naked capitalism

Yves here. Even though I pointed to this article yesterday, it is such a prototypical story of a type of success peculiar to Corporate America that I thought it warranted being featured.

By Mark Ames, the author of Going Postal: Rage, Murder and Rebellion from Reagan’s Workplaces to Clinton’s Columbine. Cross posted from eXiled.

This article was first published in The Daily Banter

Last month, shareholders finally rebelled against Citigroup, the worst of the Too Big To Fail bailout disasters, by filing a lawsuit against outgoing chairman Dick Parsons and handful of executives for stuffing their pockets while running the bank into the ground.

Anyone familiar with Dick Parsons’ past could have told you his term as Citigroup’s chairman would end like this: Shareholder lawsuits, executive pay scandals, and corporate failure on a colossal scale. It’s the Dick Parsons Management Style. In each of the three companies Parsons was appointed to lead, they all failed spectacularly, and somehow Parsons and a handful of top executives always walked away from the yellow-tape crime scenes unscathed. Read the rest of this entry »

A telling taboo in elite circles is the issue of corruption. At INET last year, after a panel discussion on the financial crisis, Jamie Galbraith said he was astonished that there was not a single mention of fraud. His observation was met with a resounding silence.

Similarly, I had a colleague tell me today that I shouldn’t use the “c” word, meaning corruption, since it would alienate potential allies. The logic is similar to arguments against being shrill. He claimed that even if a lot of people in positions of authority engage in corrupt looking behavior, that doesn’t mean they understand it to be corrupt, so calling the corrupt will merely get them worked up to no useful end. They could well think they are doing the right thing and just be victims of cognitive capture.

I deeply oppose this line of argument. First, it assumes that decision-makers don’t recognize when they are taking ethically problematic actions. The people I know who have yielded to institutional pressures to do the wrong thing say they knew they were doing so and found a way to rationalize it. And I suspect even sociopaths know where the lines are. They have to do a better job of covering their tracks when their conduct is dubious.

Second, it assumes that it isn’t worth taking a firm position on ethics because it will turn off powerful people who have engaged in questionable behavior. Better to be less accusatory in order to have a dialogue with them. I don’t buy that because being indulging their justifications of their conduct helps preserve a bad status quo.

One aspect of American exceptionalism is many still believe the US is cleaner and more above board than most other advanced economies. But if you go overseas, you will find that a lot of businessmen see the US as not particularly ethical. One British colleague who has worked with major US firms described the US as becoming more and more a scam-based economy (in fairness, he was really talking about the financial services industry). An American who works a great deal with foreign investors said his clients saw the US at best as on a par with other big countries, at worst, with Russia.

One of the big reasons for the erosion in US behavior is the notion that elite crimes shouldn’t be prosecuted because it would harm the system. Glenn Greenwald describes the pardon of Richard Nixon as a critical embodiment of this principle. And while people in influential positions have long been able to get away with all sorts of bad conduct, it’s one thing to have, say, speeding tickets disappear quietly (the hoi polloi are no wiser) and quite another to have a tax cheat oversee the IRS. In the old days, propriety and reputations mattered, and that served to check bad behavior.

So it is important to define norms and not shy away from words like “fraud” and “corruption” when they fit. While it would be nice if more people in power were capable of feeling guilt, shame will do. Thus naming and shaming are legitimate strategies for letting the elites know that the broader public is not fooled.

It’s also important to recognize that some people at the top of the food chain are willing to criticize bad actors. Ruane, Cunniff & Goldfarb, the well respected investment firm that among other things, manages the fund Sequoia, sent out a letter that is blistering by the reserved standards of that industry. It says that former Fannie chief Jim Johnson, who is currently on the board of Goldman and Target, is not fit to serve on any corporate board. Those of you who read the book Reckless Endangerment may recall the detailed discussion of how Johnson aggressively cultivated support in Washington and helped forge a coalition among affordable housing backers, banks, realtors, and homebuilders (I read the book as being far more anti-Jim Johnson than anti the GSEs per se).

The Sequoia letter says it will vote against Johnson continuing as a Goldman board member and urged clients to join them in opposing him. It describes how Johnson has “been at the center of several egregious corporate governance debacles,” not just at Fannie but also as a board member of United Healthcare and KB Homes. Oh, and he also got a Friend of Angelo sweetheart loan, when with his rich pay package, he was hardly in need of a break on his mortgage.

I urge you to read this short, scathing letter in full.

It’s welcome to see an investor wage a campaign against a tainted board member, particularly one seen as particularly connected and influential. Along with the investor rejection of Vikram Pandit’s pay package, this may be the beginning of a long overdue demand for greater accountability from the governing classes. And these calls are harder to ignore when they come from experts and peers.

By William Lazonick, professor of economics and director of the UMass Center for Industrial Competitiveness. His book, “Sustainable Prosperity in the New Economy? Business Organization and High-Tech Employment in the United States” (Upjohn Institute, 2009) won the 2010 Schumpeter Prize. Cross posted from Alternet

Corporations are not working for the 99 percent. But this wasn’t always the case. In a special five-part series, William Lazonick, professor at UMass, president of the Academic-Industry Research Network, and a leading expert on the business corporation, along with journalist Ken Jacobson and AlterNet’s Lynn Parramore, will examine the foundations, history and purpose of the corporation to answer this vital question: How can the public take control of the business corporation and make it work for the real economy?

While most Americans struggle to make ends meet, the CEOs of major U.S. business corporations are pulling eight-figure, and sometimes even nine-figure, compensation packages. When they win, the 99 percent lose. We rely on these executives to allocate corporate resources to investments in new products and processes that, in a world of global competition, can provide us with good jobs. Yet the ways in which we permit top corporate executives to be paid actually gives them a strong disincentive to invest in innovation and training. The proper function of the executive is to figure out how to develop and use the corporation’s productive capabilities (business schools call it “competitive strategy”). But that’s not happening.

In effect, U.S. top executives rake in obscene sums by not doing their jobs.

The Runaway Compensation Train

When all the data from corporate proxy statements are in within the next month or so, they will show that 2011 was another banner year for top executive pay. Over the previous three years the average annual compensation of the top 500 executives named on corporate proxy statements was “only” $17.8 million, compared with an annual average of $27.3 million for 2005 through 2007. Yet even in these recent “down” years, the compensation of these named top executives was more than double in real terms their counterparts’ pay in the years 1992 through 1994.

It might surprise you to learn that in the early 1990s, executive pay was already widely viewed as out of line with what average workers got paid. In 1991 Graef Crystal, a prominent executive pay consultant, published a best-selling book, In Search of Excess: The Overcompensation of American Executives, in which he calculated that over the course of the 1970s and ’80s, the real after-tax earnings of the average manufacturing worker had declined by about 13 percent. During the same period, that of the average CEO of a major US corporation had quadrupled! Bill Clinton took up the issue in his 1992 presidential campaign, and immediately upon taking office had Congress pass a law that forbade companies from recording as tax-deductible expenses executive salaries plus bonuses in excess of $1 million.

Unfortunately Clinton chose the wrong pay target. In 1992 salaries and bonuses represented only 23 percent of the total compensation of the top 500 executives named on proxy statements. The largest single component of executive compensation was gains from exercising stock options, representing 59 percent of the total. The Clinton administration left this so-called “performance pay” unregulated.

Perversely, one reaction of corporate boards to the Clinton legislation was to take $1 million in salary plus bonus as the “government-approved minimum wage” for top executives, and therefore to raise these components of executive pay if they fell short of that minimum. The number of named executives with salaries plus bonuses that totaled $1 million or more increased from 529 in 1992 to 703 in 1993 and 922 in 1994.

The other reaction of corporate boards was to lavish more stock options on their top executives. When the stock market boomed in the late 1990s, these executives cashed in. The average annual compensation of the top 500 named executives reached $21 million in 1999 with gains from exercising stock options representing 71 percent of the total, and $32 million in 2000 with option gains now 80 percent of the total.

From 1982 to 2000 the U.S. experienced the longest stock market boom in its history. Average annual stock-price yields of S&P 500 companies were 13 percent in the 1980s and 16 percent in the 1990s. So it didn’t require any great genius to make money from stock options. In fact, it became a no-brainer. In 1991, the Securities and Exchange Commission waived the longstanding rule that, as corporate insiders, top executives had to hold stock acquired through exercising their options for six months to prevent “short-swing” profit-taking. As before, executives did not have to put any of their own money at risk in being granted stock options. But now they could also pick the opportune moment to exercise their options without any risk that the value of the company’s stock would subsequently decline before they could sell the stock and lock in the gains.

The New Normal of Corporate Greed

The speculation-fueled “irrational exuberance” of the late 1990s brought unprecedented pay bonanzas to top executives, thus establishing a “new normal” for corporate greed. When boom turned to bust in the early 2000s, money-hungry executives had to look for another way to get stock prices up and make their millions. Their favorite “weapon of value extraction” over the past decade has been the stock buyback (aka stock repurchase). Top executives allocate massive sums of corporate cash to repurchasing their company’s own stock with the purpose of boosting their company’s stock price. Stock buybacks and stock options have become the yin and yang of executive compensation.

