Why is No One Willing to Say Wall Street is Overpaid?

The New York Times yesterday featured an article by Yale economist Robert Shiller in which he discussed how financial reform had fallen short of addressing the conditions that caused the crisis. He focused on the failure to implement effective pay reform at the large financial firms that too big or otherwise too crucial to fail:

The issues facing us are complex. Let’s look at just one of them: the provisions in the Congressional bills on executive compensation.

Certainly, executive pay has grown enormously in recent decades, and there has been much suspicion that it contributed to the crisis. But it’s not the high level of executive salaries that helped cause the financial collapse. Efforts to reduce executive salaries have perversely created the wrong incentives. A 1993 law discouraging companies from paying their chief executives more than $1 million a year appears to have led to a de-emphasis of salaries and an increase in stock options.

So here is one of those epiphanies: Those stock options didn’t lower total compensation. And they probably encouraged C.E.O.’s to expose their companies to more risk, because options’ value grows as risk does. In fact, legislators’ misunderstanding of the law’s true incentives may have contributed to the severity of the crisis.

Yves here. Um, so how exactly does this little discussion disprove Shiller’s aside, that the level of pay did not contribute to the crisis? Answer: it doesn’t. He instead shows that not-fully-thought out reform created results the reverse of what was intended: it allowed pay levels to escalate when the level of executive compensation had already become worrisome, and worse, in a way that encouraged undue risk taking.

Now some readers will argue that financial services industry pay is market determined and therefore virtuous. That’s a misconstruction. Compensation in the financial services is a classic example of market failure.

The big banks and broker dealers ALL went into the crisis badly undercapitalized. Why? Because the industry engaged in a variety of practices that allowed them to rely on what amounted to fictive capital. For instance, credit default swaps allowed them to hedge risk with undercapitalized counterparties like AIG and the monolines. When the hedges failed, the banks showed spectacular losses. Similarly, banks shifted assets into structured investment vehicles and other off balance sheet entities, but earned fees both for setting them up and providing services to them. When these entities started showing serious losses, the banks discovered they weren’t so “off balance sheet” and tool losses.

If the banks had accounted for these risks properly, they would have had to carry higher capital levels and would therefore have had to retain more in the way of earnings and pay less to employees. And the idea that escalating pay levels was needed to retain “talent” was dubious. The threat was that the best staffers would leave for hedge funds. But let’s face it, they did regardless, and hedge funds employ comparatively few people in comparison to the banks and broker dealers.

Another reason compensation across the firms was excessive was that earnings are what economists call pro-cyclical. Banks and broker dealers are structurally long. Even Goldman, which endeavored to short subprime, was still long mortgages and credit instruments generally. When interest rates fall and risk spreads narrow, banks and brokers will show profits if they do absolutely nothing. They will show profits on the rise in the value of their assets. This has nothing to do with employee actions, yet they were paid bonuses on profits that would have shown up regardless. And those profits turned quickly to losses when risk spreads widened, but no one was forced to disgorge what amounted to undeserved compensation.

In 2007, John Whitehead, former co-chairman of Goldman, debunked the idea that the current levels of pay were warranted (mind you, 2006 bonus were dwarfed by 2007 and 2009 levels):

“I’m appalled at the salaries,” the retired co-chairman of the securities industry’s most profitable firm said in an interview this week. At Goldman, which paid Chairman and Chief Executive Officer Lloyd Blankfein $54 million last year, compensation levels are “shocking,” Whitehead said. “They’re the leaders in this outrageous increase.”

Whitehead, who left the firm in 1984 and now chairs its charitable foundation, said Goldman should be courageous enough to curb bonuses, even if the effort to return a sense of restraint to Wall Street costs it some valued employees. No securities firm can match the pay available in a good year at the top hedge funds.

“I would take the chance of losing a lot of them and let them see what happens when the hedge fund bubble, as I see it, ends.”

More support comes from Andrew Haldane of the Bank of England, who in a March 2010 paper compared the banking industry to the auto industry, in that they both produced pollutants: for cars, exhaust fumes; for bank, systemic risk. While economists were claiming that the losses to the US government on various rescues would be $100 billion (ahem, must have left out Freddie and Fannie in that tally), it ignores the broader costs (unemployment, business failures, reduced government services, particularly at the state and municipal level). His calculation of the world wide costs:

….these losses are multiples of the static costs, lying anywhere between one and five times annual GDP. Put in money terms, that is an output loss equivalent to between $60 trillion and $200 trillion for the world economy and between £1.8 trillion and £7.4 trillion for the UK. As Nobel-prize winning physicist Richard Feynman observed, to call these numbers “astronomical” would be to do astronomy a disservice: there are only hundreds of billions of stars in the galaxy. “Economical” might be a better description.

It is clear that banks would not have deep enough pockets to foot this bill. Assuming that a crisis occurs every 20 years, the systemic levy needed to recoup these crisis costs would be in excess of $1.5 trillion per year. The total market capitalisation of the largest global banks is currently only around $1.2 trillion. Fully internalising the output costs of financial crises would risk putting banks on the same trajectory as the dinosaurs, with the levy playing the role of the meteorite.

Yves here. So a banking industry that creates global crises is negative value added from a societal standpoint. It is purely extractive. Even though we have described its activities as looting (as in paying themselves so much that they bankrupt the business), the wider consequences are vastly worse than in textbook looting.

Yet its incumbents tout their ‘talent” and insist on their right to mind-numbing pay because their services are allegedly so valuable to the economy.

Yet after applying a wrecking ball to the global economy, the banks got big handouts, and like Fannie and Freddie pre crisis, the banks get to borrow at cheaper rates than would otherwise apply because investors understand full well that governments stand behind big financial firms. Haldane again:

It is possible to go one step further and translate these average ratings differences into a monetary measure of the implied fiscal subsidy to banks…The resulting money amount is an estimate of the reduction in banks’ funding costs which arises from the perceived government subsidy..

For UK banks, the average annual subsidy for the top five banks over these years was over £50 billion – roughly equal to UK banks’ annual profits prior to the crisis. At the height of the crisis, the subsidy was larger still. For the sample of global banks, the average annual subsidy for the top five banks was just less than $60 billion per year. These are not small sums…

On these metrics, the too-big-to-fail problem results in a real and on-going cost to the taxpayer and a real and on-going windfall for the banks.

