"Heads I Win, Tails You Lose"

New York Attorney General Andrew Cuomo's report on the compensation and bonus payments at banks has been published and it's an interesting read.

Four banks actually paid out more in bonuses than they earned--paying out billions when they were losing (tens of) billions--and even the banks that made money, the bulk of their profits went to employees, not investors.

In some senses, large payouts became a cultural expectation at banks and a source of competition among the firms. For example, as Merrill Lynch's performance plummeted, Merrill severed the tie between paying based on performance and set its bonus pool based on what it expected its competitors would do. Accordingly, Merrill paid out close to $16 billion in 2007 while losing more than $7 billion and paid close to $15 billion in 2008 while facing near collapse. Moreover, Merrill's losses in 2007 and 2008 more than erased Merrill's earnings between 2003 and 2006. Clearly, the compensation structures in the boom years did not account for long-term risk, and huge paydays continued while the firm faced extinction.

I'm a bit confused as to how compensation can get so woefully disconnected from performance and am concerned that this problem hasn't been properly addressed. The conventional wisdom that banks need to pay astronomical salaries and bonuses to attract the top talent, which then maximizes profitability, doesn't seem to be true. As the case with Merill shows it actually made no profit over the course of six years, yet its employees were compensated as if those profits were real and lasting.

With Goldman Sachs and others paying back TARP money so they can get free of government oversight on their compensation structure, it doesn't seem like Wall Street has learned anything from the meltdown.

With Goldman Sachs and others paying back TARP money so they can get free of government oversight on their compensation structure, it doesn't seem like Wall Street has learned anything from the meltdown.

It sounds like they've learned that it doesn't matter what they do, because nobody has the balls to hold them accountable for it.

JoeBedurndurn wrote:
With Goldman Sachs and others paying back TARP money so they can get free of government oversight on their compensation structure, it doesn't seem like Wall Street has learned anything from the meltdown.

It sounds like they've learned that it doesn't matter what they do, because nobody has the balls to hold them accountable for it.

Many people did try to hold them accountable - the market tried to put them out of business, and it was their political connections that "saved" them at our expense. (I say "saved" because it is not at all a foregone conclusion.) And they'll do it again, and again, and again until we put people into power who are not beholden to the banks and will kick them to the curb, regardless of the consequences. When you remove risk from the system you get perverse results.

Aetius wrote:

Many people did try to hold them accountable - the market tried to put them out of business, and it was their political connections that "saved" them at our expense. (I say "saved" because it is not at all a foregone conclusion.) And they'll do it again, and again, and again until we put people into power who are not beholden to the banks and will kick them to the curb, regardless of the consequences. When you remove risk from the system you get perverse results.

I finally figured out what I hate about that statement, Aetius.

The market is just too f*cking slow. It didn't try to put those banks out of business in 2007 and 2008 because it was too busy making oodles of (fake) profits off of their behavior. . It might eventually correct things, but in the meantime it creates such a massive bubble that everyone ends up and gets f*cked.

If there was a direct relation to attempts to game and cheat the market and financial penalties, I might actually buy what your selling. But it doesn't work that way. That's why I favors regulation and restrictions, because the one thing that is clear is that greed is a crappy thing to use as the primary driver of an economy.

As it relates to compensation, someone needs to figure out a way that encourages the long-term health of the companies and their investors. Anyone can game a quarter to hit a target number, usually at the expense of future quarters. I've seen this at every company I've worked at. Any bonus structure (and even compensation) should factor for performance *over* a long period of time. Anything else generates what we just went through--years of boom followed by a bust that wiped out all of the gains of that boom.
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It might eventually correct things, but in the meantime it creates such a massive bubble that everyone ends up and gets f*cked.

Several of them would have gone away in the 2001-timeframe crunch, sans massive Fed intervention. The bubble and damage came from the Fed -- the banks were exploiting the liquidity and low interest rates they provided.

And they were far from the only players -- the government was absolutely central with the GSEs, Fannie Mae and Freddie Mac. Without them providing massive liquidity as well, the banks wouldn't have had the false signals that ready cash sent them. The 'implied government guarantee' (which turned out to be explicit, so the market was right about the implied part) meant that they could borrow and lend at rates below any other player. Lowering interest rates on loans drives up demand; driving up demand drives up prices; driving up prices drives down defaults. With defaults so low, GSEs (and the banks, trying to compete against the government-guaranteed "private enterprise") lowered lending standards, starting another cycle up. Then new customers started drying up, and defaults were still low, so credit standards were relaxed again. And then again, and again, and again, until there was literally nobody left to lend to. Then the 'virtuous cycle' turned vicious.