Let’s take a look at how it works: The board of directors of Acme Corporation authorizes the CEO to repurchase the company’s own outstanding shares up to a specified value (say $5 billion) over a specified period of time (say three years). On any dates within this three-year period, the CEO then has the authority to instruct the company’s broker to use the company’s cash to buy back shares on the open market up to the $5 billion limit and subject to the SEC rule that the buybacks on any one day can be no more than 25 percent of the company’s average daily trading volume over the previous four weeks. That might permit Acme to do buybacks worth, say, $100 million per day. It may be the end of the quarter, and the CEO and CFO want to meet Wall Street’s expectations for earnings per share. Or they may want to offset a fall in the company’s stock price because of bad news. Or they may want to ensure that the increase in the company’s stock price keeps up with those of competitors, who may also be doing buybacks. Whatever the reason, by the laws of supply and demand, when the corporation spends cash on buybacks, it “manufactures” an increase in its stock price.

Then, with the stock price up, the CEO, CFO and other insiders may choose to cash in their stock options. Presto! They make tons of money for themselves.

Meanwhile, these executives will tend to ignore investments in innovation and training. Some companies actually fund their buybacks by laying off workers, offshoring jobs to low-wage countries, and taking on debt. The top executives’ weapon of value extraction becomes a weapon of value destruction. They are rewarded handsomely by not doing their jobs.

In 1981, 292 major corporations spent less than 3 percent of their combined net income on buybacks. In 1982, however, the SEC passed a rule (10b-18) that gave corporations that did very large-scale stock repurchases a “safe harbor” from charges of stock-price manipulation. Buyback activity then became larger and more widespread, increasing substantially over the course of the 1990s. From 2003 to 2007, buybacks really took off, and by 2007 the very same 292 corporations now spent over 82 percent of their net income repurchasing their own stock.

The financial crisis and the Great Recession forced a slowdown in buybacks. S&P 500 companies repurchased a record $609 billion in 2007 but pared it down to $360 billion in 2008 and $146 billion in 2009. They stepped it back up to about $289 billion in 2010 and an estimated $440 billion in 2011. It is quite possible that buybacks in 2012 will be even higher than in the previous record year of 2007. And look for executive pay to increase as well.

Concentration of Income at the Top

Make no mistake about it. Executive pay is a prime reason why in 2005-2008 the top 0.1 percent captured a record 11.4 percent of all household income (including capital gains) in the U.S., compared with 2.6 percent three decades earlier. In 2010 (the latest Internal Revenue Service data available), this number was 9.5 percent. The income threshold among taxpayers for being included in the 0.1 percent in 2010 was $1,492,175. Of the executives named in proxy statements in 2010, 4,743 had total compensation greater than this threshold amount, with a mean income of $5,034,000 and gains from exercising stock options representing 26 percent of their combined compensation.

Total corporate compensation of the named executives does not include other non-compensation income (from securities, property, fees for sitting on corporate boards, etc.) that would be included in their IRS tax returns. If we assume that named executives whose corporate compensation was below the $1.5 million threshold were able to augment that income by 25 percent from other sources, then the number of named executives in the top 0.1 percent in 2010 would have been 5,555.

Included in the top 0.1 percent of the US income distribution were a large, but unknown, number of US corporate executives whose pay was above the $1.5 million threshold but who were not named in proxy statements because they were neither the CEO nor the four other highest paid in their particular companies. To take just one example, of the five named IBM executives in 2010, the lowest paid had total compensation of $6,637,910. There were presumably large numbers of other IBM executives whose total compensation was between this amount and the $1.5 million top 0.1 percent threshold.

Let’s Put CEOs to Work for Us

Under the Obama administration, virtually nothing has been done to constrain top executive pay. President Obama signaled his unwillingness to take on the issue when, in an interview in February 2010, he was asked about the many millions paid in 2009 to Jamie Dimon, CEO of JPMorgan and Lloyd Blankfein, CEO of Goldman Sachs, in the wake of the financial meltdown and bank bailouts. "I know both those guys; they are very savvy businessmen,” the president said. “I, like most of the American people, don’t begrudge people success or wealth. That is part of the free-market system."

The “Say-on-Pay” provision in the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act sounds good, but it just reinforces a system of incentives the does not work. This provision gives public shareholders the right to express their non-binding opinion to corporate management on issues related to executive compensation. If Congress had understood what drives executive pay in the U.S., however, it would have recognized that the granting of Say-on-Pay rights to public shareholders is part of the problem, not the solution. Through a combination of stock options and stock buybacks, Say-on-Pay provisions reinforce an alignment between the incentives of top executives and the interests of public shareholders that has been undermining investment in America’s future.

It is about time that we took control of exploding executive pay. It is not just that the sums involved are unfair, and as history has shown, will only become more obscene. These executives control the allocation of resources that represent the well-being of the 99 percent, and the ways in which they bank their booty is doing severe damage to the U.S. economy. The investment strategies of business corporations are too important to be left under the control of those who gain when the 99 percent lose.

Real News Network highlighted a foreign broadcast on Spain’s “indignados,” and the way they have been providing advice to other anti-neoliberal movements around the world. I’m not sure it has gotten the attention it warrants, but the people that were involved in Occupy Wall Street early on conferred a good deal with seasoned protestors in Spain and Egypt.

Adam Davidson has an article in the Sunday New York Times Magazine, “The Other Reason Europe is Going Broke,” that manages the impressive feat of making you stupider than before you read it. It misrepresents most of the few facts it contains in appealing to American prejudices about our cultural, or in this case, economics superiority, to sell worker bashing.

Davidson uses the spectacle of Europe going into an economic nosedive to claim that one of the big things wrong with Europe is its spoiled workers. The piece is anchored in a glaring, fundamental misrepresentation. It argues that Americans are much better off than Europeans because we have a higher GDP per capita (more on that in due course) and asserts that that is because Europeans are not able to compete in world markets:

After decades of trying, Europe as a whole still can’t quite figure out how to be flexible enough to compete in the global economy.

The basis for Europe’s supposed failure compared to the supposedly more flexible and innovative US? That its trade with the rest of the world is more or less in balance. By that standard, the US is a abject failure from a competitive standpoint, since we’ve run sustained trade deficits since the early 1980s (with a brief period of a surplus in the early 1990s). So by Davidson’s standard of competitiveness, the US is an abject failure, particularly since the euro has risen against the dollar since 2001 (and even with its recent fall is still well above that level).

And even though Davidson presents himself as a messenger, he clearly sides with this anti-worker paradigm:

It’s a core view of U.S. business that success requires a degree of destruction. If workers can’t be fired, companies can’t drop unproductive businesses and invest in more promising new ones. If workers know they’ll get generous government benefits no matter what, so the theory goes, they’ll get lazy.

Funny, German managers actually prefer a system that allows them to maintain staff levels at reduced pay when the economy is weak. And anyone who has managed an operation, as opposed to a soi-disant economist, will tell you that hiring new staff is a painful exercise: the interviews, the initial period when they are less productive (this is not just a matter of job skill; every business has certain idiosyncrasies that a new employee must learn). And firing people is no party either, and it distracts and demoralizes their peers. And the conventional view that European productivity gains lagged those of the US starting in 1995 is increasingly questioned. From Paul Krugman in 2009:

I went back to something that was a hot topic not long ago, and will be again if and when the crisis ends: the apparent lag of European productivity since 1995…I noticed something that gave me pause.

In their paper, van Ark etc. identify the service sector as the main source of America’s pullaway — which is the standard argument. Within services, roughly half they attribute to distribution — roughly speaking, the Wal-Mart effect. OK.

But the other half is a surge in US productivity in financial and business services, not matched in Europe. And all I can say is, whoa!

First of all, how do we even measure output of financial services? If I read this BEA paper correctly, we more or less use “checks cashed” — or, more broadly, the number of transactions undertaken. This may be the best we can do, but it’s a pretty weak measure of actual work done by the financial system.

And given recent events, are we even sure that the expansion of the financial system was doing anything productive at all?

In short, how much of the apparent US productivity miracle, a miracle not shared by Europe, was a statistical illusion created by our bloated finance industry?

Dean Baker has argued for some time that, properly measured, the productivity gap between America and Europe never happened. I’m becoming more sympathetic to his point of view.

Now let’s get to the GDP per head part. The notion that GDP is all that it is cracked up to be as a measure of economic prosperity is challenged in another article in the New York Times over the weekend, “The Myth of Japan’s Failure” (hat tip reader Scott):

There are a number of facts and figures that don’t quite square with Japan’s image as the laughingstock of the business pages:

• Japan’s average life expectancy at birth grew by 4.2 years — to 83 years from 78.8 years — between 1989 and 2009. This means the Japanese now typically live 4.8 years longer than Americans. The progress, moreover, was achieved in spite of, rather than because of, diet. The Japanese people are eating more Western food than ever. The key driver has been better health care.

• Japan has made remarkable strides in Internet infrastructure. Although as late as the mid-1990s it was ridiculed as lagging, it has now turned the tables. In a recent survey by Akamai Technologies, of the 50 cities in the world with the fastest Internet service, 38 were in Japan, compared to only 3 in the United States…

• The unemployment rate is 4.2 percent, about half of that in the United States.

• According to skyscraperpage.com, a Web site that tracks major buildings around the world, 81 high-rise buildings taller than 500 feet have been constructed in Tokyo since the “lost decades” began. That compares with 64 in New York, 48 in Chicago, and 7 in Los Angeles…

William J. Holstein, a prominent Japan watcher since the early 1980s, recently visited the country for the first time in some years. “There’s a dramatic gap between what one reads in the United States and what one sees on the ground in Japan,” he said. “The Japanese are dressed better than Americans. They have the latest cars, including Porsches, Audis, Mercedes-Benzes and all the finest models. I have never seen so many spoiled pets. And the physical infrastructure of the country keeps improving and evolving.”