Barry Ritholtz in a post today, correctly takes apart Shiller’s recommendation (deferring a substantial portion of pay, which would be forefit if a company were bailed out or failed) and recommends a superficially appealing solution, returning to a partnership model:

The thought process behind this is that risky corporate activities should also become a risk to the firm’s executives…The hope is that “this will transform executives’ thinking about risks — and may help prevent another disaster.”

I sincerely doubt it. Similar disincentives were already in place — and they failed miserably.

At each and every one of the companies that went bust due to their excessively risky speculations — from AIG to Bear to Citi to Fannie Mae to Lehman to WAMU — every executive had huge amounts of stock, stock options, and future salaries at risk. Lehman’s Dick Fuld reputedly lost over $500 million dollars in stock value, and a few of Bear Stearns execs lost close to a $ 1 billion dollars each in asset value.

The mere threat of future losses has already proven insufficient to moderate behavior. Holding back $100s of 1000s of dollars — or even millions of dollars — is a meaningless inconvenience to the people whose net worth is measured $100s of millions or billions of dollars.

Barry then offers partnerships as a model:

I did discover one group of Wall Street firms whose senior management took a very measured approach to managing risk..

The group? Wall Street partnerships…

Partners have “joint and several liability.” Every partner is fully liable, up to the full amount of the relevant obligation, for the actions of every other partner. This has the effect of focusing the minds of management on exactly what the worst case scenario of their behavior can wreak….the creditors can proceed to recover losses from the personal assets of every partner. Bank accounts, Houses, boats, vacation property, 401ks, cars, jewelery, watches, etc. are all fair game for creditors.

Not surprisingly, none of the Wall Street partnerships got into trouble…

Yves here. While I agree 100% that Barry’s proposal is superior to Shiller’s it’s not the panacea he makes it out to be. First, partnerships were reckless in the 1920s and many failed in wake of the Great Crash. Ironically, Barry cites Brown Brothers as an example of a modern partnership that has behaved prudently, but the current Brown Brothers was born of the merger of the teetering Brown Brothers & Co. into the stronger Harriman & Co. in 1931. There was another large wave of partnership failures and mergers in the wake of the 1960s back office crisis, but because these firms got into trouble as the result of operational problems, as opposed to the misuse of borrowed money, it did not have wider economic fallout.

Second, there are a lot of ways that executives can slip the leash, from putting assets in countries where it would be hard to repatriate, or even locate them (there is a reason Jews fleeing persecution used to sew diamonds into their clothing, it is a compact and portable form of wealth) to quitting at the first sign of business troubles, to only taking risk in very long-dated exposures (again, to shift responsibility for any blowups on to successor management) And who would want to take on that sort of liability unless he could an exhaustive audit of the banks’ exposures? Thus, if someone were to turn down a high level position, rumors could easily start that the bank was in trouble, which in a worst-case scenario would precipitate a run.

Third, how would you draft regulation to deal with sales of severely weakened firms? Look at the sale of Merrill to Bank of America, which was lauded as a coup by John Thain (in terms of the value received by Merrill shareholders). It sure was, Bank of America later cut a deal with the government to cover Merrill losses. And this sort of partnership liability concept would lead the authorities to write waivers to firms like JP Morgan that step in to buy troubled firms like Bear.

One of the reasons that Barry forgets that partnerships led to more caution wasn’t simply the prospect of unlimited losses. It was also that partners had most of their wealth tied up in the firm, and could withdraw it only gradually after they retired. This led them to take a long-term perspective and also prevented the pursuit of a lavish lifestyle. And it further lessened mobility among junior staff. Partners would only take people into the partnership that they had observed over long periods of time. Unless he was exceptionally talented, someone who came in mid-career to a firm would be at a disadvantage relative to those who had spent their career there.

But the focus on executive pay divers attention from the fact that pay levels across the big players is wildly out of line, given their ever-growing government guarantees. n a paper by Piergiorgio Alessandri and Haldane, “Banking on the State” (hat tip reader Scott), they describe how support to the financial system has ratcheted up in the wake of crises, which only makes it more attractive for banks to gamble. They note:

This is a repeated game. State support stokes future risk-taking incentives, as owners of banks adapt their strategies to maximise expected profits….the latest incarnation of efforts by the banking system to boost shareholder returns and, whether by accident or design, game the state. For the authorities, it poses a dilemma. Ex-ante, they may well say “never again”. But the ex-post costs of crisis mean such a statement lacks credibility. Knowing this, the rational response by market participants is to double their bets. This adds to the cost of future crises. And the larger these costs, the lower the credibility of “never again” announcements. This is a doom loop.

The “St Petersburg paradox” explains how a gambling strategy which starts small but then doubles-up in the event of a loss can yield positive (indeed, potentially infinite) expected returns. Provided, that is, the gambler has the resources to double-up in the face of a losing streak. The St Petersburg lottery has many similarities with the game played between the state and the banks over the past century or so. The banks have repeatedly doubled-up. And the state has underwritten any losing streak.

Yves here. In other words, given the inability of bankers to avoid crises, this destructive pattern will continue until the banks break their backers, meaning the state, or we find a way to stop the game. Loudly contesting the idea that the pay levels at the major capital markets players are in any way warranted is part of the process of bringing the industry to heel.

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  1. attempter

    Shiller says:

    The issues facing us are complex.

    No. They’re not. Conceptually the problem is very simple.

    We have pure parasite gangsters who produce nothing who are stealing a vast amount of the wealth created by society. They’ll keep stealing every cent they can until they’re completely destroyed. Period.

    But when one is too much of a moral coward to face this clear fact, one must artifically complexify the “issues” to justify seeking “solutions” in a fantasy world walled off from the real one.

    Yves here. In other words, given the inability of bankers to avoid crises, this destructive pattern will continue until the banks break their backers, meaning the state, or we find a way to stop the game. Loudly contesting the idea that the pay levels at the major capital markets players are in any way warranted is part of the process of bringing the industry to heel.

    That’s the way it is. The Bailout State is already starting to crack under the pressures of the Bailout, which is the real reason the system wants to move to “austerity” everywhere. The Bailout will soon be insufficient to keep the loot flowing, so the kleptocracy has to move from the bailout’s relatively indirect robbery to the direct robbery of stealing pensions and abdicating on services so more public money can be freed up to be stolen.