The government and its interventionism in that market is both the cause and the driver of these latest bubbles; the Fed provided the fuel, the GSEs and AIG provided the illusion of safety. The banks were really just along for the ride.

Remember, the GSEs failed long before the banks did.

Also: it is the Fed's primary responsibility to prevent bubbles. They are THE GUYS for this sh*t. They could have stopped this whole mess instantly.

This is Alan Greenspan's f*ckup, more than any other single person. These bubbles were obvious to laypeople, and the noise about them got strong enough that Greenspan was actively denying that bubbles could exist; that's on record. So it's not like that chucklehead wasn't aware of the problem.

We're in a lot more pain that we're even feeling at the moment, because of the massive interventions to stop failures -- this hasn't actually stopped any pain. It's only deferred it, and made it worse.

The piper will be paid.

OG_slinger wrote:

The market is just too f*cking slow. It didn't try to put those banks out of business in 2007 and 2008 because it was too busy making oodles of (fake) profits off of their behavior. . It might eventually correct things, but in the meantime it creates such a massive bubble that everyone ends up and gets f*cked.

This bubble has been building for much longer than three years. Malor is right - these companies should have gone out of business in 2001, but again, the supposed regulators bailed them out. There should have been a reckoning in 1986 and 1987 ... but again, the supposed regulators bailed them out. Chrysler should have been dead in the late 1970's, but again the supposed regulators bailed them out. Now we've bailed them out ... again. What do you think the next bubble is going to look like, even assuming we can re-inflate it?

If there was a direct relation to attempts to game and cheat the market and financial penalties, I might actually buy what your selling. But it doesn't work that way. That's why I favors regulation and restrictions, because the one thing that is clear is that greed is a crappy thing to use as the primary driver of an economy.

What do you think happened last year? Where do you think last year was, if not an attempt to game the market by using the Federal government as a backstop? What do you call funneling money to Goldman Sachs through AIG? The only way to control greed is to MAKE SURE companies that get too greedy fail. Your "regulation" and "restrictions" have enabled these companies to raid the public treasury to support themselves again, and again, and again, and are continuing to do so as we speak.

As it relates to compensation, someone needs to figure out a way that encourages the long-term health of the companies and their investors. Anyone can game a quarter to hit a target number, usually at the expense of future quarters. I've seen this at every company I've worked at. Any bonus structure (and even compensation) should factor for performance *over* a long period of time. Anything else generates what we just went through--years of boom followed by a bust that wiped out all of the gains of that boom.

We have a way to do this. It works very well in the small and medium business arena, because those companies are allowed to fail if they screw up. The ones that are having problems are the ones that aren't allowed to fail. When there is no risk and you can't lose, there is no restraint, and no consideration of the long term. It's very straightforward.

The problem with letting them fail is that you don't disincent others from getting into that position in the first place, when there are methods to do so. Banks failed in the late 80's, but that didn't prevent similar problems from knocking over banks in the next two decades. It's all well and good to say "leave them alone, they'll fail", but the corollary that that will put the brakes on executives seems to be wrong, because the executives vote themselves golden parachutes and let the company hang after they've drained it dry.

Laissez faire fails unless it's modified with regulations and oversight. Now, for political reasons we've had regulation that was *designed* to allow abuses, but it's based on the same free market theories you're propounding. It's just more evidence that that approach is not complete in and of itself.

Put another way, if you are an executive, it rarely matters what condition your business is in, because most of them have lucrative exit plans. They can't fail and so they become disconnected from the business, creating the very effects you want to avoid. Letting the companies fail hurts the employees and the market sector far more than the company leadership.

That does not in any way mean that the bailout money should be used for executive bonuses or salaries. It should be used to increase lending or returned, and the practice of issuing massive bonuses - bigger than income bonuses in some recent cases - should be *illegal*.

The problem with letting them fail is that you don't disincent others from getting into that position in the first place, when there are methods to do so.

Well, being broke and hungry is a fairly powerful disincentive to others. Adding more regulation to later entities to make sure they don't make the same mistakes isn't a bad idea -- but you let the original entities suffer from their mistakes. If they know they're backstopped, they'll go crazy, and destroy us all.