Frankly, I have been hearing from the mid 1990s onwards that things in Japan were no where near as bad as depicted in the Western press. And from the most savvy Japan watchers (as in people who have lived there during this period), the view I hear most often is that it was to Japan’s advantage to depict itself as a basket case, so the US would not press for a stronger yen (remember, Japan is a military protectorate of the US, so we actually can push it around from time to time. For example, during the 1987 crash, the Treasury market became wobbly, and the Fed called the Bank of Japan and told it to buy Treasuries. The BoJ called banks like my then employer Sumitomo, who fell into line).

But the most important tidbit is later in the article, and it touches on hedonic adjustments to GDP, a topic that is not often discussed in polite company. We’ve covered this in greater depth before, for instance, in this 2007 post:
Let’s look at GDP. That’s a fundamental figure, surely beyond question or compromise. Really? Our GDP stats include something called a “hedonic price index” basically to allow for the fact that computers are becoming more powerful at lower costs. In essence, the US grosses up the price of computers in its GDP reports to adjust for the fact that computer prices are dropping.

These adjustments are significant. The US is the only country that uses hedonic indexing. The Bundesbank complained that if they calculated GDP the way we did, their GDP growth would be 0.5% higher. And the cumulative distortion is massive. In 2005, Michael Shedlock contacted the Bureau of Economic Advisers and they supplied some dated information on hedonics (including a spreadsheet). Even so, he found that hedonic adjustment to GDP was 2.257 TRILLION dollars, or 22% of then-current GDP.

And now let’s get to the kicker. Here is how Davidson characterized the US versus Europe, at the top of his piece:

But G.D.P. per capita (an insufficient indicator, but one most economists use) in the U.S. is nearly 50 percent higher than it is in Europe. Even Europe’s best-performing large country, Germany, is about 20 percent poorer than the U.S. on a per-person basis (and both countries have roughly 15 percent of their populations living below the poverty line). While Norway and Sweden are richer than the U.S., on average, they are more comparable to wealthy American microeconomies like Washington, D.C., or parts of Connecticut — both of which are actually considerably wealthier.

The IMF reported these per capita GDP figure for 2011, per Wikipedia, in the World Economic Outlook Database-September 2011. Davidson apparently chose another source, possibly the World Bank or the CIA Factbook, which puts the US higher in the relative rankiing:

And even before you make a roughly 20% adjustment to US GDP that the hedonic indexing hocus pocus suggests might be in order.

It seems difficult to fathom how anyone could argue for squeezing labor when Europe is a living laboratory in how it simply produces a downward spiral. It was the right remedy when inflation was rampant, but that ceased being a pressing worry over two decades ago. It is now a useful canard to facilitate transfers from ordinary workers to top management, and it appears there is no shortage of propagandists like Davidson to carry the message.

One of the big differences between private companies and public ones is private ones care a lot more about preserving their franchise, which includes their staff. In the old days of Wall Street (which I do not romanticize as a golden era, but man, it looks better than what we have now) partner would take bare bones pay in bad years to keep comp level for everyone else adequate. Similarly, in the 1970s and 1980s, when a company faced headwinds, and in particular, had to cut staff, it would be seen as a sign of poor leadership to a CEO to raise his pay.

Now that a two decades of executive pay increases way in excess of economic fundamentals and stock price increases have firmly established that shareholders be damned, CEOs have become even more aggressive in playing their “heads I win, tails you lose” game with stakeholders. Per the Guardian:

Chief executive pay has roared back after two years of stagnation and decline. America’s top bosses enjoyed pay hikes of between 27 and 40% last year, according to the largest survey of US CEO pay. The dramatic bounceback comes as the latest government figures show wages for the majority of Americans are failing to keep up with inflation….

This year’s survey shows CEO pay packages have boomed: the top 10 earners took home more than $770m between them in 2010. As stock prices began to recover last year, the increase in CEO pay outstripped the rise in share value. The Russell 3000 measure of US stock prices was up by 16.93% in 2010, but CEO pay went up by 27.19% overall. For S&P 500 CEOs, the largest companies in the sample, total realised compensation – including perks and pensions and stock awards – increased by a median of 36.47%. Total pay at midcap companies, which are slightly smaller than the top firms, rose 40.2%.

I don’t have a ready answer to this problem of CEO greed and narcissism. They operate in a world where this sort of behavior is applauded or at least rationalized, and broader public criticism is depicted as jealousy, rather than an accurate perception that CEOs are abusing their positions via their pay arrangements. More progressive tax rates would make a BIG difference, but we are a long way from that sort of change taking place.

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The fact that the New York Times is running as its lead op-ed a piece by Nassim Nicholas Taleb arguing against any bank bonuses points to a hardening sentiment among the elites against the banks. (Related proof is a post by Felix Salmon endorsing principal reductions for stressed but salvageable mortgage borrowers).

I lost all sympathy with the executives and producers of major banks in 2009. Here, after having gotten massive, hugely visible rescues, and continuing support in the way of super low interest rates (a massive transfer from savers), they did not do the right thing, which was to lay low for a couple of years, cut pay, and rebuild their balance sheets. Instead, banks fell all over themselves to repay the TARP simply to escape its think restrictions on executive pay, and Wall Street bonuses in 2009 and 2010 exceeded the 2007 record. Note that former Goldman co-chairmam John Whitehead had taken the unusual step of excoriating Lloyd Blankfein for Goldman’s “outrageous” 2006 pay and argued the firm could afford to lose those who believed they had better opportunities at hedge funds.

As we’ve argued, banks, particularly in this era of extraordinary support (rock bottom interest rates, regulatory forbearance, underpriced insurance schemes) enjoy far more government support than any other industry, including defense contractors. They can’t properly be considered to be private companies. They are utilities and need to be regulated as such. And if they won’t rein in pay levels on their own, it should include restrictions on pay.

Key sections of the Taleb op-ed:

More than three years since the global financial crisis started, financial institutions are still blowing themselves up…it is only a matter of time before private risk-taking leads to another giant bailout like the ones the United States was forced to provide in 2008…

Instead, it’s time for a fundamental reform: Any person who works for a company that, regardless of its current financial health, would require a taxpayer-financed bailout if it failed, should not get a bonus, ever. In fact, all pay at systemically important financial institutions — big banks, but also some insurance companies and even huge hedge funds — should be strictly regulated.

Critics like the Occupy Wall Street demonstrators decry the bonus system for its lack of fairness and its contribution to widening inequality. But the greater problem is that it provides an incentive to take risks. The asymmetric nature of the bonus (an incentive for success without a corresponding disincentive for failure) causes hidden risks to accumulate in the financial system and become a catalyst for disaster. This violates the fundamental rules of capitalism; Adam Smith himself was wary of the effect of limiting liability, a bedrock principle of the modern corporation….

Bonuses are particularly dangerous because they invite bankers to game the system by hiding the risks of rare and hard-to-predict but consequential blow-ups…

Consider that we trust military and homeland security personnel with our lives, yet we don’t give them lavish bonuses. They get promotions and the honor of a job well done if they succeed, and the severe disincentive of shame if they fail. For bankers, it is the opposite: a bonus if they make short-term profits and a bailout if they go bust. The question of talent is a red herring: Having worked with both groups, I can tell you that military and security people are not only more careful about safety, but also have far greater technical skill, than bankers…

What would banking look like if bonuses were eliminated? It would not be too different from what it was like when I was a bank intern in the 1980s, before the wave of deregulation that culminated in the 1999 repeal of the Glass-Steagall Act, the Depression-era law that had separated investment and commercial banking. Before then, bankers and lenders were boring “lifers.” Banking was bland and predictable; the chairman’s income was less than that of today’s junior trader. Investment banks, which paid bonuses and weren’t allowed to lend, were partnerships with skin in the game, not gamblers playing with other people’s money.

Taleb is right, of course. It is too bad that most Americans are allergic to government restrictions on compensation, even when it is amply warranted. Sadly, it will probably take another blow up to change their minds.

A corollary to Upton Sinclair’s famous saying, “It is difficult to get a man to understand something if his salary depends on his not understanding it” is “People promote ideas that help them secure or preserve a privileged position on the totem pole.”

A glaring example of these observations came in an op ed in the Sunday New York Times by Steve Rattner, former Lazard mergers & acquisition partner, later head of the private equity firm, Quadrangle Partners. He is best known as the chief negotiator in the auto bailouts (and he was criticized for not involving any auto industry experts). He paid $10 million to settle a kickbacks investigation and agreed not to work for a public pension fund in any role for five years. I happened to see Rattner on a panel at a Financial Times conference earlier this week and he elaborated on some of the themes in this piece, “Let’s Admit It: Globalization Has Losers,” which reader Brett asked me to debunk line by line. I’ll spare you and focus just on the most critical and bald-facedly dishonest bits.

Let’s start at the top:

For the typical American, the past decade has been economically brutal: the first time since the 1930s, according to some calculations, that inflation-adjusted incomes declined. By 2010, real median household income had fallen to $49,445, compared with $53,164 in 2000. While there are many culprits, from declining unionization to the changing mix of needed skills, globalization has had the greatest impact.

Apparently the NYT fact checkers give guys at Rattner’s level a free pass. This is false. Where was Rattner in 2007 and 2008? Real median income peaked in 2007, and that was modestly higher than in the last cyclical peak, in 1999. The decline in income (nominal, not just inflation adjusted) is the direct result of the global financial crisis, not inflation. So his entire piece is based on an inaccurate claim which has the effect of diverting blame from bankers like him.

This next bit is sneaky but worth pointing out:

The phenomenon that free traders like me adore has created a nation of winners (think of those low-priced imported goods) but also many losers.

