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.

Comments

[David]

Once the banks decided to accept taxpayer money (TARP) then they need to accept the will of the government shareholder, the taxpayer. The taxpayer sees that these banks that took the bailout are compensating people far, far in excess of their (the taxpayer's) own salaries.

So, limit the compensation which is the will of the government shareholder and let the Andrew Halls of the world leave their current institution and start up new firms, just as they do in the rest of industry.

Not only were the banks leverage 20 and even 30 times but that leverage was backed by short term loans that were renewed on a day-to-day basis. Bear Sterns went under because JP Morgan refused to continue with these loans. Lehman went under because JP Morgan and Bank of America refused to continue with these loans.

Senior management at these banks made no effort to truly understand the mortgage backed securities nor did they realize they were funding a housing bubble with the rise in the cost of housing far exceeding the rise in salaries needed to fund the increased costs of housing. The bubble was also caused by artifically low federal reserve interest rates which were bound to increase.

[ngbstl]

There's a lot of smart people with smart ideas out there, and certainly a lot of people will come up with similar ideas, and I'm just a regular dude, but still kinda cool that my (honestly self-generated!) idea (that I sent to the SEC "suggestion box" July09) is now put forth by a Wall Street Big Dog in the WSJ!...

"Charge 'Systemic Risk Insurance' premiums to all firms of a certain size. Let's face it, each and every time Wall Street creates a crisis, the Fed has and always will come to the rescue to some degree or another. Even though it may be revolting to "bail out" these risk-takers, it's better than what is often the likely alternative: systemic breakdown that will have adverse affect on Main Street. Armed with the data listed it the items above (derivative and leverage exposure), the Fed can charge insurance premiums to firms based on sophisticated (non-Gaussian, fractal-mathematics-based) models that can generate what-if scenarios to estimate (at least give an idea, rounded up to err on the side of caution!) the cost to the taxpayer to fix a mess caused by their derivative and leverage exposure. First, this would create a fund similar to the FDIC, SIPC, and PBGC [for banks, broker/dealers, and pension trusts, respectively], so that this fund would be the first line of defense instead of hitting up the taxpayer. Second, and more importantly, as these insurance premiums would be a drag on profits, it would incentivize firms to better manage risk, and not take increasingly extraordinary risks as the cost of "risk insurance" would raise accordingly."

[Tino Argimon]

The proposition that pay controls are won't do the trick is on point. It's a populist, populace-pleasing attempt to control greed. Indeed, controling leverage is the best and only way to avoid - or at least minimize - this kind of mess. Capital rules are the essential defining parameters of the sand box, and that's all you can define. One can't dictate how "the kids will play in the sand box", all one can do is make sure the sand box is as safe as possible for them, but kids will be kids, and if they have unlimited access to leverage, they will use it to excess. That is proven through the millenary history of finance. It isn't insane that Dick Fuld could make $30M a year or whatever while we all watched Lehman go down the tubes - what is insane is that Fuld had nothing or no one telling him "thou shall raise capital, no if's, and's or but's, or else we're taking you over." And the capital raise should have taken place not in response to a crisis situation having been reached - it should have happened when LB was at 60, then at 50, the 40 and so on, rather than those guys continue to say "oh we'll make it on our own, we've been through this before" etc etc. So there - it's the leverage drug that must be curtailed from the junkies, they will go through fits of withdrawal in the adaptation process, violent convulsions, they will try to find new ways to access the drug, and here's where regulation needs to make sure we have air-tight capital rules.

[s]

Obama has a problem on his hands. 180 billion to bail out AIG and pay it's counterparties 100 cents on the dollar so that they can continue to knock the cover off the ball. I love the idea of him explaining to the American taxpayer that leverage, not risk was the reason we needed to bail these firms out so they could lavish themselves with huge bonuses.

[Roger H]

Worth looking at:
(pay and benefits disparity between government/public education and those who work in the private sector,)

http://www.thefreeenterprisenation.org/ohmy.aspx

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