They can't fail and so they become disconnected from the business, creating the very effects you want to avoid.

If we let companies fail when they screw up, you will likely see a very great deal less of that. Other boards will want to make sure their stock options remain valuable.

Bailing them out, but letting them survive, and then passing regulations, will not work. Why? Because they're demonstrated bad players, and enumerating badness is the stupidest way to do security. We can't enumerate all the bad things companies could possibly do, so we let them suffer ALL their consequences, and then we regulate LATER companies to prevent those consequences.

If we bail out and regulate, they will come up with endless new ways to skirt the regulations, because we haven't removed the bad players from the market. The same people with the same drives are in place, and they know that no matter how bad they screw up, it's all on Uncle Sam's dime. This has already been the worst disaster in American history, and it's rapidly compounding. The next big blowup is probably going to take down the entire world at once. And it will be all the same players at fault, because we haven't let the market do its job, by destroying their solvency and thus removing them from the system.

When you look at who made those huge bonuses, did you see how much profit they generated?

Many, many negative billions, Ulairi.

(edit: added a paragraph halfway down)

Let me hit on that enumerating badness thing a little more.

The naive way to do security is to default to allowing everything. You then try to identify all the bad behaviors, and stop them. This is enumerating badness -- this thing is bad, this thing is bad, this thing is bad, and so on. But the bad guys in the world can always find a new bad thing to do. First it was email spam, and then referrer spam, and now message board spam - lots of that last here at GWJ. It's an endless arms race; you stop the latest bad thing, and then they come up with a new bad thing. And they keep breaking in, over and over and over, because we can't possibly foresee every bad thing, ever.

The smart way to do security is to enumerate goodness, and disallow everything else. This behavior is good, this behavior is good, this behavior is good. You gradually can enumerate new ways of being good. This opens far, far fewer holes -- instead of you chasing after the bad guys, trying to plug leak after leak after leak, they have to chase you, and figure out if you enumerated goodness incorrectly. This is much, much harder, at least an order of magnitude harder.

The problem is, we can't enumerate goodness in an economy, because we would lose all flexibility and ability to adapt to change. It just can't be done without stopping all forward progress, and things would very rapidly break down. Economies can't be static, and you can't enumerate goodness, so you're FORCED to enumerate badness.

But then you have the original problem again -- there's always a new bad thing. And the only way to enforce rules ahead of time, that you didn't think of, is to let bad players fail. There are an infinite number of bad behaviors in an economy, so the only way to catch and remove those, consistently over time, is to allow the market to work and remove players who engage in them. This forces other players to use more of their brains when cooking up their schemes; if they KNOW it will bankrupt them, they won't engage in it. But if they know it won't, because Uncle Sam will keep them solvent, they probably will.

edit to add: Basically, if they're on their own, with no federal backing, they have to enumerate their own goodness. We don't have to foresee everything, they apply their own expertise to try to find it ahead of time. If they fail and evaporate, we know something else not to do, and perhaps apply it to other companies of that type, if we're convinced it's destructive.

Goldman Sachs is a great example; they knew the housing market was going to blow up, so while they had a whole unit writing business they knew was bad, they had another unit writing business betting against housing! And they were only able to do that because they knew the Feds would make all the badness go away with the magic of the printing press.

If they knew they wouldn't have a rescue coming, they would have been far more circumspect, and the bubble would have been far less insane -- they clearly knew it was doomed, but stayed in the market because they knew they had a backstop. How many others knew the exact same thing? How much of that bubble blew up because of our bailout mentality? With the "implied" guarantee on the GSEs, I'd say it was a central component. The Federal Reserve provided the punch, and Congress provided guaranteed rides home for free, along with an amazing hangover remedy, so the economy had one insane party.

I can't see how you'd expect any other outcome.

Malor wrote:

Many, many negative billions, Ulairi.

Every person within those firms lost money?

If you look at people who got big payouts and see how much they earned for the firm, it's not what the media reports.

But, then again, what do I know actually working in the industry. I'll let people continue with the "Bankers bad!" meme.

Pimps have pride in their work too.

Ulairi wrote:

But, then again, what do I know actually working in the industry. I'll let people continue with the "Bankers bad!" meme.

How many of those people would still be working if not for the massive bailout/backstop of the financial services industry in 2008? How much appetite for risk would there be if the government had actually stepped in and shown that they were willing to tell the investors who provided so much capital to these profitable traders to take the full range of losses?