    So one of the parts of the process should be to meet every hint of the fraudulent notion that any of this “compensation” looting is justified (and never let them get away with absolutely fraudulent words like “compensation” or “earn”), or that the “issues” are “complex”, with the clear truth:

    These are parasites and criminals who produce nothing but needless cost.

    Every cent they extract is being stolen.

    1. craazyman

      As usual, you nail it with a word hammer.

      These people are beyond disgusting, beyond repulsive and beyond any form of justification, rationalization or excuse. They are an embodiment of instinct run amok without any form or repression or consciousness. They are bacteria. And society desperately needs a strong antibiotic to prevent it from dying.

      A start would be the formation of a political economic theory that candidly and forefully recognizes that our “financial intermediaries” as they are constructed do not, as the textbooks say, serve to efficiently allocate society’s resources by navigating the problems of adverse selection and moral hazard.

      Instead, they compound those problems, distort the allocation, and repugnantly loot a large share of it.

      Let a textbook start there. And let that be taught in economics and finance schools. And let the reconstruction begin.

      A good first step would be the recovery of the fraudlently and possibly criminally acquired compensation across a large spectrum of Wall Street in recent years, and the use of that money to fund a capital base for community-sponsored banks around the country. I won’t hold my breath on that one, though.

      1. attempter

        I think their textbooks aleady do say that, which is why they’ve had to come up with all their neoclassical modifications.

        Otherwise they could never justify anything beyond microscopic profit levels in all these mature sectors. The capitalist textbooks say all this profit should no longer exist. In mature sectors, high “profit” levels are not based on productivity but are signals of market failure. They aren’t legitimate capitalist profits but oligopoly rents which should be purged completely.

        “There’s no such thing as a free lunch” is one of the most infamous scams. What Chicago was really doing with that was trying to defend parasitic rents by simply defining them out of existence. You dogmatically declare there are no free lunches, and therefore it automatically follows that anyone who’s extracting wealth has to be “producing” something. Because “the market” by definition doesn’t sustain free lunches. So parasitic rentiers and monopoly-bloated fraudulent “profits”, really just thefts, are ideologically defined out of existence.

        So if you wanted a real capitalist textbook it would have a title like The Captivity of Capitalism and would just give primers on what capitalism was supposed to be while the main subject matter would be analyzing corporatism and oligopoly rents as monstrosities which are noxious to a rational economy, democracy, and freedom itself.

        (Of course I would say all this was always the logical consummation of capitalism, but there’s lots of people who claim to want “real” capitalism, so my comment is suggestions toward that, if it were really possible.)

        1. craazyman

          Granted all of that, but actually Fred Mishkin’s textbook “Economics of Money, Banking and Financial Markets” does in fact define the reason for the existence of financial institutions as the navigation, on behalf of savers, of adverse selection and moral hazard in the investment process.

          I have read much of his 1995 edition, which I purchased at a used book sale. Every once and a while I try to roll up my sleeves and do the dirty work, rather than just channeling everything.

          Fred Mishkin is a former Fed Governor and a professor of economics at Columbia University.

          Clearly, rather than navigating these hazards on behalf of savers, these institutions fraudlently manipulated them on behalf of management and at the expense of savers and of society at large.

          Economics needs better grounding in pyschology. And not the lightweight nit-wit shit called Behavioral Economics. I mean the real stuff that analyzes instinct and identity . . . like Freud, Jung and the pyschoanalytic school; anthroplogists like James Frazer; social theorists like Gustav LeBon; religious prophets such as Jesus; and illustrators of insanity such as Shakespeare, etc.

    2. sgt_doom

      Excellent comments.

      To phrase it another way, the taxing of labor, the untaxing of the wealthy, and the decriminalization of fraud for the super-rich.

      Time to take back all those ill-gotten gains from those debt-financed billionaires, then wield the guillotine.

  2. a

    IMHO pretty nearly everyone earning Wall Street money is probably overpaid. Sure, there will be the odd exception – the researcher who has discovered a new drug which saves the lives of thousands. But do sports figures deserve their money? Don’t think so. Entertainment figures? Nope again. Etc. So maybe, rather than trying to figure out a way to make Wall St. compensation lower, we should just raise taxes a lot on higher earners, and figure out better ways to stop these earners from moving their money off-shore.

    1. Frank Powers

      @ a:

      Again, I’d like to point out Sam Pizzigatti’s “Greed an Good”, wherein he outlines a simple mechanism for the restriction of “compensations” – namely a maximum wage amounting to ten times the minimum wage currently paid, combined with increased taxes on assets and liabilities, if I remember correctly. That would still enable executives et al. to increase their maximum compensation, but at the same time require that the average pay level goes up as well, resulting in a smaller, more just and socially more beneficial spread of income. The whole, excellent book is available for download on his webpage, http://www.greedandgood.org


      You’re damned right. We’re being ripped-off, all of the time. Neo-feudalism, anyone?

    2. Toby

      The deeper question is this: why is money the best (or only) reward mechanism we can/have come up with? Or: Is money a reward/punishment mechanism that can only overdo it? It always seems to be that the rich get richer and the poor poorer.

      Then there’s the chance happening of overpaid sports people and entertainers. Their value to society can hardly equal the ludicrous share of the pot they earn, compared to say good nurses and teachers. But because money yields, over time, a society obsessed with financial profits, social goods like health and education are forced to take a back seat. We end up prioritizing those things that make loads of money, no matter the cost to society.

      What do we need to do to money to correct this obvious failing?

      1. Frank Powers

        An essential part of the money problem is that money not only acts as a direct reward machanism, but as a (psychological) self-enhancement mechanism as well: up in the high ranks of corporate leadership (or billionaire country, for that matter), money has long lost its direct exchange-value and rather functions as a kind of score, allowing for a direct comparison between the “players” and their peers.

        The game they’re playing is the one everyone plays, the game of raising one’s self-worth, quelling one’s anxiety in the face of life and one’s own mortality and aggrandizing one’s self-esteem. Pity is they’re using the source stuff itself for that purpose, removing it from its original role as a mere medium of exchange, and turning it into something they never can have enough of. Because let’s face it: There are only so many cars, mansions, and yachts you can reasonably buy and use, only so many suits you can wear, and only so many banquets you can feast on. After all, “enough is as good as a feast”, as the saying goes. Unfortunately, taking into account money’s changed role as a signifier of score, they never can have enough, as the score never gets settled and the “game” goes on and on. So they continue to rob and rip off and will always do so, until they or we find a different way to quiet their existential Angst.