We don’t have a system of free trade. It’s managed trade. As William Greider has pointed out, most other countries play the game in a way to produce better national outcomes (fewer lost jobs and trade surpluses). We seem to be running our trade policy not to optimize our national interest, but that of large international corporations, which is far from the same thing.

The next bit is pure reductivism:

A typical General Motors worker costs the company about $56 per hour, which includes benefits. In Mexico, a worker costs the company $7 per hour; in China, $4.50 an hour, and in India, $1 per hour. While G.M. doesn’t (yet) achieve United States-level productivity in China and India, its Mexican plants are today at least as efficient as those in the United States.

American management is also more expensive than management in Mexico or China or India. And I think you’d be hard pressed to say American management is better than management, say, from Sweden or Australia, where CEOs are vastly less well paid than here. So shouldn’t we expect CEO and upper management wages also to fall?

And remember, as we have said in other posts, the evidence is overwhelming that not only is CEO pay in the US not correlated with performance, it is negatively correlated with performance. The best paid CEOs deliver the worst results, and the leaders of Jim Collin’s stellar performers in Good to Great all paid themselves modestly.

We need to peel back several layers to debunk this notion that labor costs trump everything. First is that Rattner is implicitly arguing that the world is frictionless. But that is misleading. The US is a big market, and there are advantages in being close to the customer, in terms of rapid response, carrying smaller inventories (and thus having smaller losses when you get it wrong), lower shipping and financing costs. IKEA, which is in a low end manufacturing business, has its manufacturing for the US located in the US.

Second, he is also assuming that all products are more or less commodities. But the job of management is to find a way to gain competitive advantage, and being a low cost competitor is one of many options. I’m sure you’ve paid a big premium to buy food or a drink at a convenience store now and again. They are competing on location, not cost. Similarly, I’m always amused at techies who hector Apple product users in comments. They seem angry that consumers will pay a big premium for ease of use or maybe just sheer coolness (and I have to say, as a Manhattan person, being able to see a live person at 3 AM and get something diagnosed and fixed is worth a lot to me). So a fixation on costs too often reveals a management lacking in imagination and gumption facing increasingly competitive and mature markets.

Third, his focus on direct factory labor is disingenuous. Direct factory labor is typically just north of 10% of the cost of most manufactured goods; for cars, we are told it’s 13%. Even if you can extract meaningful savings there, you have significant offsets: the upfront cost of re-orgainzing production (which in the outsourcing scenario include hiring costly outsourcing “consultants” and paying attorneys to paper up the deals), higher ongoing managerial costs, higher shipping and related inventory financing expenses. Yes, there are cases where outsourcing and offshoring have been a big success, but there are also others where the benefits have been underwhelming and have come at considerable costs to US workers, communities, and the economy (see a very good long form discussion by Leo Hindery).

And in many cases where big multinationals come out ahead, it isn’t due solely to labor cost savings. As Greider pointed out:

At IBM back in the 1980s, [Ralph] Gomory watched in awe as Japan and other Asian nations captured high-tech industrial sectors in which US companies held commanding advantage. IBM invented the disk drive, then dropped out of the disk-drive business, unable to compete profitably. Gomory marveled at Singapore, a tiny city-state, as it lured American manufacturers with low-wage labor, capital subsidies and tax breaks. The US companies turned Singapore into a global center for semiconductor production.

And this sort of thing continues. I discussed long form the fate of a world class coated paper mill in Escanaba, Michigan. The main culprit in its demise was overleveraging and excessive compensation to executives who knew bupkis about the paper industry. But another factor I did not include in my getting-to-be-too-long post and was pointed out by readers in comments were the considerable subsidies given by the Chinese and Indonesian governments to their papermakers.

Consider the implications: if the only factor at work were factory labor, as Rattner implies, you’d see far fewer jobs ceded to foreign markets (put it another way: if the labor cost differential were a sufficient inducement, foreign governments wouldn’t need to offer such generous subsidies).

To put it another way, the argument that Rattner is making is basically that of the Stopler-Samuelson theorem. Let’s turn the mike over to development economist Dani Rodrik:

The Stolper-Samuelson theorem is a remarkable theorem: it says that in a world with two goods and two factors of production, where specialization remains incomplete (plus a few more technical assumptions), one of the two factors–the one that is “scarce”–must end up worse off as a result of opening up to international trade. Not in relative terms, but in absolute terms. But the theorem is also quite limited in its applicability. It applies only to a case with two goods and two factors, and so its real world relevance is always in question.

But there is a version of the theorem that is remarkably general and powerful. It says that regardless of the number of goods and factors, at least one factor of production must experience a decline in real income from trade as long as trade induces the relative price of some domestically produced good(s) to fall (and as long as the productivity benefits from trade are restricted to the traditional, inter-sectoral allocative efficiency improvements, about which more later). All that this result requires is a very mild assumption, namely that goods be produced with varying factor intensities (i.e., use different combination of factors). The stark implication is that someone will lose, even if the nation as a whole becomes richer.

So to give an example: Let’s say that as a result of globalization, the wholesale price of a car falls from $20,000 to $15,000. Let’s further assume that materials costs were $6000, direct factory labor was $3000, factory overheads were $2000, shipping is $1000, marketing is $2500, other management costs (top brass, IT, legal, accounting) were $2000, interest cost are $1000, and $1500 is for capital investment (as in repairs and replacements), with a target profit of $1000. Per Stopler-Samuelson, something has gotta give to get the manufacturing price down to $15,000.

But it does not have to be worker wages. For instance, over the years, we’ve seen manufacturers of all sorts get smarter (and in some cases, just stingier) in their use of raw materials. And all bets are off if you increase productivity. That means you can use fewer workers, but maintain their pay levels. As Rodrik continues by discussing a paper by Broda and Romalis that found that trade with China reduced income inequality in the US. Huh? Per Rodrik:

The puzzle here, at least on the face of it, is that one would expect China’s trade to have had the largest price impact on labor-intensive goods. And if so, wages of unskilled workers must have fallen even more, along the lines of the Stolper-Samuelson logic sketched out above. Can we still say that trade with China has helped reduce U.S. inequality?

The first thought that comes to mind is that Broda and Romalis are talking about consumer prices, and Stolper-Samuelson effects depend on changes in producer prices–i.e., prices of goods that are actually produced in the U.S. If nobody in the U.S. produces the garments and toys that China exports to the U.S., then it is conceivable that the relative price of labor-intensive goods will fall without hurting real wages.

But then this is unlikely, given substitutability between Chinese- and U.S.-made goods. And indeed another paper, by Raphael Auer and Andreas Fischer, employs a clever technique to document a sizable negative impact on U.S. producer prices from trade with China and other labor-abundant countries. So the benign effect of Chinese exports, if any, is not due to the fact that the U.S. no longer competes head-to-head with that country in similar products.

What gives? The Auer and Fischer paper underlines another important result. What lies behind the decline in U.S. producer prices in trade-affected sectors is not wage or other input price reductions but mostly increases in total factor productivity. So perhaps what is going is that the Stolper-Samuelson logic is defeated by increases in sectoral productivity induced by import competition. The mechanical link between prices and factor costs–which I appealed to above in the proof of the generalized S-S theorem–breaks down whenever there is productivity change. After all, if TFP increases, employers can afford to pay unchanged wages even if the prices they face decline.

So this is where the misdirection by Rattner is crucial. Until the 2000s, in every economic expansion, labor got the bulk of the increase in GDP, typically over 60%, via more jobs and increased pay. Post 2000, there was an astonishing change, a shift from labor share, which fell to below 30%, and a massive increase in corporate profits. In other words, there was huge shift away from labor to capital. This has little to do with globalization and much to do with the weakened bargaining power of US workers. As much as it has become fashionable to look down on unions (and their corruption and short-sightedness hasn’t helped), having well paid blue collar workers helped the negotiating position of non-unionized white collar employees.

Rattner also conveniently fails to discuss how the rapacious tendencies of private equity firms made matters worse. An unduly candid investor described the business model in Confidence Men: pile debt on the acquisitions, and if only one of ten made it (meaning survived!) you still made a good return for investors. So many companies in Europe have gone bankrupt thanks to the tender ministrations of PE pirates that the officialdom has read them the riot act. PE firms have to register, and they cannot either buy companies or raise money in the Eurozone unless the conform to regulations, which include strict limits on leverage.

Rattner argues in his piece that we should imitate Germany and focus on high skill manufacturing. But Germany’s population is roughly 1/4 ours and they already dominate certain niches. Rattner at the FT conference called for the US to start producing more engineers, which readers will laugh out of the room. Engineers don’t get paid enough for more people to want to seek out that career path; many of you have told me the only way to make a good living was to get another degree, like law, and go into another line of work.

And even if copying Germany might be a viable approach, it would take something like industrial policy to get there. Note the US already has industrial policy by default, with banks, the mortgage-industrial complex, military contractors, agriculture, and Big Pharma among the favored groups. But no, Rattner pooh-poohs the whole idea. Better to have industrial policy determined by lobbying effectiveness than a more thoughtful process:

The prospect of Washington lurching into the private sector is terrifying, as illustrated by the debacle of Solyndra, the solar energy company that failed with $535 million of taxpayer loans. While countries like China have put large resources behind industries they want to nurture, we should resist the temptation to plunge deeply into industrial policy.

I wish I had the space to discuss Solyndra in depth, but the sort form is that the failure of that deal is not an indictment of the overall program. If you are a VC investor, you expect a certain percentage (actually a pretty high percentage) to come a cropper. Solyndra was only a bit over 1% of the portfolio, and it appears to be the only loss. This looks like a classic “shit happens” deal failure: the investment looked sensible at the time, silicon prices collapsed, which had a direct, negative impact on competitiveness. Even so, a later-stage independent investor provided funding, which further confirms the original investment was not misguided (you’d get no rescue investors coming in if it looked like a hopeless turkey).

