Andy Kessler

Marketplace Radio: Reform won't change Wall Street pay

Marketplace Radio

12:00 minute mark.

WSJ: Bank Pay Controls Aren't the Answer

In his weekly radio address on Saturday, President Barack Obama said that "we cannot allow the thirst for reckless schemes that produce quick profits and fat executive bonuses to override the security of our entire financial system and leave taxpayers on the hook for cleaning up the mess." A day earlier, Treasury Secretary Tim Geithner told the New York Times that "you don't want people being paid for taking too much risk."

So now the administration wants to control the pay of employees of banks and Wall Street investment firms.

Kenneth Feinberg, the administration's "pay czar," is being tasked to oversee employee compensation at firms that took bailout money from the government's Troubled Asset Relief Program (TARP). The Federal Reserve will require thousands of bank holding companies and state banks to submit their compensation plans for approval.

The administration has it wrong. It wasn't reckless schemes and excessive risk that sunk banks and Wall Street; it was excessive leverage. And thanks to cheap money and twisty regulations, risk was extremely undervalued. Banks owned huge portfolios of real-estate loans and mortgages specifically because they, and regulators, didn't think they were taking much risk at all.

Outlaw pay and pay will only go to those outside the reach of the law

Populist pay limits are squarely aimed at Wall Street, not local banks, yet for the most part Wall Street doesn't take much risk. Highly profitable investment banking and sales and trading are agency businesses, doing work for customers for a fee. Of course bad trades happen, and there are the rare rogue traders like Barings' Nick Leeson, who hid losses and sunk the firm, or Jérôme Kerviel, the young trader who lost $7 billion for the French bank Société Générale. But Wall Street firms are quite good at managing day-to-day trading risk.

The unwritten deal between public Wall Street firms and their shareholders is that employees get half of revenues as compensation. Yes, half. Shareholders, after expenses of phone calls and computers, get the rest, usually around 20%. In other words, Wall Street is a 70% profit-margin business. And Goldman Sachs, with the help of 0% interest rates, continues to knock the cover off the ball.

As competition and electronic trading ate into the agency businesses and profits in the early 2000s, the firms redirected their capital to invest in mortgage-backed securities, pocketing the 2%-3% difference between mortgage rates and their cost of short-term capital. This was the easy trade, the safe trade—not a "thirst for reckless schemes."

Bear Stearns, Lehman Brothers, Morgan Stanley, Citigroup, Merrill Lynch, Goldman Sachs and others believed the mortgage-backed security was the low-risk investment, and so it couldn't hurt to use leverage—i.e., borrow far more than the capital they had on hand, 20 times or even 30 times as much, to make additional investments in these securities. The firms raised huge sums of money—from other banks, money-market and mutual funds—so they could multiply 2%-3% gains into those large 70% profits and compensation. It wasn't risk but leverage that did in the financial system. Without that leverage, we'd have had an investment-banking profit crisis, not a credit crisis.

Yet if politicians still insist on limiting pay, there are only a few ways to do it:

• Limit risk? Good luck defining it. Great traders know that what looks low risk is often the scariest trade. You can't legislate market smarts.

• Pay Caps? So do you limit executive pay to $250,000? $1 million? $100 million? Who picks, how, and what are the effects? Not all Wall Streeters are equal. If oil trader Andrew Hall can't get paid $100 million after making Citigroup shareholders money, he is going to set up shop across the street and do it himself. Sure, he'll have to scrounge for his own capital, and maybe not borrow as much. But to evade the regulators' pay handcuffs, people will simply not work for a regulated company. Outlaw pay and pay will only go to those outside the reach of the law—whether they move to a hedge fund in Greenwich, Conn., or to an investment banking firm in London.

• Raise the cost of insurance? After overextending themselves with excess leverage while doing supposedly low-risk trades, Wall Street firms and banks got bailed out by a combination of low-cost capital from the Treasury, guaranteed debt by the Fed, and deposit insurance by the FDIC. It is clear in hindsight that Wall Street and banks have been underpaying for the twin pillars of the Fed as lender of last resort and the FDIC to limit bank runs. And so, yes, it is time to find a formula that adequately values that risk and charges Wall Street firms for this bailout insurance. There are market mechanisms today, in the form of derivatives, that price the risk of doing business with specific firms. Transparency is what will let the Fed and the FDIC use the market to protect the market. If done right, the increased costs will eat into the employees 50% take and therefore limit compensation.

