a percentage of total pay, and taxing them.

“In the hours and days to come, all the finance ministers will understand the suitability of the French position and will rally to it, and in a very formal way that may surprise you,” Lagarde said…

“The British were more positive than could be deducted from news reports in the past week,” Dutch Finance Minister Wouter Bos said. Earlier, in response to a question about the U.K.’s efforts to curb bonuses, Bos said he sees “some major countries moving in the right direction but not every country is moving yet as quickly as they possibly could.”

A U.K. official said the government in London “is committed to ending the short-term bonus culture and pay practices that could threaten the stability of the financial system. We need to see measures that are global in scope,” said the official, who spoke on condition of anonymity.

German Deputy Finance Minister Joerg Asmussen said the U.K. endorsed the French proposals “in principle.” The EU wants “a clear relationship between bonus and performance.”….

“Now we have to find a common G-20 position in London,” Asmussen said. “It won’t be enough for Europe to take a position.”…

This will be a very difficult thing to get agreement on and implemented across a wide range of countries,” said Jonathan Loynes, chief European economist at Capital Economics Ltd. in London. “Experience shows it needs to be sorted out on a country-by-country basis.”

A new and welcome front may be opening in the efforts to rein in an overly powerful and now explicitly state-backed financial services industry: challenging its claims that its activities are good for society. While the provision of credit is important to any economy beyond the barter stage, finance should be the handmaiden of commerce, not its master. But the perverse (and disproved) logic of financial economics, that markets are efficient (and by extension, virtuous) means that those associated with them can assert that their services are vital, even if what they are really doing is tantamount to looting.

One salvo comes tonight in the Financial Times, in “Overmighty finance levies a tithe on growth,” by Harvard economics professor Benjamin Friedman,

The crucial role of the financial system in a mostly free-enterprise economy is to allocate capital investment towards the most productive applications…

If a new fertiliser offers a farmer the prospect of a higher crop yield but its price and the cost of transporting and spreading it exceeds what the additional produce will bring at market, it is a bad deal for the farmer. A financial system, which allocates scarce investment capital, is no different.

The discussion of the costs associated with our financial system has mostly focused on the paper value of its recent mistakes…The estimated $4,000bn of losses in US mortgage-related securities are just the surface of the story. Beneath those losses are real economic costs due to wasted resources: mortgage mis-pricing led the US to build far too many houses. Similar pricing errors in the telecoms bubble a decade ago led to millions of miles of unused fibre-optic cable being laid.

The misused resources and the output foregone due to the recession are still part of the calculation of how (in)efficient our financial system is. What has somehow escaped attention is the cost of running the system…..

For years, much of the best young talent in the western world has gone to private financial firms. At Harvard more than a quarter of our recent graduates who have taken jobs have headed into finance…. we are wasting one of our most precious resources…..much of their activity adds no economic value.

Perversely, the largest individual returns seem to flow to those whose job is to ensure that microscopically small deviations from observable regularities in asset price relationships persist for only one millisecond instead of three…

In the US, both the share of all wages and salaries paid by the financial firms and those firms’ share of all profits earned have risen sharply in recent decades. In the early 1950s, the “finance” sector (not counting insurance and real estate) accounted for 3 per cent of all US wages and salaries; in the current decade that share is 7 per cent. From the 1950s to the 1980s, the finance sector accounted for 10 per cent of all profits earned by US corporations; in the first half of this decade it reached 34 per cent…

What makes a more efficient financial system worthwhile is not just that it allows us to achieve greater production and economic growth, but that the rest of the economy benefits. The more the financial system costs to run, the higher the hurdle…

Economic decisions are supposed to turn on weighing costs and benefits. It is time for some serious discussion of what our financial system is actually delivering to our economy and what it costs to do that.

A second effort is being mounted by French president Sarkozy is proposing international standards to rein in bank pay. This is a bold idea, since only international coordination can work to constrain pay, but the countries controlled by the financial classes are certain to reject or dilute any such idea.

From Linda Beale:

French President Sarkozy has seen how banks have responded to the financial crisis of their own making with extravagant bonuses for the very employees responsible for huge losses that led to central bank interventions and much taxpayer funding at stake. To put it starkly, he doesn’t like it. So he has proposed a solution.

