This post first ran on July 27, 2009
I am sorry to make Roger Ehrenberg an object lesson as far as this post is concerned, because I am a fan of his work. He is articulate and insightful. I have often featured his posts in Links as opposed to in posts and felt a bit bad about it, in that I wanted to give them more attention, but had nothing to add.
However, I am sick and tired of the “sanctity of contract” theme as far as outsized bonuses from “dead other than by the grace of the US taxpayer” organizations are concerned, and Ehrenberg lobbed in a vote firmly in the “sanctity of contract” camp. And while he does argue for changes in what he calls the Wall Street trader compensation model, the record does not give much reason to think his suggested remedies will actually change behavior all that much.
First, to the “sanctity of contracts” bit. I don’t seem to recall many, or frankly any Wall Street types going on about sanctity of contracts when agreements with the UAW were reworked to save GM. So tell my why should big financial firms that would be toast other than by virtue of the munificence of the suffering American taxpayer be any different? The case that is getting everyone exercised is Andrew Hall of Citigroup, which is the lead candidate in the zombie bank casting call. Hall would have NO contract had nature been permitted to run its course. That inconvenient fact does not seem to be acknowledged by Hall defenders.
Being at a firm means all boats rise and fall with the fate of the firm, That construct was well understood in the days of partnerships and has gone completely out the window in the era of public ownership, aka Other People’s Money. If you did an A job in a C year, you did worse that if you did a C job in an A year. Unfortunate, but those were the breaks.
My beefs about Hall’s pay are not the level per se but the structure. He appears to have a firm within a firm, an arrangement that often leads to bad ends (Mike Milken at Drexel and the AIG Financial Products Group are the poster children, but I have seen smaller scale variants that also wound up causing trouble for the organizations housing them). He refused to comply with efforts to integrate his unit into the asset management group, which presumably would have been better for the bank, so he clearly wants to have his cake and eat it too: enjoy the advantages of Citi’s cheap borrowing costs (an important advantage in his business) and infrastructure (he is relieved of much of the hassle of running a business) and can focus on a year long horizon rather that worrying about Sharpe ratios and monthly NAVs. And his deal appears extraordinarily rich, with the cut for his group below but presumably not much below 30%, well above hedge fund norms.
Second, as I have said repeatedly here, employment contracts can and do get voided and renegotiated ALL THE TIME. I have seen this happen both at client organizations and in my professional circle. And this is true of contracts generally. Circumstances change, people of good will try to recut a deal, and if someone is a pig about it, then the aggrieved side moves on to more aggressive measures. There is nothing terribly unusual about this. It is an unpleasant fact of modern life. Having a contract does NOT mean it is sacrosanct. Please. How many of these people who are carrying on about sanctity of contracts are still on their first wives? “Sanctity of contract” means there are costs of modifying or exiting the deal.
Let’s consider another case where “sanctity of contracts” didn’t stand for much: credit default swaps. A little bit of history that has gone by the wayside: CDS written pre the Delphi bankruptcy required presentation of the bond for the protection buyer to collect. Delphi was the first large bankruptcy and was considered to be a test of the market. The industry realized the Delphi CDS outstanding greatly exceeded the amount of cash bonds. That meant first, there would be a mad scramble to buy bonds to present at the settlement, meaning a huge price squeeze, and second, the overwhelming majority of people who had bought protection would find it to be useless.
The powers that be came up with the cash settlement mechanism even though it was not permitted in the original swap documentation. The big dealers were very keen to keep the market going. Had they stuck with the original construct, CDS protection buyers who did not have bonds would not have profited, and the burgeoning of the market to significant multiples of the value of the underlying bonds probably would have come to a screeching halt. And notice how this was done. To go to cash settlement post Delphi would have been a belated recognition of a need to change procedures. But modifying it on the fly is quite another matter.
Ehrenberg argues that traders should be paid on a long-term basis, with their 80% bonuses reinvested in a capital account, He points out, and I agree, that stock based compensation does not influence trader behavior, They don’t ascribe much value to the shares.
But I am not sure the evidence supports Ehrenberg’s view, that that hedge fund compensation model actually leads to more prudence. The big and obvious benefit is it does allow for losses in bad years to be offset against gains in good years. That is undeniably an important gain. It would presumably put an end to certain year end tricks to pump up positions up and dump losses in the next year, with the idea that the trader has made enough from the chicanery to afford the worst case outcome, namely, a resume put.
However, I am skeptical of the further benefit that Ehrenberg asserts, that it will lead traders to take more of a long-term perspective. Now in fairness, he does say it is “more likely” to improve behavior, and I cannot disagree with that formulation, but I think the change in behavior would be less marked than he believes.
Traders are very fixated on maximizing their annual take, and also too often regard their past gains as money in the bank. The LTCM partners famously had pretty much all their money invested in the fund, and we know how that movie ended. And what is more striking is that both Myron Scholes and John Meriwether started new funds, each of which failed. Given their records, I would imagine they were expected to and did reinvest a fair bit of their earnings. Similarly, if you look at the level of hedge fund disasters last year versus those among traders at big firms, would you see much difference? I genuinely do not know the answer, but given the high rate of hedge fund failures, having a lot of cash tied up in the business did not seem to prevent widespread hedge fund implosions.
As much as philosophically anything is better than the current model, I am skeptical that relying on pay to create good incentives is an adequate check for having risk controls, in the form of someone skilled but more conservative act as a check. The egos and short term focus of traders of many traders makes them hard to contain, and unlikely to restrain themselves, even if it were rationally in their best interest.