        Of course, we could also just throw them in jail. But whoever moves up probably won’t be any better. And we might be able to instigate a new set of rules, like the one Pizzigati (www.greedandgood.org) advocates, or any different one – but still, until we get a change in consciousness and in handling the basics of our human existence, the temptation to highjack any reward system for our personal needs of (a false) security and self-aggrandizement will always be there.

        1. Toby

          Frank Powers said: “until we get a change in consciousness and in handling the basics of our human existence, the temptation to highjack any reward system for our personal needs of (a false) security and self-aggrandizement will always be there.”

          Agreed, and I agree with the rest of your comment, but the above sentence fragment strikes me as the crux of this. It’s not about rules and regulations any more, hell it’s even deeper than the money system (though that has to change). It’s about us and how we understand ourselves asa species and our relationship with an environment we must share to survive.

          We’ve been hooked on “more more more” for far too long. Money is one of the reasons for this, but we invented money so our ignorance is the deeper problem. My hope is that dealing with money at the structural level necessarily involves facing up to much else that we have got wrong on our journey to this impasse.

          1. Frank Powers

            As I learned from your blog that you’re based in Berlin – perhaps we should meet and chat a little… You’ll find my email-address in my blog’s imprint (Impressum).

            Kind regards, Frank

    3. liberal

      Difference is that sports figures and entertainers, whatever their other sins, don’t periodically destroy the economy.

      1. don

        Another important difference is that the sports figure can’t hire or stock the board that sets his or her pay. Anyway, for the very successful, it is product endorsements that make up the bulk of their income.

        1. Jon

          The difference is that entertainers and sports figures earn their money usually by selling tickets or cds etc. So they are actually a better representative of what pure capitalism should look like. People vote with their dollars. If the cd or concert is no goo,d or the player sucks they naturally earn less. It is a true meritocracy.

          Wall Street pay on the other hand is just fraud, collusion , conspiracy and gangsterism.

  3. anon

    Why aren’t more people talking about nationalizing credit? Not temporarily, as an emergency measure, but permanently?

    This is one of Michael Hudson’s proposals in the following excellent interview on “Guns and Butter,” at KPFA (“Listener -supported Pacifica radio” in Berkley):
    Guns and Butter – June 16, 2010 at 1:00pm

  4. Jojo

    ALL of them are overpaid.

    But the question that should be looked at is HOW do they get overpaid? The only way this can happen is if they are charging their customers excessively, thus generating the excess cash to be able to comp people excessively.

    Customers SHOULD be asking – WHY are we paying you so much for your services? Isn’t anyone willing to provide the same services at less cost? If not, then it sounds like there is some sort of monopoly there.

    1. Greg

      Unfortunately, the “customers” – buy side fund managers – are playing with other peoples money. Their careers and incentives aren’t aligned with those that provide the money.

  5. RichFam

    Why does the market allow for such high compensation? There’s two possiblities that I can see: a complete failure of corporate governance (the bankster theory) or these high paying jobs are hard to get and to keep (the actual reason).

    Your basic wall street trader, salesperson, fund manager had a hard time getting their job and has very low job security. Also, there’s not a ton of these jobs that pay so well – there are more press articles and blog posts on the subject than there are high paying wall street jobs.

    So all this regulation of banks will work, kinda. Less risk at the big banks will mean less risk to the risk taking employees of the banks and less sexy (scary) stuff for the banks to sell. So job security will rise, comp will fall.

    The fallout:

    Some risky, hard to get jobs remain and they pay even better because there’s less of them (why do you think Goldman made so much in 2009?).

    The 3-10 people who work in support of that risky job get fired (don’t even try to tell me this doesn’t happen – see layoffs at Bear from the JPM buyout).

    These risk takers and salepeople are smart and they like to make money so they’re not going to just start looking for minimum wage jobs – they’ll go to or form those partnerships and small companies you spoke of. This is risky and they’ll get paid based on real earnings, many will get payed more than you would like I’ll guess. Others will have to move on. Others still will work at different banks.

    Just because you don’t like what they do doesn’t mean they’ll listen to your bull****.

    So I work on wall street – here’s a news flash – 60-80% of the professionals I know have lost there jobs over the last two years – but almost every one of them have found another job doing the same thing either at another established company or at a small newer one. Less money, more money, families disrupted, whatever – we’re all evil anyway…

      1. D. Warbucks

        There’s no need to engage in street criminality when there is Wall Street criminality to be had.

        1. RichFam

          How much did you guys pay for that IPAD? criminally pricey but an approved way to make money I guess

    1. D. Warbucks

      “why do you think Goldman made so much in 2009?”

      Don’t tell me you read this blog and don’t know!

      1. guidothekp

        May be it is because the Fed is printing money and directly depositing into the banks’ accounts so that the bonuses can be paid? Who knows what is going on with Fed anyway?

    2. Anonymous Jones

      Well, that is fine if you want to believe that, RichFam. My experience (on a daily basis) with bankers and traders has not left me as impressed by the “talent.”

      Also, to not understand the franchise value of these institutions and to not question whether the division of gains between owners and executives is fair given the huge structural advantage provided the executives by the franchise in place is simple head-in-the-sand nonsense.

      1. RichFam

        Which is why I think corporate governance is a real problem no matter the industry. Also, call it talent, drive or luck these jobs have very low job security and very high income variability.

  6. Independent Accountant

    I have said similar things for years. Banks are undercapitalized and designated bank officers should be forced to repay three times their last three years compensation if the bank fails. Barring that, banks should not be incorporated.


  7. Siggy

    I spent alot of time on LaSalle Street, Second City, Wall Street a little west; San Francisco was Wall Street West.

    I worked there from 1952 to 1970. I was a board marker, a phone clerk, and a registered representative. I did due diligence for IPOs and I was paid an inordinet sums of money for my efforts.

    When I left LaSalle Street in 1970 we were in the midst of a bear market that would last well into 1975/76. Brokerage firms were consolidating and commissions were being cut in half. Retail customers were leaving the market and we had yet to experience the 401-K. Similarly, we did not then have a viable options market or some of the other recently developed options and derivative products. Each of the firms I worked at was a partnership.