Rattner apparently missed a different Rodrik article, a Financial Times op ed, in which he warned:

If there is one lesson from the collapse of the 19th century version of globalisation, it is that we cannot leave national governments powerless to respond to their citizens.

Yet an unfettered system is precisely what Rattner is promoting, no doubt because it works to his and his fellow rentiers’s advantage.

Yves here. Before reacting reflexively to the thesis of the article, consider this corroborating view from the former chairman of Goldman, John Whitehead, back in 2007:

“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 went even further, recommending the unthinkable, that Goldman cut pay:

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,” Whitehead, 85, said….

By Bruno S. Frey, Professor of Economics at the University of Zurich and Margit Osterloh, Professor (em.) for Business Administration and Management of Technology and Innovation, University of Zürich; and Professor, Warwick Business School. Cross posted from VoxEU

As the bonus culture in the financial sector once again comes under attack, this column rubbishes the typical defence that banks need to pay top dollar to attract the best talent.

Scientific literature has extensively dealt with variable pay-for-performance. Despite the fact that serious problems linked to this approach have thus become obvious, many authors continue to support compensation according to predetermined performance criteria because they are committed to the traditional concept of the ’homo oeconomicus’.
Overall, there has been a marked change of opinion in academia (see for instance Bryson and Freeman 2008 on this site). The idea that people are solely self-interested and materially orientated has been thrown overboard by leading scholars. Empirical research, in particular experimental research, has shown that under suitable conditions human beings care for the wellbeing of other persons. Above all, they are not solely interested in material gains (see eg Frey and Osterloh 2002). Recognition by co-workers is greatly important. Many workers are intrinsically motivated, ie they perform work for its own sake because it is found challenging and worth undertaking. This applies not only to qualified employees but also to persons fulfilling simple tasks. They often are proud of their work and performance.

There are four major arguments against variable pay-for-performance:

In a modern economy, it is practically impossible to determine tasks that are to be fulfilled in the future precisely enough so that variable pay-for-performance can be applied. In a society continually faced with new challenges, superiors oftentimes find it impossible to fix ex ante what an employee will have to do in the future.

It would be naïve to assume that the persons subjected to variable pay-for-performance would accept the respective criteria in a passive way and fulfil their work accordingly. Rather, they spend much energy and time trying to manipulate these criteria in their favour. This is facilitated by the fact that employees often know the specific features of their work better than their superiors. The wage explosions observable in many sectors of the economy can at least partly be attributed to such manipulations, eg when managers are able to contract easily achievable performance goals.

Variable pay-for-performance results in employees restricting their work to those areas covered by the performance criteria. In the literature, this is known as the ’multiple tasking’ problem. This may induce employees to spend considerable time and energy during their work trying to find a better-paid job with another firm. They therefore neglect their tasks insofar as they are not contractually fixed by the performance criteria.

Variable pay-for-performance tends to crowd out intrinsic work motivation and therewith the joy of fulfilling a particular task. However, such motivation is of great importance in a modern economy because it supports innovation and helps to fulfil tasks going beyond the ordinary.

Many observers acknowledge these problems connected with variable pay-for-performance and even emphasise them. They nevertheless cling to this form of compensation because they do not see any alternative. However, there are well-proven and effective ways to induce the members of an organisation to perform in a desired manner. The three most important ways are the following:

First, the employees have to be carefully selected. Above all, employers must check whether the job seekers are interested in the work to be performed or solely in the money that will come along with it. In all too many sectors of the economy this task seems to have been neglected. In the financial sector, for example, many persons have been chosen whose only goal is to get as high a salary as possible. They therefore exhibit no loyalty to the firm and immediately accept any job that offers higher compensation. As a result, the fluctuation among employees has increased strongly. Efficiency has been reduced because the tasks have to be taken over by ever new persons who lack the experience necessary.

Secondly, employees have to be paid a fixed compensation corresponding to their performance. They must be given the signal that they are paid a good wage but that they are expected to work accordingly. Thus, a market wage has to be paid in order to be able to win and keep employees. The compensation can after some time be adjusted on the basis of a comprehensive evaluation of their work. This procedure avoids the multiple tasking problem. At the end of the year, one can also distribute part of the profit to employees according to their contribution to overall performance rather than according to ex ante criteria.

Thirdly, awards can be used to enhance employees’ work motivation. Awards such as “Employee of the Month” support social recognition among the members of the firm. They should therefore be presented in a festive ceremony, emphasising what type of performance is important to the firm. Research on awards in a call centre of a credit-card company suggests that the motivation of the persons getting the award is enhanced. The performance of the employees not getting an award is not reduced. Rather, they make an effort to get the award in the future (Neckermann et al 2008). Employees working in a team are usually proud that (at least) one of its members has received an award.

Variable pay-for-performance is an attractive concept to compensate employees only at first sight. It turns out to be a mistake when analysed more thoroughly. As argued here, there are more favourable alternatives available.

It might behoove a publication that styles itself as the newspaper of record to do some basic fact checking rather than take dictation from parties with an obvious axe to grind and publish it as news.

I’m going to give the disgraceful New York Times story, “Outsiders’ Ideas Help Bank of America Cut Jobs and Costs” a long form treatment, not only because it may help readers recognize PR masquerading as news, but also because the bits of this story that the Times didn’t bother to probe help illuminate how the retail banking industry became predatory and how some of the mechanisms to transfer wealth to people at the very top are well hidden from the great unwashed public. Thus, this post is a companion piece to our piece today on the rise in poverty and continuing destruction of the middle class in the US.

The New York Times piece is hagiography about the cost cutting process at Bank of America, in which the Charlotte bank will shed 30,000 jobs, more than 10% of its workforce. It starts with the misrepresentation of calling the belt-tightening a “turnaround plan.” That implies that the business of the bank is in trouble and the headcount reduction measures can save the day.

This is utter bunk. Bank of America was already a very cost and efficiency driven bank, to a fault. It botched its acquisition of the private bank US Trust by imposing its stingy ways on customers who had every reason to demand a bit of cosseting. It went so far as to impose ATM fees on a customer base that typically held 6 to 7 figure balances in checking accounts.

Banking expert Chris Whalen has called the cost cutting effort “criminal”. He points out the obvious: there is nothing wrong with the bank’s operating businesses. The threat to BofA’s survival comes from litigation on its mortgage backed securities business, and the bank would do better to preserve the fundamental value of its business by declaring bankruptcy.

While I encourage you to listen to this entire segment, take particular note of Whalen’s comment at 2:25: “They’re trying to throw things out of the balloon, if you use the metaphor, to save their own careers, Brian Moynihan and the people Ken Lewis put in place.”

So what is this New York Times story about? It’s to legitimate a unnecessary cost cutting process. And the ugly part, which the article perversely tries to present as a plus, is the role played by the consultants. In a remarkable display of a lack of basic fact gathering, the Times never mentions that they get a piece of the action. Indeed, not only does the Times fail to mention their pay arrangements, it compound the error by emphasizing an ungalmorous meeting, which creates the impression that their pay demands might be modest too (pizza, after all, is a staple of college kids and programmers):

As Bank of America executives prepared last week to announce the first phase of their turnaround plan, a group of consultants hurried to complete their recommendations for the overhaul, called Project New BAC.

The 44 senior bank managers and roughly two dozen consultants assigned to the initiative worked through lunch, barely pausing to enjoy the pepperoni, sausage and vegetarian pies that had been ordered from a pizzeria….

The consulting firms enlisted to help with Project New BAC — EHS Partners and the Promontory Financial Group — are what are known in the industry as bank doctors. Financial firms often turn to these specialists in periods of crisis, seeking out their recommendations on deep and wide-ranging cuts to bolster revenue and eliminate unnecessary expenses.

The idea is that outsiders can find thousands of small savings and inefficient processes that insiders may miss.

Promontory and EHS both have long ties to Bank of America, and to each other.

Eric Holder, who is leading EHS’s work on Project New BAC, and Neil Smith, Promontory’s head consultant on the project, were both members of a team from Tandon Capital Associates that helped the Fleet Financial Group with a similar effort in 1994.

On that project, called Fleet Focus ’94, Mr. Holder and Mr. Smith worked with a team of 50 internal managers known inside the bank as the “Nifty 50.” One of those 50 managers was a budding young lawyer named Brian T. Moynihan.

The ordering pizza in is a nice “gee we are all ordinary, roll up our sleeves” types, but don’t be fooled. The people at that table are raking in very big bucks for getting people fired.

Tandon Capital Associates is named for Chandrika Tandon, who was a partner at McKinsey. Neil Smith and Eric Holder also worked for McKinsey (I know Chardrika and Neil; Eric joined after I left the firm).

McKinsey has long done cost cutting work, and at least when I was there, in the mid-1980s,the firm was plenty ambivalent about it. In downturns, clients were most interested in that sort of project, and they were not difficult, anyone in the firm could do them (they were considered “process” studies: you followed a playbook). And in service firms like bank, all meaningful costs relate to headcount, so these studies were all about firing people. A lot of consultants, including partners, didn’t like firing people. In addition, there were mercenary reasons not to like firing people. Some of them would be senior, and would find new jobs. Anyone who had been given the heave-ho as a result of a McKinsey project would be certain to oppose the use of McKinsey at their new employer.