According to BNA’s Daily Tax RealTime, he has announced plans for a proposal for bonuses modelled on the recent coordination among countries in dealing with tax havens and banking secrecy. The proposal, to be fleshed out at the September meeting of the G-20 governments, calls for a coordinated effort by the G-20 governments to reign in bonus behavior. Each country would agree to impose a tax on bonuses, to be levied at the same rate across the group. In addition, each country would agree to an overall limit on bonuses, calculated as a percentage of the bank’s revenues. The tax would be dedicated to financing guarantees of deposits.

The idea I like the best is restricting bonuses as a percent of revenue for any state-backed organization. That will lead all the people in safe fee businesses to decamp and eliminate the incentives to swing for the fences for the activities supported by taxpayers. I wish that this could serve as a shot across the bankers’ bow. However, a horde of professionals (lawyers, accountants, lobbyists) benefits from outsized Wall Street pay and will also fight tooth and nail to beat back any pay restraints.

I read my first management book at the age of 11, not because it was a management book, but a best seller at the time, And it may have been imprinted by it more than I realized. The Peter Principle says that managers are promoted until they reach their level of incompetence. The classic example is promoting the best salesman to be a sales manager. The joke (all too true) is that you both lose your best salesman and gain a lousy supervisor.

That pattern says that organizations as a whole are not very capable (if they recognize this danger, they should try to manage against it, but the popularity of The Peter Principle did not change corporate practice one jot, at least as far as I can tell). And of course, it explains why there are so many crappy managers and executives.

John Kay of the Financial Times applies this idea to financial firms, arguing that they diversify their way into incompetence:

Financial institutions diversify into their level of incompetence. They extend their scope into activities they understand less…

The principle of diversification into incompetence applies from the largest financial institution to the smallest. AIG was America’s leading insurance company. The company did not just undertake credit insurance, but was the largest trader in the credit default swap market. That is how its financial products group, employing 120 people in London, brought about the collapse of a business that employed 120,000.

Yves here. Citigroup is another example. It isn’t so much that Citi made a disastrous acquisition as it dedicated itself to massive reach as a corporate imperative: be as global and be in every conceivable product niche. That is a prescription for being unable to manage yourself, which is the essence of the big bank’s problems. Back to Kay:

The boredom factor is important. Much of traditional banking is quite boring. The desire to find new challenges is an admirable human trait. It is, however, very expensive for shareholders to allow their chief executives to indulge it.

Public sector bodies are usually constrained in their activities, so deregulation is often a trigger for expensive experimentation. In Britain, many of the efficiency gains from privatisation were squandered in diversification: I watched senior managers spending 80 per cent of their time on activities that generated 1 per cent of turnover and minus 10 per cent of profit. But it is more fun to go on jollies to Buenos Aires than to fix leaking pipes.

To win an auction when you don’t know what you are bidding for is often to lose. This winner’s curse is often behind bad acquisitions because the successful purchaser is the bidder most willing to pay too much. Hence the contest between Royal Bank of Scotland and Barclays as to which bank would court bankruptcy by buying ABN Amro. Ignorance of products may also be a problem. When you are the newcomer and know little, the business that gravitates to you will be the business no one else wants.

But the driving factor is hubris. Jim Collins’s well-timed study of How the Mighty Fall applies to every business I have mentioned. The financial services industry is particularly vulnerable to hubris because sections of it are not very competitive, and randomness plays a large role in the outcome of speculative transactions. It is therefore particularly easy for those who work in financial institutions to make the mistake of believing that their success is the result of exceptional skill rather than good fortune. What more natural to believe than that extraordinary talent will find pots of gold under other rainbows? Until vanity is vanquished, I anticipate that diversification to the level of incompetence will continue to be a powerful element in business behaviour.

With all due respect, I think Kay has the essence of this wrong. First, deals are engrossing and sexy. They are very intense, the top executives are the focus of Big Decisions, and they have a horde of high priced talent catering to them (well actually, leading them by the nose, but they are usually so adept at it that the client often does not realize he is no longer in control).

But the big driver is that bank CEO pay is correlated with the size of the institution. And it is much easier to get big fast by acquisition than organically. Big deals are a wallet-lining activity, and the advisors understand that very well.