    I like partnerships, joint and severable liability is a very good incentive for prudent risk taking. Time and again in investment committee I saw joint liability fully considered. Inevitably it was determined that you cannot calculate away inherent risk and no matter how you doctor it up, a crummy balance sheet is a crummy balance sheet.

    Structured finance is little more than three card monty. It’s structured because you can’t sell the sorry truth that the borrowing is being made to fill an empty bag. Off balance sheet enterprises are nonsense, you have an interest, it’s on the balance sheet. The liquidation value of anything on the balance sheet is, at best, 50% of its NPV and 25% is probably the price you’ll accept when the creditors come for their pound of flesh.

    Reality check, 90% of the firms that fail in any given year are over levered and grossly under capitalized. It has always been that way. There was a time when most nonfinancial firms had quick ratios of 1.25 to 1.5. Today the ratio is around .95 to 1. There’s a reason for that, the currency has no inherent value and some moron has made up a marvelous little ‘new’ paradigm called modern monetary theory. Modern monetary theory is an excuse for being dirt poor and having to rely on borrowed funds for survival.

    Those who adhere to MMT are slaves to commercial paper, repos, similar borrowings and a government thru artful convolution prints money at will. The convolution part is the interplay between the Fed and the Treasury. If it weren’t so socially destructive it would be a marvel of the human capacity for creative and evasive thinking.

    The MMT adherents have no real independence and as a consequence they are forced to chase yield, the risks be dammed. And, it has ever been and will ever be that big yield means big risk.

    Until circa 1971, small profit trades were rarely considered, the profits wouldn’t pay enough to turn on the lights. If you had to lever the deal up to make it work, it didn’t get done. LTCM is a classic example of a firm doing small profit highly levered up trades. Get on the wrong side of that type of trading and you’re toast.

    Big compensation used mean a nice Christmas bonus, maybe buy a new car and a bigger share in the partnership. Retained earnings was the bottom line for us. Retained earnings were our go away money. Big risk, someone dies or decides to go to some out of the way place and contemplate their navel and you’re in violation of the 2000% rule.

    I say bring back the partnership, keep a place at the table for the guy who sees all the risks. Cut the current compensation level by half. Someone wants to go elsewhere, God Bless and God Speed. Think you’re irreplaceable, you’re so dumb you don’t even belong there in the first place and good riddance to you.

    Carried interest is money earned in the normal course of the operation of the enterprise. It’s ordinary income, tax it as such. Ooooh the 2 and 20 guy will howl, you just gored his ox.

    I have no idea as to why we can’t be honest about the irrational level of compensation on Wall Street other than the fact that when it is tabled one is subject to the slings an arrows of outraged kleptocrats.

    1. psychohistorian

      Thank you for the comments on MMT. I also have nagging problems with their assumptions.

  8. Matt

    To summarize, isn’t this a fundamentally philosophical problem? For someone to say that a private firm is overpaying someone (especially on Wall Street) is basically a critique of the concept of an “efficient” labor market, which is basically a critique of capitalism. Luckily for us, Yves is willing to go there, but most mainstream folks, like Barry Ritholtz just aren’t willing to go there. Even non-conventional or behavioral economists like Shiller have to go there very carefully by focusing on how complicated things are.

    1. D. Warbucks

      “is basically a critique of the concept of an “efficient” labor market, which is basically a critique of capitalism.”

      I love how no matter how much we pay bankers out of people’s tax dollars, they still call it “capitalism.”

      1. sgt_doom

        Exactly and well said. Today, the anti-meritocratic construct is reframed as “free market” — the rigged game also referred to as “free market” — whatever became of free enterprise?

    2. liberal

      It fits right in with textbook analysis of capitalism, once you realize that Wall Street as a whole does not make profit, but rather collects rent.

  9. Mannwich

    This is legalized theft. Plain and simple. Call a spade a spade here. It’s theft of the capital that would be better and more efficiently allocated to more socially productive activities.

  10. GeorgeNYC

    There are other historical precedents for the partnership model not just Wall Street prior tot he 1990’s. Prior to 2000, the Lloyd’s insurance market relied entirely upon the capital of individual “Names” whose liability was unlimited. They were in essence “partners” for their proportionate share of the risk. They quite literally had individual unlimited liability which is confirmed by the bankruptcy of quite a number of the “Names” when their liabilities grew as a result of US pollution and asbestosis liabilities. ALL of their assets could be seized if the syndicates they subscribed to lost money. (Not just some “pledge” or “investment.”).

    This was a 300 year old market that was well regarded as one of the most dynamic and innovative financial markets in the World and it was run entirely upon the basis of unlimited personal liability. Further, the individuals who were actually writing the risks, the Lead Underwriters, were also required to be “Names” on the syndicates they led and thus have proper “skin in the game.” Only after 2000 were “limited” liability capital vehicles allowed to become “Names.” One could actually argue that since such “limited” liability capital has become involved that LLoyd’s has actually lost some of its innovativeness and become more hamstrung with “corporate” compliance.

    The point for this discussion is to really turn the question back on its head. What we forget is that “limited” liability companies are not entities that exist in the “state of nature” they are an explicit grant of limitation given by the state to business organizations. The original intent was to encourage certain types of large scale capital deployment that might not otherwise be possible (i.e. building canals. Colonizing countries, etc.). Now anyone with a pulse and a home address can be given this grant.

    The question might therefore be more properly stated as why do we as a society need to subsidize speculation by granting such limitations of liability? Looking at the Lloyd’s market as an example, quite clearly, the original thought was that such risky activity was best carried out by people whose personal fortunes were at stake. I wonder how Mr. Blamnkfein would be acting if he thought he could lose everything he owned if Goldman crashed.

  11. Jim in MN

    So we have a system that pays people obscene sums to push risk to the limit and destroy lives in the process. As noted in these comments, the signature of criminal enterprise.

    Clearly we need reform that puts the life-destroying risks off the table, i.e. criminalizes them. If the returns from legal financial activity don’t justify obscene rewardss, then the reform is working.

    So, let’s not limit compensation but instead limit the financial sector’s structural ability to do damage; keep increasing the limits until compensation becomes normal. That’s when we know we’ve limited their criminal activities sufficiently….