In the 1980s, some members of the financial institutions group focused more on pricing and cost related work. “Pricing” was often what Elizabeth Warren now calls “tricks and traps”, it’s the reason a standard credit card grew from one page as of 1980 to a full 30 pages (when all the relevant sections are included) in language Alan Greenspan has said he can’t parse.

The working oar on the first pricing study, for checking account products at Citibank, was a former econometrician, Zosai Mucha. It made the bank $30 million, an enormous amount of money in those days. A consultant named Paul Allen took that sort of work further and eventually left McKinsey to start his own firm (Chandrika, who brought the cost cutting expertise, and Paul Allen originally were partners; they later split up)

As CEO pay became more stock price related and top executives started to care more about meeting earnings expectations than growing businesses the old fashioned way, cost cutting was a much easier and faster way to boost bottom lines than developing new products. That provided the impetus for Tandon Capital and other headcount cutting specialists, such as Mitchell Madison, another group of ex-MckKinsey types that focused on saving costs in the purchasing area (this was a particularly shrewd focus; purchased goods and services account for 20% to 35% of most big firms’ total spending. You cut costs not by firing people at your client, but by squeezing vendors).

It is important to understand the business model of these firms. The predecessors of EHS and Promontory, meaning Tandon and Paul Allen’s firm (and to a lesser degree Mitchell Madison, since firms like EHS and Promontory also now look to reduce costs of major contracts), used pre-set pricing formulas in which they got a high percentage of the amount saved as their fee. Central to the approach of both firms was to have the whole project accounted as a restructuring, with their compensation buried in the total.

To give an sense of how large the fees might run, Chandrika’s firm had landed an assignment with the old Chase in the mid-late 1990s. The project was canceled as a result of a merger, but the contract was still valid and they payout was on the order of $100 million (my understanding is this was a breakup fee). Similarly, a guesstimate by an informed source is that the fees on a medium-large project, say $400 million in savings, would be 5% or $20 million. Fees presumably scale down as deal sizes increase, so the $5 billion BofA assignment would presumably be set at a lower percentage. By contrast, the going rate for bona fide restructuring specialists like Houlihan Lokey or Gordian Group (remember these deals are accounted for as restructurings) are in the 0.75% to 1.5% range.

The major consulting firms, such as McKinsey, Bain, and BCG, also do this sort of assignment for normal consulting fee, which results in a much lower price tag. So why do these specialists get hired? The boutiques did, and probably still, take a much more active, hands on approach than is typical for most consultants. Paul Allen once approached me about working on one if his project, and he and his entire team would move to the client’s head office for the duration of the project, which could run from five months to as long as a year. They would act as part of the senior management team which would give them board and senior
executive visibility that traditional management consultants would almost never have. This would likely produce a higher level of execution of the proposals made.

But the downside is creating client dependence. I joked that the goal at McKinsey was to invade at the fingertip and go for the brain, and these focused firms have done a much better job at it. One former Mitchell Madison partner has an ongoing relationship with one major financial services firm that spans 20 years, back to his days at McKinsey. That’s longer than the life expectancy of most marriages.

Now let’s see how this is dressed up by the Times. It starts with a sanitized account of the history, discussing the deal that put Tandon Capital on the map, for Fleet Financial:

At Fleet, the consultants recommended cutting Styrofoam coffee cups that cost the company $48,000 a year. Name-brand toner for Fleet’s laser printers was replaced with a generic toner to save $200,000 a year.

In all, Fleet cut annual costs by $300 million and laid off 3,000 workers. The changes helped Fleet’s bottom line and set the stage for an eventual takeover.

This is straight dictation. The Times gives two examples that total less than 0.1% of the total. There is no amount of painless styrofoam cup level ideas that will get you to $300 million in savings. In the case of the Fleet study, the team recommended (and got paid on) cuts that were too deep; the bank had to reverse some of them due to adverse side effects.

Moreover, it is unlikely that these ideas came from the consultants, as the article headline suggests. A standard practice in this type of work is for client teams to identify and rank savings ideas (this then begs the question of why you need consultants, ex to provide impetus and de politicize the firiings; I lived through Sumitomo Bank’s regular kaizen, and it pushed very aggressively for staff to come up with cost saving ideas. I’d defy any bank to run leaner than Sumitomo did; it went so far as to take five months to reimburse employee travel expenses!). And this is confirmed by the story in the case of the current Bank of America project:

Bank of America declined to comment on the two firms, and a spokesman said many of the changes made in Project New BAC had come from bank employees rather than from outside consultants…. In phase one, roughly 150,000 ideas were submitted by Bank of America employees, and the best were presented to Mr. Moynihan and his management team.

So given the failure to probe how this normally hidden business works, does the article do any actual investigation? All I could detect was on gossip. Holder and Smith, along with Jeremy Eden, had founded EHS Partners, but Smith and Holder had not gotten on and Smith had split to form the team at Promontory Capital (which is headed by former Covington & Burling partner and OCC chairman Gene Ludwig). So the one bit of sleuthing the Times does is on whether a pair that separated on bad terms is getting on in this big stakes project. Needless to say, they didn’t get much of an answer.

The Times completely misses any one of a number of possible real stories here: to what extent are these studies really successes (Fleet, after all, was eventually acquired)? Are the rich fees warranted? Given the Whalen argument, that Bank of America’s operating units are healthy and the cost cuts are all to delay the day of reckoning for Moynihan’s and the C level executives, aren’t these consultants enablers of and participants in looting (using gimmicks to report exaggerated profits and suck out more than is warranted in pay until the enterprise goes bankrupt)?

Ultimately, the Times missed the opportunity to look at cost reduction, which is really firing people, as one of the mechanisms for transferring income and wealth from ordinary people to the top 1%. But the Grey Lady is only occasionally willing to shoot at fellow members of the elite, so predictably, it gave the Charlotte bank and its hired guns a free pass.

Philip Pilkington pointed to this Real News Network video as a companion piece to our post on how executives in the coated paper industry have strip-mined their own companies.

If you had any doubts as to who Obama sees as his real constituency, this should settle it.

One frequent and frustrating line that often crops up in the comments section of this blog is that American labor has no hope, it should just accept Chinese wages, since price is all that matters. That line of thinking is wrongheaded on multiple levels. It assumes direct factory labor is the most important cost driver, when for most manufactured goods, it is 11% to 15% of total product cost (and increased coordination costs of much more expensive managers are a significant offset to any savings achieved by using cheaper factory workers in faraway locations). It also assumes cost is the only way to compete, when that is naive on an input as well as a product level. How do these “labor cost is destiny” advocates explain the continued success of export powerhouse Germany? Finally, the offshoring,/outsourcing vogue ignores the riskiness and lower flexibility of extended supply chains.

This argument is sorely misguided because it serves to exculpate diseased, greedy, and incompetent American managers and executives. In the overwhelming majority of places where I lived in my childhood, a manufacturing plant was the biggest employer in the community. And when I went to business school, manufacturing was still seen as important. Indeed, the rise of Germany and Japan was then seen as due to sclerotic American management not being able to keep up with their innovations in product design and factory management.

But if you were to ask most people, they’d now blame the fall of American manufacturing on our workers. That scapegoating serves to shift focus from the top of the food chain at a time when executives have managed to greatly widen the gap between their pay and that of the folks reporting to them.

Let me give you an all too typical example of how American management has contributed to the demise of our industrial competitiveness, namely, the former Mead Corporation paper mill in Escanaba, Michigan, which is now part of NewPage, owned by Cerberus.

The Escanaba mill makes coated paper. Coated paper is shiny paper, the sort you find in most magazines, catalogues, and art books. Coated paper is fussy to manufacture, which makes it daunting in a continuous process setting like a mill. In a highly-capital intensive continuous process business, downtime is hugely expensive.

In 1969, Mead added a #3 machine in Escanaba. Paper machines are very long-lived; you’ll find machines over 100 years old in use, since older, well maintained, well-located machines (as in with access to comparatively cheap power and pulp) can be competitive on grades of paper which are made in small runs (as in the slow speed of the machine is not a negative). The #3 machine was world class at the time of its installation. There was no reason to think it could not be highly competitive through 2020 or 2030 if properly maintained.

Starting up a new machine, however, is not an easy process, and the #3 machine was not operating at the expected efficiency level. Management nevertheless pressed forward with a further mill expansion in 1970-1971, of a kraft-recovery system. The best workers on the #1 machine were moved to the #3 machine which did not solve the problems on #3 and worsened the results of the #1 machine. It took an over two year turnaround effort to get the mill operations up to a good level of productivity.

By the mid 1970s, the Escanaba mill had gone from being the dog to the star. Mead had reorganized to be decentralized, so the Escanaba mill had its own sales force and a true stand-alone P&L Escanaba was one of 40 divisions yet produced the majority of Mead’s free cash flow. Mead added added a #4 machine in Escanaba in 1982. The mill was recognized as one of the best coated paper makers in the US, and demanding publishers such as National Geographic, Smithsonian, and Playboy sought out its product

Mead has also had troubled period with its unions, in particular a bad strike in 1975-6. But a real turn came in the later 1980s. Mead had had a series of record-breaking profit years, each higher than the last, yet sought to squeeze the unions in 1989.

The 1980s were the heyday for papermakers. By the later 1990s, Mead had started scrimping on shutdowns, which is when the plant’s equipment gets maintenance and repairs. Twice a year shutdowns were replaced by annual shutdowns.

In 2002, Mead merged with WestVaco to form MeadWestVaco. The shallow dot-bomb era recession led to further reductions in reinvestment. A $5 million shutdown budget for Escanaba was reduced to under $2 million, even as the departing Mead CEO received a $30+ million golden parachute.