But the knee-jerk reaction—to squeeze "greedy Wall Streeters" who nearly sunk the economy—is misguided.

Forbes: Lehman and Meritocracy

 

http://www.forbes.com/2009/09/14/lehman-brothers-goldman-sachs-bankruptcy-anniversary-opinions-contributors-andy-kessler.html

Part of the charm of Wall Street, and what scares most reasonable people away, is that it is as close to a meritocracy as exists on this earth. It's dog eat dog. It's sink or swim. You do a trade and it makes money, then you're a hero (for a moment anyway) and deserve a bonus. You bring in a deal, you get paid. You lasso more clients' assets under your firm's roof, you're a hitter. I once discovered some good news on the stocks I followed before the rest of the Street, and mentioned it to the sales force at a morning meeting and moved markets in New York, Tokyo and London. I had the head of global equities pat my head on the elevator ride up the next morning. Pat my head! I was told he never does that.

The flip side, of course, is what makes Wall Street so dangerous. You lose money for the firm and you're a heel. Do it again and you don't get paid that year. Do it a third time and you're out of a job. Just like that. Gone. I've seen it happen to friends and acquaintances at just about every firm up and down Wall Street. There is no tenure on Wall Street, no job security, no long-term guarantees. Ten- and 20-year careers end in a flash. Happens all the time, and everybody who works in the business knows this.

That's one reason why everyone is paid so well. Think of it as combat pay. But the other reason compensation is many, many multiples of the average wage in this country is that trading stocks, doing IPOs, merging companies, managing money is a very lucrative business. Not everyone can do it. It looks easy, football-field-sized trading rooms jammed with adrenalin-rush maniacs sitting in front of huge LCD screens. It might as well be a call center in Mumbai. But it's hard. Really nasty hard. Wall Street hires in that 99 percentile zone. And then they make your life miserable hoping you'll quit before they break you. Or hoping they break you before you lose money for the firm. It's not WalMart or General Motors or even Pfizer or Intel. It's trial by fire.

You would think that would make the entire workforce afraid to do anything for fear of being tossed out on their can, back into the cruel, cruel averagely paid world. But a meritocracy works in the opposite way. You have wicked smart people trying to prove to each other that they are smarter than everyone else. Unlike acing a chemistry final or even nailing your ACT tests, the score is kept with real money--how much your trading desk makes for the firm--how big a chunk of the bonus pool you command for your do-or-die heroics day in and day out.

Another not-so-secret revealed--it ain't fun, that's what Harry of Hanovers or Ben Benson's are for after 4 p.m. Pour a stiff one and recall sticking the guy at the First Bank of Neenah for a teenie (I'm dating myself talking about 16ths of a dollar) or bagging the OpenTable IPO or whatever the next deal is.

I'm reminded of all this because September 15, is the one-year anniversary of Lehman Brothers heading off to the great trading room in the sky. The debate will rage on for decades whether Paulson and the Treasury or Bernanke and the Federal Reserve should have saved them from failing. There is no good answer. Bear Stearns was bailed out six months earlier. Bank of America with the Merrill Lynch anchor around their neck was bailed out maybe four months later.

But the crude reality is that Lehman Brothers is a classic Wall Street story. Inside and outside, it was a meritocracy. They wanted to one up on Goldman Sachs, generate as good a return on equity and earnings growth so they could win the meritocracy game and get paid in spades. How dare Bear Stearns' CEO make more than ours! Let's lever this sucker up with mortgage-backeds and create a trillion-dollar balance sheet. If not us, who? And by the way, very few people at Lehman really understood how upper management was playing this meritocracy game with the rest of Wall Street with the rank and files' careers.

When that trade went south, and their creditors pulled their short-term financing, (OK, Jamie Dimon at JP Morgan was particularly egregious pulling a $5 billion plug), the ugly side of meritocracy reared its head. You lose money, you're out. Goodbye. It was nice knowing you. Every single person working at Lehman knew this personally, or should have known. That's the giant sword hanging over everyone's head, the stench of fear, that keeps the game going and going. I've got to use my 99 percentile smarts and win. If I don't, I'm toast, so I'll work harder, think harder, and of course play harder with my winnings that everyone else. The outside-meritocracy downside became the inside-meritocracy homicide.

Lehman is gone, sure, but Wall Street and the meritocracy lives on.