  12. F. Beard

    Heck, I don’t care what anyone is paid if they earn it in a free market. But what we have in the US is a government backed fractional reserve banking cartel using the government enforced monopoly money supply. Fix that fundamental flaw and root of much evil will be eliminated.

    1. sgt_doom

      I’m a bit unclear as to where this “free market” happens to be, dood.

      Could you possibly point me — and the rest of the world — in the proper direction????

  13. Blurtman

    On the Sunday morning news show circuit was Rahm Emanual, a criminal, lecturing the little people on appropraite strategy and behavior.

    In the previous administration, there was a criminal Treasury Secretary promising blood in the streets if we did not bail out the banking oligarchy.

    Were things any more inane during the days of the USSR?

    The USA is in horrible shape. The corruption in the leadership is beyond obvious.

    1. sgt_doom

      “.. was Rahm Emanual, a criminal…”

      Now, don’t you think that’s a bit harsh? After all, Rahm left his warm, BP-financed condo, wearing his expensive Wasserstein Perella – financed suit, and spoke from his hedge funds-sponsored political career.

      1. Blurtman


        “On the Sunday morning news show circuit was Rahm Emanual, a criminal with a penchant for expensive tailored suits, lecturing the little people on appropriate strategy and behavior.”

  14. Francois T

    The level of pay in the financial industry (FIRE) will never be addressed in a meaningful way before society fully grasp the consequences of the incredible amount of penetration of said industry within the political apparatus.

    Right now, they already employ ~1,400 lobbyists that are former lawmakers and Hill staffers. Think about the level of incestuous relationships and networking effect such a number can have. FIRE spent (and is still spending) 1.4 million dollars every day to defeat or water down any financial reform bill, at a time where the costs of presidential elections double every 4 years. And I’m not even talking about Congressional and Senate elections yet. Banksters can freely talk that much, since money is free speech. (Thank you SCOTUS!)

    Can anyone spell c-a-p-t-u-r-e?

    Furthermore, the banks have a friend at the the highest level of the economic decision making process, namely, the Fed, which is for all intents and purposes, controlled by the banks. There is an obvious reason why Turbo Tax Timmy, (ex-NY Fed President, once offered the top job at Citi, had lunches with banksters 4 days a week etc., etc.) in the midst of the auto bailout, accepted no less than 86 calls from the banksters while the House Chairman of the Financial Services Committee (Barney Frank) had to leave messages. I mean, say what you want about Barney Frank, but one would be inclined to think, when the sounds of reform acquired hurricane levels, the Sec of Treasury would be inclined to, I don’t know, TALK with one of the most important players on the Hill. This bank ownership of the Fed and the accompanying influence goes a long way to explain why BO couldn’t even think about replacing Burntwinkie, despite a proven record of cluelessness.

    Another form of particularly pernicious lobbying comes from the economist cast. It is vital to bear in mind the following fact: The Fed sponsor in one way or another, north of 50% of the “rising stars” economists in this country. Apart from the obvious (and not so obvious) forms of groupthink inherent to such closed circles, can anyone proclaim with a straight face that these people would dare to go against their prime benefactor wily nilly? Color me skeptic, but I don’t think so.

    In a word, what we have in this country is a near fatal combination of forces that spwaned an almost absolute lock-down on the political system by the FIRE sector. The laws are written to favor them, which enhance their profitability and the extra money is recycled into the lobbying machine which in turn… It is like this old ad of the Hygrade sausage: “More people eat’em because they’re fresh, and they’re fresher because more people eat’em!”

    Quite frankly, I do not know what will it take to break this vicious cycle. Will we the light at the end of the tunnel? Let’s hope the light in question is not the freight train coming at us.

    1. Stelios Theoharidis

      This is basically the iron law of oligarchy. These social, economic, and political power structures are self-reinforcing, the more power that they collect the more effective they become at accumulating more and defending their territory. They no longer need to fortify themselves with walls when they can pay a army of lawyers, strategists, lobbyists, fake “think tanks”, political shock troops, and PR firms to protect their interests.

      It is a bit of an simplification to say that the Financial industry has captured government in any way that the military industrial complex, the healthcare industries, NRA, APAC or any other group has entrenched themselves into the political process. Politicians can’t really even discuss cutting down on agricultural subsidies or suggest that the NRA disclose PAC contributions. Lobbying on behalf of private interests has basically become bread and butter for politicians and their staff members. Politicians these days basically fight over who has the legitimate right represent these concentrated interests. But both sides are pretty much bought and paid for with some exceptions amongst our nations politicians.

      But this occurs over an over again, this is not a special situation in any way that the trusts, US motor industry, or british trading companies were special situations. However, I do believe that these groups have become considerably more effective in maintaining their position and rent upon the generally unrepresented masses through the advent of modern PR. Not only has this process deepened into the political structure through intense use of campaign contributions but it has also widened through the engineering of public consent, framing of political dialogue, formation of fake protest actions, development of parallel intellectual institutions. One would hope the interests would attempt to canibalize each other, but they are still feeding off of the american public and the global poor.

      The most ancient art is the art of making someone your bitch, and what we see before us is their modern opus. Specific interest groups have managed to convince a large contingent of the American public through too much Ayn Rand and Fox News that corporations are an poor over-regulated underdog, that community activists and unions are gangsters and thugs, and attempts to protect the environment or human health are conspiracies of global elite / violations of our freedoms.

      I would actually suggest a 80% windfall tax on lobbyist incomes, a constitutional convention to restructure the senate towards more proportional representation, limitations on political representatives terms, one national holiday for voting, but that would only get the ball rolling. Some sort of clearing mechanism is important in these contexts, new oligarchies will form as that is inevitable, they will again pull apart the various reforms enacted when their insatiable hunger for wealth and power put international stability in jeopardy, that is just the nature of the game. But in no way is it novel or exclusive to the financial industry.

    2. MarcoPolo

      Have been wanting to tell you how much I enjoyed the post you wrote earlier. I’m not a writer. When I put something up here I can feel people’s eyes glaze over. Hyperbolic, I think was the reaction.

      Re: “the incredible amount of penetration of said [FIRE] industry within the political apparatus.”