Cerberus acquired the Escanaba mill along with four other MeadWestVaco mills in 2005, forming the company now known as NewPage. Cerberus set return on invested capital targets that were, to put it politely, audacious for the paper industry, which led it to scrimp even more on keeping the plant operations up to snuff.

Cerberus also, in a remarkably bone headed move, bought some troubled mills from Stora Enso, apparently on the hope that it would be able to corner the coated paper market. Consistent with that strategy, Cerberus prefers to shutter mills that don’t meet its return targets rather than sell them, apparently out of the misguided view that it can remove enough capacity to affect its pricing power (this logic is questionable for a second reason: paper grades are specific, and the mills sold may not wind up being competitors of remaining NewPage operations). From CapeCod Today:

Some revealing statistics: NewPage shut down six mills in 2008. It closed its paper mill in Niagara, Wisconsin, the only major source of employment in a city of 1,800. The mill provided 319 jobs, with workers averaging $60,000-a-year. According to local officials, the plant had two potential buyers, but NewPage let the mill sit idle. Wrote newspaper columnist Ed Lowe at the time, “The hardship of the mill closure here parallels that of Kimberly (Wis.), where 600 well-paying paper mill jobs were scuttled as part of the evolving business plan of NewPage…Both mill closures devastated their communities…Some lifelong residents of Niagara worry that their city’s future ended with the production at the mill.”

In Kimberly, NewPage refused to sell to two buyers and declined the support of the Governor to keep the plant open. “This is a case of a corporation taking a productive, profitable plant and closing it, and refusing to sell it to anyone else,” Andy Nirchl, president of the United Steel Workers local, said at the time.

It tried putting through a 60% price increase in 2009, and was forced to roll it most of the way back as its competitors implemented only modest price hikes. This took place when the standing of the mills was falling. Escanaba was shipping product that had breakage problems; its quality had gone from being among the best to middling to low. In 2010, NewPage has had three CEOs, including the notorious Bob Nardelli, who has been named one of the worst CEOs of the 2000s and the worst CEO of all time by CNBC. Paper industry incumbents have not thought much of Cerberus’s management acumen. From Paper and Other Absolute Truths:

President and CEO, E. Thomas Curley, had barely learned the most efficient traffic routes to the office, when he was handed a check for $1.265 million, told not to come back, and, by the way, “don’t forget that you ‘resigned’”. Not a bad four month gig – I doubt that Lady Gaga does that well.

I believe that Mark Suwyn, Chairman and company Director, had been with NewPage from the “Cerberus” beginning. NewPage lost money every year under Suwyn, and was the worst managed company in the business. For that performance, Suwyn will walk away with a cool $2 million.

As an aside, it was reported that Suwyn engaged his son’s consulting firm in 2009, at a cost of $747,000, to provide training for “improving communications skills, consensus building and problem solving abilities.” (NewPage 2009 SEC Form 10-K, at 117). That is so disappointing, and in such bad taste. The program apparently didn’t work either.

The very good news is that there is no upper level management of NewPage. There is no Chairman. There is no President. There is no CEO. If this were allowed to continue for a few years, some real progress could be made.

Robert Nardelli, who has a big Cerberus title, is responsible for the NewPage performance, and is now the non-executive chairman of NewPage. That non-executive title is very important. It means he shouldn’t be in a position to make any decisions.

This entire mess was created, of course, by Cerberus mismanagement. They hired the wrong people, gave them impossible marching instructions, and have continue to play an expensive game of musical chairs at the highest levels of the company. The initial strategy of “pump and dump” didn’t work, and now Cerberus is relegated to actually operating a company. This is not their strength. But then, what is their strength?

If you think this criticism sounds overly harsh, read some earlier posts on NewPage (see here and here). Independent of the bad management, the paper industry is a poor candidate for an LBO, since it has high operating leverage, high ongoing reinvestment needs, is cyclical, and does not offer high returns even at the best of times. Unless you are confident you’ve bought at the bottom of a cycle, it’s one of the worst conceivable industries for a private equity investment.

NewPage lost $88 million in the first quarter 2011, which is an improvement over the $175 million loss for the same quarter in 2010. Its second quarter loss widened to $132 million. NewPage has held up payments to contractors, apparently to preserve dwindling cash.

Cerberus is negotiating a restructuring of the NewPage debt and may file for bankruptcy. The financiers will all get their cut and will move on to the next deal. Yet the workers at these mills and the communities they anchor, like Chillicothe, Ohio and Luke, Maryland (two other places I lived when I was growing up) will suffer the consequences of this rent extraction.

Alright, I have a mea culpa here. Check out this quote from June 2008:

Bank of America’s Ken Lewis is trying to crack a big nut in taking on Countrywide Financial to its balance sheet. To date, BofA has been fairly successful in limiting its writedowns during this credit crisis, but there are any number of problems attendant with the Countrywide transactions. I thought surely BofA would recognize these risks and back out of the Countrywide deal. But, it looks like full steam ahead. Some of these may cause BofA to be exposed to major financial losses in the future.

-More reason BofA is crazy to take on Countrywide

It’s three years since I wrote that now and I think we are definitely seeing this was the right call. Here’s the thing though: In August – two months later – I wrote:

Basically, the LA Times is showing that Countrywide represents the most obvious case of mortgage fraud, predatory lending, and other ills that caused millions to take on loans they would otherwise not have. As mortgage lending is at the core of the problems facing the U.S. economy, doing a few Countrywide perp walks would be a coup in any politician’s book.

But, then there’s Angelo Mozilo. He is a man who made hundreds of millions of dollars while the mortgage market fell apart and people lost their homes, dreams, and life savings. The U.S. government, the state governments and many an Attorney General will do everything they can to be the first to arrest Mozilo to parade around before the U.S. public. This is what politicians do — Attornies Generals are politicians too.

And, remember, Mozilo was also the originator of IndyMac, which spectacularly went bust this past month.

Why Bank of America took on this kind of open-ended legal risk is beyond me. But, one thing is for sure: we will see convictions at Countrywide.

-Ex-Countrywide CEO is the new Ken Lay

Did you get that last sentence: “But, one thing is for sure: we will see convictions at Countrywide.”

That was dumb. Now I know that the best way to rob a bank is to own one.

Lesson learned.

P.S. – watch Bill Black regale you with tales about the Great American Bank Robbery. That may put some context around how very wrong I was – and also why the President will pay at the polls for high unemployment despite what some polls say. I think James Carville would say: It’s the bailouts, stupid.

In case you doubted that America needs more progressive taxation, the case in its favor has just been made in a study, “Executive Excess 2011: The Massive CEO Rewards for Tax Dodging,” by the Institute of Policy Studies (hat tip readers aet and Vlad via the International Business Times). The report found that the CEOs of 25 major companies paid themselves more than their companies paid in Federal income taxes. Exhibit 1 on page 31 names and shames them (well, assuming they are capable of shame), and they include John J. Donahoe of eBay, Robert Coury of Mylan Labs, Jeff Immelt of GE, and Robert Kelly of Bank of New York. The New York Times article on the report elicited some not-convincing rebuttals.

Note that this was 1/4 of the 100 companies with the highest reported CEO pay. Perhaps it’s time to restrict the total pay over a threshold level to all C-level execs to a percentage of Federal income tax payments?

The summary also notes the increasing disparity between average worker and top executive pay, with the multiple of 263 in 2009 rising to 325 in 2010.

The report debunks the idea that the pay reflected superior performance in any arena other than tax avoidance (note that other studies have found that CEO pay is negatively correlated with performance):

What are America’s CEOs doing to deserve their latest bountiful rewards? We have no evidence that CEOs are fashioning, with their executive leadership, more effective and efficient enterprises. On the other hand, ample evidence suggests that CEOs and their corporations are expending considerably more energy on avoiding taxes than perhaps ever before — at a time when the federal government desperately needs more revenue to maintain basic services for the American people. This disinvestment also undermines the infrastructure and services that small and large businesses also depend upon.

Investigative journalists and tax research organizations have been documenting how U.S.-based global companies are aggressively shearing — and even totally eliminating — their federal income tax obligations. This past March, for instance, The New York Times traced the steps General Electric has taken to avoid U.S. corporate taxes for the last five years. Citizens for Tax Justice, as part of a forthcoming study on tax avoidance among the Fortune 500, has identified 12 corporations that have paid an effective rate of negative 1.5 percent on $171 billion in profits.

The study includes a table showing how much the 25 companies targeted spend on political contributions and lobbying. It also cites an idea presented here at Naked Capitalism by Doug Smith, that of a maximum wage:

From Doug’s post:

So, be it proposed:

“That any enterprise receiving taxpayer funds shall not compensate that enterprise’s highest paid person in an amount greater than twenty-five times what the lowest compensated person receives.”

First, note that this proposal would not apply to enterprises that do not receive any taxpayer funds.

For those, however, receiving bailouts, deposit insurance, government guarantees, tax breaks, tax credits, other forms of public financing, government contracts of any sort – and so on – the top paid person cannot receive more than twenty-five times the bottom paid person. This ratio, by the way, is what business visionary Peter Drucker recommended as most effective for organization performance as well as society. It also echoes Jim Collins who, in his book Good To Great, found that the most effective top leaders are paid more modestly than unsuccessful ones. And, critically, it is a ratio that is in line with various European and other nations that have dramatically lower income inequality than the United States.

Note, second, that this identifies the top paid person – not the CEO. Even though outrageous CEO pay and its ill effects on severe income inequality is much in the news, CEOs are not always the highest paid person.

