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.
The “Sanctity of Contract” crowd is as hypocritical as you can get. The Sanctity of Banker’s Pay is ABSOLUTE and it is a crime against The Gods to question said sanctity. But they can all crow about the Crominibus’s provision to allow Workers’ Pensions to be unilaterally reduced … a contractual obligation of the employer every bit as legitimate as these Bankster’s Bonus arrangements.
It’s all very simple. In any 1%-dictated contract, your obligation to pay them is sacred, and their right to ignore any obligation to you is also sacred. Perfectly balanced, and Our Glorious SCOTUS has already held repeatedly it considers that perfectly fair.
” I am skeptical of the further benefit that Ehrenberg asserts, that it will lead traders to take more of a long-term perspective.”
Indeed. The banks and Wall St. won with the bank bailouts. No need to change behavior if you get bailed out, no heads roll, and the taxpayer looks to be on the hook for the foreseeable future. The banks and Wall St are calling the tune now, so contracts are only important as they affect the banks and Wall St, apparently.
The very idea of getting rich by essentially shuffling paper is disgusting.
Reject the two party status quo. Do not hold your nose and vote for a Democrat because you detest the Republican opponent and vice versa. Write-in a candidate of your choice.
Unfortunately, it is trickle down contract sanctity with those at the top using math and language complexity as a disguise for consent. I am liking this effort to re-synthesize topics that may have fallen through the cracks. Its never too late to deconstruct fraud….
The problem with the TBTF banks is the implied assumption the top layers of management are part of that equation. It has been imbedded in them from the day they attended the MBA vocational schools.
They are wrong on several levels: a CEO who does not have a stand in, a “Lieutenant CEO” has not been doing his duty versus the company, employees, customers and lastly shareholders. Armies that lost battles because the General did not have qualified stand in are legion.
Further in the short term there is always the staff-aasistant to keep things running on the tactical level, maybe not on the strategic. Does Jamie D. and Lloyd B. sign all of the correspondence that go es out over their signature alledgedly? given their claims to ignorance during congressional hearings one would think not.
So when a Bank has to bailed out, the bonuses should cease and the top boys get the cardboard box for personal stuff and five minutes to get out, don’t forget to cut up their company ID and wipe their passwords.
Thanks Yves, I was a believer in contracts all along until you mentioned the unions in this article. Some things just slip by me. I will try harder.
Please read the function contracts serve. They are not shackles. They ARE meant to define how you operate under normal conditions and impose costs if you want to get out of the agreement. Unfortunately, if you have two parties with a significant power disparity, one party can often force changes that are not warranted or fair because the other side lacks resources to fight the contract breach.
That is why is it critical to remember the old legal saying, “A contract is only as good as the parties that enter into them.”
Unfortunately, Our Glorious SCOTUS has effectively abolished the idea of adhesion contracts and replaced it with might makes right.