      To put it like that is to underestimate the problem. Like HIV turns our immune system against our bodies, the checks & balances of govt. and its regulatory framework have been subverted to feed the parasite. The political apparatus is as much a part of the problem any anything else. Both should be removed. Chances of that?

  15. William R. Short

    Dear “naked capitalism” writers,

    Re: Exec. compensation,
    My former Minnesota 5th Dist. congressman Martin Sabo introduced a bill in each of his last 5 terms, that would have limited the amount of an executives salary ($1 million) is deductible as the cost of doing business, but were still free to pay them as much as the boards and their captive compensation committee would allow. He called this bill “the Income Equality Bill”.

    Best wishes,
    William Short

  16. LeeAnne

    Price controls, including salary controls, DO NOT WORK, HAVE NEVER WORKED.

    Graduated income tax works. Tolerating accumulations of $Billions by any individual is insane. Added to that, tax-free inheritance of those Billions tax free? INSANE.

    Its hard to argue with insanity.

  17. edward ericson Jr.

    I don’t see how Sabo’s bill (or this description of it) differs from the law we already have. Anyway, I’m with Frank Powers. Very well put en re the “keeping score” aspect of all this. So why not bring back the 90 percent income tax bracket? For much of the last century–and the high growth years at that–the top marginal income tax rate was between 70 and 90 percent. Confiscatory. Until the bailout bill is paid–and probably beyond that–the federal government should levy a similar tax on incomes above, say $1 million. Or make it $2 million to account for inflation. Make it for income from all sources, “earned” and not, and apply it to deferred compensation as well. No more salting the bonus away forever or until your accountant can confect a bogus “business loss” to offset your taxes on that. Increase I.R.S. CID and complex case divisions to handle the influx (and collect a bit more of the $100 billion per year we’re already leaving on the table under the current system), et voila! Revenue on the one hand plus a curb on psychotic pay.

    1. Walter Map

      So why not bring back the 90 percent income tax bracket?

      Income derived from racketeering and extortion are traditionally tax-exempt.

  18. steehead23

    Here we are, yelling about the rewards banksters reap. Yessiree, $50 million per annum is plenty of income, particularly for a crook. Of course I agree that banksters should be paid less, but pay is only half of the system of incentives affecting behavior. The other incentive is the fear of prosecution. Magnetar and other offerings made which the originator shorted, make it clear that there was an intent to deceive investors. This deception was conducted by individuals against the stated policies of their companies. Yet, it is the companies, not the individuals the prosecutors are hounding. I agree that working to limit executive compensation would be a good thing, but I believe that effectively prosecuting a handful of them would do more to chasten industry risk taking.

  19. Pithhard

    I’m a Wall Street alum with no particular love for the people who work there now. But I’ve got to weigh in on the side of sanity. All these rants are no doubt very therapeutic to the hard core leftists who love to get a good hate going. But they are a waste of time. Let me waste a little time telling you why you’re wrong, though stuff like facts and logic are probably anathema to you. I’ll keep it really short.

    Financial intermediation is essential to the efficient allocation of capital and economic growth (just ask Yves if you don’t believe me). No sane person will trust such work to any but the smartest, best educated, dedicated and competitive individuals available. These people are not infallible, nor are they any more honest or trustworthy than average (although every person who works on Wall Street has their background fingerprints checked by the FBI before hiring). They also don’t work cheap, and they never ever will. Move on to the next topic.

    1. Yves Smith Post author

      With all due respect, that’s utter nonsense. The result of the last 15-20 years has been a massive MISALLOCATION of resources, due in large measure to predatory behavior and looting in the financial services industry. You’ve had to turn facts on their head to justify your position.

      Did you bother to read the post? Evidently not.

      Haldane’s analysis is damning. Look at the cost of crises. Contrary to your fact-free assertions, the financial services industry as it now operates is massively NEGATIVE value added.

      So how do you justify the lavish pay? Or for that matter, the brain drain to an industry that is destructive by any measurable standard? Answer: the pay bears no relationship to the real value of the services. The comp should be much lower because, frankly, financial intermediation, contrary to your assertions, is NOT that hard. We had a financial services industry that was not destructive to the greater economy from the 1930s through the late 1970s. It was pretty dull and per Simon Johnson, financial services industry workers were paid pretty much on par with those in other fields of endeavor.

      Another defense of industry pay is the spurious arguments about the benefits of “innovation.” As I said in ECONNED,

      But opacity, leverage, and moral hazard are not accidental byproducts of otherwise salutary innovations; they are the direct intent of the innovations. No one was at the major capital markets firms was celebrated for creating markets to connect borrowers and savers transparently and with low risk. After all, efficient markets produce minimal profits. They were instead rewarded for making sure no one, the regulators, the press, the community at large, could see and understand what they were doing.

      And it does not require “talent” to be in this business. I worked at Goldman in its most prestigious, difficult to enter businesses. Not a single task I was asked to do was hard (for instance, the joke was that all it took to do due diligence was a good haircut and shined shoes), nor did the job content change much as one got more senior. You were worried about the same transaction details; the difference was the juniors were at the office late at night, supervising temps; the more senior folks had more client face time, and were more often in airports on pay phones (this was pre the cell phone) checking back to the mother ship for market updates and to make sure the juniors were on top of things. As far as I could tell, the main reason for having people with top resumes was to justify the fees; it was an exercise in branding.

      This misnamed “talent” is that the industry has specialized know-how which you can acquire only from within. An electrician also has specialized skills; you wouldn’t ask a plumber to do his job, but no one would dream of calling it “talent”.

      In fact, this piece argues that the problem with Wall Street is that it started attracting smart people:


      I suggest you also read this:


      1. steehead23

        Yves, I read the smart people caused the meltdown piece – and you know what? It rings true. And it makes sense. If a risk analysis incorporates assumptions that seem reasonable and the outcome suggests the venture would be highly profitable, how many decision-makers ask the quants to go game the numbers, do a Monte Carlo, or look at the worst case? Too few apparently. So let me offer a slightly left of center twist on the thesis. The problem isn’t that Wall Street’s worker bees are too smart for the good of the hive, it is that obsessive quests for profits has made the decision-makers dumber than a sack of rocks.

    2. Walter Map

      “Financial intermediation is essential to the efficient allocation of capital and economic growth”

      Since when does crashing the economy for fun and profit constitute “efficient allocation of capital and economic growth”?