Third, the proposal uses a ratio – 25-to-1 – instead of an absolute dollar figure. If a taxpayer funded enterprise wishes to pay the top person, say, $50 million, they can do so: just as long as the lowest paid person receives $2 million. In other words, instead of today’s limitless top wage being supported by taxpayer money – that is, socialism for the rich and only the rich — this proposal is equitable toward all.

Fourth, the choice of compensation is made by the enterprise – not by government officials.

Fifth, this approach to the maximum wage dramatically benefits the economy through some blend of more job-creating investment by the enterprise (through deploying higher retained earnings), and/or more consumer spending, savings and investment because of increased take home pay (and/or shareholder dividends) for the many instead of the few. It would, for example, immediately provide stimulus to restart our heavily consumer-driven economy.

Sixth, this proposal is competitively neutral: all enterprises using taxpayer funds must abide by the same 25-to-1 ratio of top-to-bottom compensation. In most industries, competitors respond to opportunities similarly; that is, if there are government opportunities, all try to take them and, if there are no such arrangements, none do. Nothing changes except the uses to which taxpayer funds get deployed as compensation. The new maximum wage rule levels the playing field for all competitors.

Nor, seventh, would this proposal have any adverse effect on the market for talent. Again, all enterprises are subject to the same rules. Moreover, there’s never been any – zero, zilch, nada – evidence that top pay correlates with sustained enterprise performance. Indeed, quite the reverse. Which, again, is why Drucker, Collins and others all note that talent and performance are not correlated to income inequality-levels of executive pay. The more likely result is the opposite: the maximum wage ratio will put enterprises using taxpayer funds on a better, sounder path to performance than those who don’t use taxpayer funds!! Meaning, of course, that such enterprises will attract the talent they need – not the talent they do not need.

Eighth, this proposal can and should be enacted by all federal, state and local jurisdictions that provide taxpayer funds to enterprise. And, of course, with the appropriate inclusive definitions of ‘compensation’ (salary, wages, bonuses etc) and “person’ to avoid cheating and evasion.

Ninth, enforcement will be inexpensive. Enterprises would be required to submit just two numbers to the appropriate tax authority: the highest and lowest compensation figures. If the ratio is in excess of 25-to-1, the offending enterprise will be given a simple choice: claw back the top earner’s compensation to the appropriate level; or, within, say, 30 to 45 days, pay all of the lowest earners the required amount; or, a combination of the same steps needed to bring the enterprise in line with the maximum wage rule. (If deemed necessary, generous rewards to anonymous whistleblowers could support monitoring and compliance efforts).

Tenth, and finally, remember that we’re talking about OUR MONEY. It’s not the ‘government’s money”. It’s OUR MONEY. And we insist that enterprises wishing to be funded and/or compensated and/or insured and/or tax advantaged with OUR MONEY abide by the maximum wage in order to reduce destructive, economy killing and unhealthy income inequality. When publicly funded companies operate within the 25-to1 maximum wage band, we all benefit.

It is the free choice of free enterprise whether or not to use OUR MONEY. If you are part of an enterprise and wish to pay anyone, including yourself, more than today’s all-too typical extreme, greater than 300 times the lowest wage earner, go ahead.

But do not use OUR MONEY.

Hopefully this study will provide more impetus to efforts to reform the corporate tax code and executive compensation. As we’ve discussed at length in earlier posts, the modern public company is an excellent vehicle for looting. Public shareholders are too weak and too transitory to have the means and motivation to curb the rent extraction by the executive group and the board.

By Richard Smith

Continuing this blog’s august tradition of tangling with dodgy Scottish financiers, we turn our attention away from RBS’s ex-CEO, adulterous failed banker Sir Fred Goodwin, (pausing only to note that his wife has at last thrown him out, and high time too), and towards the equally inexplicably Teflon-coated architect of another Caledonian banking trainwreck: former HBOS director, and now youthful pensioner, Peter Cummings.

The meat will be in future posts; first, some background, and then a swipe at the Financial Services Authority, which was the UK’s banking regulator when HBOS was doing its dirty business, and is now muffing the clean-up.

Like RBS, the HBOS collapse is another variation on the endless 2008 theme in which precarious short-term funding models combine with crummy assets to produce a combined liquidity-and-solvency crisis. HBOS was initially “rescued” by way of a government-sponsored shotgun marriage with Lloyds Bank; it soon turned out that HBOS’s funding problems were sufficient to overwhelm its new parent, too. The UK taxpayer stepped in, taking a 43% stake; which isn’t going to be easy to sell on, just yet.

But it got a lot worse. Once the semi-nationalization deal was done, “problem loans” surfaced pretty quickly. Cummings ran HBOS’s Commercial lending division, with execrable results. And deeper down in his division, it went well beyond imprudence, to alleged large scale fraud, as documented in posts at “Naked Capitalism” by Ian Fraser, for instance:

The allegations concern money-laundering, corruption and fraud activities between 2002 and 2007 involving Reading-based bank executives and consultants from a corporate turnaround specialist called Quayside Corporate Services…

Many of the allegations are from companies that were forced to use the services of Quayside and were then loaned large sums of money, much of which was removed in Quayside fees. From 2007, after fraud allegations surfaced, scores of companies were put into administration. The suspects, which include numerous Quayside consultants, then allegedly expropriated physical assets worth scores of millions and, in administration deals from April 2007, were permitted by the bank to take ownership of many surviving assets.

And where there’s alleged fraud on this scale (the total involved seems to be around £1Bn), any cover up would have to be massive:

Whistleblower Paul Moore, who was ousted as group head of regulatory risk at HBOS in 2005 after he sought to alert its board to self-destructive behaviour in its retail sales arm — plus many of the owners of the 50-plus companies that got sucked into the fraud and were put into administration as part of an alleged cover-up — believes that board-level directors at HBOS including former chairman Lord Stevenson, former chief executive Andy Hornby and former head of corporate Peter Cummings ought to be investigated.

They claim that senior executives at the firm failed to notify the whole HBOS board and the Financial Services Authority (FSA) about the criminal nature of the activities. Senior sources from the impaired assets divisions of other leading banks claim that at their organisations, it would be inconceivable for large numbers of loans worth many millions of pounds to be extended to companies with debt problems without board-level executives being aware.

Moore said: “There are inferences from the evidence of the involvement of senior executives and board members either in the fraud itself or in a conspiracy to pervert the course of justice – in other words in a cover up.”

HBOS senior managers have always denied any knowledge of wrongdoing.

Well, actually. they would, wouldn’t they?

The contrast between the life styles of the perpetrators and the victims is striking, too:

The most sickening thing about the whole sordid debacle is that the alleged perpetrators wre able to buy an fund the running costs of two mega-yachts in the Mediterranean Sea, having siphoned funds out of a state-rescued bank. And secondly, that the decent company directors, whose businesses and indeed lives have been destroyed, or harmed, as a result of the bank’s behaviour, continue to be persecuted, with one couple having been through 22 separate court hearings as the bank seeks to repossess their home, in the apparent hope of silencing them.

To judge by the energy and promptness with which it has pursued its investigations, the FSA, the UK’s financial regulator, is fine with all of this.

In fact, according to the Sunday Times of 24th July, FSA is keen to do a nice little deal with Peter Cummings (who was, incidentally, the director of 149 of the companies to which HBOS lent, many of which were joint ventures between the bank and its favoured clique of property tycoons, though none of these appear to have been beneficiaries of the Reading branch’s largesse). The proposed FSA deal is this: Cummings agrees to a lifetime ban from the securities industry, and the FSA in return drops its investigation into his tenure as director of corporate banking at HBOS. That’s an investigation which could only embarrass the great and good on the HBOS board at the time, and, indeed, would leave the FSA itself struggling to explain the quality of its banking supervision during the period in question. So pretty much a win-win, then: unless you are one of the fraud victims; or believe, quixotically, naively, that such cataclysmically bad oversight (or is it plain malfeasance?) ought to be investigated, and if appropriate, prosecuted.

Unfortunately for the FSA’s cosy proposal, the uncooperative Mr Cummings suspects his assailant is brandishing nothing more threatening than a wet noodle, and has invited the FSA to either produce evidence of wrongdoing, or clear his name.

Irrespective of that, Nikki Turner (one of the fraud victims) was sufficiently incensed by the reported deal proposal to draft an open letter to the Chairman and CEO of the FSA, respectively Lord Turner (former vice-chairman of Merrill Lynch) and Hector Sants (former CEO of Credit Suisse in Europe).

Here are some highlights of the letter:

• The loans made by Reading-based bank executives vastly exceeded the control limits supposedly applied by HBOS’s Commercial Lending  wing.
• The “extraordinary transaction” of British Linen Properties may be the subject of a future post here at Naked Capitalism.
• The payment of £29Mn by HBOS, to  companies that were already in administration, surely cannot have been authorised by any of the HBOS executives now on fraud charges, but by someone more senior.

To avoid prejudicing the existing fraud investigation, which involves more junior HBOS types, this open letter appears with redactions. This must be a first. It is the sort of contorted gambit one adopts when working one’s way around regulatory inertia, British legal protections, libel suits, and police process. All of this has slowed down the delivery of the letter by several weeks, as you see.

Readers in jurisdictions with less cockeyed attitudes to civil liberties and fraud investigations are welcome to chuckle, or sigh. Of course, Thames Valley Police may contact me via yves@nakedcapitalism.com if they feel they need to set me straight on anything.

Before I finally hand over the microphone to Nikki T., please be assured that I’ve seen enough to be happy that the allegations below are well documented: the deeply suspicious dealings of Mr Cummings, the improbable obliviousness of other HBOS board members, and the inertia, prevarication (and connivance?) of the FSA.