    3. Blurtman

      That’s pretty funny and well done. For a brief moment, I thought you were serious.

      I get it. Just like the Harvard Business School only admits the smartest, best educated, dedicated and competitive individuals available.

      Say no more (wink, wink, nod, nod).

    4. mock turtle

      pithard above said

      “Financial intermediation is essential to the efficient allocation of capital and economic growth…”

      i dont believe you and, i question if even you believe the company-line nonsense you spew

      the country did far better long before the invention of complex securitization games, structured investment vehicles and the explosive growth of OTC traded derivatives by parties who have no physical interest at stake in what they hedge

      these bright and best people to whom you refer as deserving so richly their huge compensation…. have mis-allocated capital so badly that we are likely on the verge of a great depression and catastrophic political upheaval

      since the S&L crisis of the 80s the FIRE sector of the economy has struck what may be a mortal wound the nation far worse than the terrorists wildest dreams

      my sincerest hope is that someday they are gathered up, tried fair-and-square and if found guilty by a jury of their peers, given their just…..and final… compensation

      1. Doug Terpstra

        Very well said. But Pithhard undoubtedly slithered away under Yves’ withering fusillade.

        This self-evident hooey continues despite being utterly discredited: “Financial intermediation…essential to the efficient allocation of capital and economic growth” … entrusted only to the “smartest, best educated, dedicated and competitive [swindlers] available.” Arrrrg, mateys! Avast ye swabs!

  20. Walter Map

    “Why is No One Willing to Say Wall Street is Overpaid?”

    Overpaid and underimprisoned. Wall St. crashed the economies of several countries using the grossest frauds imaginable and has gotten away with it by buying up politicians and promising to do it again if they don’t cooperate. Justice would be served by fencing off the area with razor wire and turning it into a prison.

  21. Hrm

    Very simple way to fix pay across the board (at all types of companies, not just finance firms), and does not require any caps. No employee can make more than 100 times the lowest paid employee (this would include all compensation, and no employee would be exempt – that include facilities, security, the works). Want to make 5 million a year? Your lowest paid employee must be making 50k.

    1. Frank Powers

      Decrease that ratio even further – make it ten times. Sounds ambitiuos? Yes, but more sane as well. You wanted to make five million bucks? Alright – the minimum wage had to be raised accordingly.

  22. mock turtle

    point of clarification, …my reference at 542 to prithhards quote about financial intermediation being essential..

    i did not intend to imply that financial intermediation was not essential…

    but rather that the bankstas failed, deliberately, at prudent financial intermediation, choosing instead to mis-allocate capital with risky, levered up schemes

    1. Doug Terpstra

      Well, you must admit, it was VERY efficiently allocated into a very few pockets.

  23. Avg John

    The world population is 6.5 billion people and growing exponentially. With all of this talk of China and other emerging nations becoming consumer based societies with a huge appetite for autos, electronics, household appliances and goods, and upscale housing, nobody seems to be talking about how the earth will be able to sustain such pressures on it’s limited resources.

    Can you imagine 3 billion gas guzzling auto’s hitting the global highways everyday, 6 billion computers and 12 billion electrical appliances and air conditioners sucking up electrical energy, the impact on agricultural resources in 30 years, million of new housing developments springing up. This is the reality that many of the world’s children are looking at. Why don’t economists start showing us the economic projections and impact of China and other emerging countries becoming consumer based cultures instead of what a 1/3 of 1% relaxation of their currency means to people’s 401k’s this year.

    Good grief. I understand that the Social security system now is paying out more than it is taking in. How did this come to be? Wasn’t it suppose to be solvent until 2037 or something. This is how our government has managed a smaller issue such as the Social Security system, how will they manage to address a global community of 9 billion people?

    It’s like no one in the financial/economic community addresses any problem until it becomes a crisis. What, do we wait for the entire global economy to breakdown into chaos before we enlarge the debate beyond where the Dow and S & P 500 finished today? Our nation can’t intelligently manage our economy today, so how in heck’s name are they going to plan and prepare for such a challenging new world?

    There are bigger problems than we are talking about and we need the truth now.

  24. MickeyHickey

    Normally I favor gov’t intervention to curb excessive greed and risk taking, particularly when it damages society as a whole. I do not think it is wise for gov’t to set wage ceilings for small groups of people. It is the job of gov’t to set the ground rules for society as a whole. Excessive income that is damaging society can be returned to society by using the existing tax gathering mechanisms. The gathering apparatus is already in place the added incremental cost of collecting higher taxes will be minimal. The political price of raising taxes on Wall Street and all it chancers and hangers on has never been so low. There will be collateral damage but eggs have to broken to make omelettes.

    1. Frank Powers

      I do not think it is wise for gov’t to set wage ceilings for small groups of people.

      That would be the beauty of a maximum wage (a “ceiling”) coupled to the minimum wage by a fixed ration, say 10:1, 15:1 or 20:1. That way, the ceiling would not be a fixed one, but could easily be lifted further up if those in the highest income class desired to do so – by increasing the minimum wage, thus limiting income spread as a whole to a socially and economically justifiable level and putting maximum incomes on a healthy basis, i.e. a more healthy society.

  25. Martin, Nanaimo BC

    Haldane’s analysis of the costs the financial sector inflicts on the rest of us neglects the most catastrophic of all – had the 1929 crash never happened, most likely, Hitler would never have come to power and World War II would not have happened.

  26. James W.

    I am currently a rising junior enrolled in the Ivy’s League’s only undergraduate business school (hint hint). After reading numerous books and blogs on Wall Street and modern Finance, I’ve begun to utterly detest field. I wasn’t born with a silver spoon in my mouth (in fact, quite the opposite), and had to work my ass off to get the position that I am in today. I, in no way, shape, or form, want to hurt my community. Sadly, most of my fellow students do share my dislike of the field. For them, it is a matter of getting the highest paying job that they can, and leaving everyone else to fend for themselves. It is not that they are unsympathetic, but that they see no other alternative in our plutocracy. The problem isn’t simply limited to business students; I know others who aspire to be corporate lawyers over prosecutors, or plastic surgeons over general practitioners, simply because of the estimated pay figures.

    Honestly, I want to know if there is anyway that I, as a business student, can still make a decent buck creating value in the world? If not, then I might as well join in the wholesale destruction of this country.

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