Ulairi wrote:
Malor wrote:

Many, many negative billions, Ulairi.

Every person within those firms lost money?

If you look at people who got big payouts and see how much they earned for the firm, it's not what the media reports.

That's like giving the general of a theater of operations a medal even though you lost the entire war. Individual performance doesn't matter if the walls are tumbling down around you.

It doesn't matter if the division you worked for made money because your parent company lost money--billions or tens of billions. That means the profits you generated really don't exist anywhere except on a sub-ledger report.

If my company doesn't hit its numbers, I don't get my personal bonus no matter how well I did my job. It's really that simple.

You can blame it on the Fed again, but these were decisions banks made to pay themselves (very well) before everyone--including their investors. They increased their compensation based on what turned out to be false profits, used those false profits to justify even bigger compensation packages, and then, finally, disconnected compensation from performance when it became clear that things were not going to be go so well. The Fed didn't do this. The government didn't mandate it. The companies did it to themselves. How is this an efficiently operating market?

Well, being broke and hungry is a fairly powerful disincentive to others. Adding more regulation to later entities to make sure they don't make the same mistakes isn't a bad idea -- but you let the original entities suffer from their mistakes. If they know they're backstopped, they'll go crazy, and destroy us all.

Premise: Executives and top traders in financial firms will make millions or more even if the company fails, or has losing years.

Corrollary: The leaders and top technical staff who define the company's course will not be affected financially by failure.

Thus, letting these companies fail will not disincent the leadership from driving them into risky transactions, and thus will not greatly reduce the risks they are willing to take for profits.

In other words, I think your assumption that the leaders of the company will be "broke and hungry" is wrong.

I agree that the way the bailout is going is messed up. But that's because we turned over stacks of cash to the same people who created the problem under the assumption that fewer guidelines rather than more would be best (ie, the Bush team was still working under Reagan-style economic theories.) I think the Obama team has been loathe to mess with the formula, and that's wrong. But the problem with the bailout is that it's not being used to bail, essentially. (Some banks have actually used it properly to their credit, I'm speaking to AIG and the other egregious abusers.)

But I see the source of the problems in the very prescription you give of standing back and letting the market work. The financial markets are rife with greed, and the laissez faire approach is reflected in the last 25 years, and we are seeing now the end result. We've partly tried your experiment and it's brought us to our knees. Doing it fully would break the economy.

We need a new understanding of economics, yes. But the non-scientific approach and extreme free market prescriptions of the Austrian school are not the way to go. They *inspired* the problems we have today, and that's just with a partial implementation. It's hard to argue that going deeper into laissez faire would be better, given the examples we have so far.

That's my take on it. Because government has taken on the role of the central bank, and because fiat currencies *require* a central bank, we have no choice but to make the central bank as effective as possible. We're committed, and efforts to apply principles of non-fiat currency into the current environment are dangerous, because they implicitly act to reduce the capabilities of the central bank.

Robear wrote:

Premise: Executives and top traders in financial firms will make millions or more even if the company fails, or has losing years.

Corrollary: The leaders and top technical staff who define the company's course will not be affected financially by failure.

Thus, letting these companies fail will not disincent the leadership from driving them into risky transactions, and thus will not greatly reduce the risks they are willing to take for profits.

You're stating anyone who is very wealthy is not interested in continually making money, i.e., not interested in the future of their company. Given your premise and corollary, why bother to do anything? Just George Castanza the whole thing and phone in work.

Malor wrote:

If we bail out and regulate, they will come up with endless new ways to skirt the regulations, because we haven't removed the bad players from the market. The same people with the same drives are in place, and they know that no matter how bad they screw up, it's all on Uncle Sam's dime.

Right. If we state certain organizations can never lose, we have to be forever ahead of the game to avoid bailouts. Given the usual leadership in these organizations and the size of the respective actors, that seems pretty unlikely. The best we can hope for is paying off one bailout before we engage in another.

You're stating anyone who is very wealthy is not interested in continually making money, i.e., not interested in the future of their company. Given your premise and corollary, why bother to do anything? Just George Castanza the whole thing and phone in work.

No, I'm stating that the they are willing to take extreme risks for extreme profits, because their price for failure is negligible. In other words, even when the company is taking ridiculous risks, that means little to nothing to them.

Robear wrote:
You're stating anyone who is very wealthy is not interested in continually making money, i.e., not interested in the future of their company. Given your premise and corollary, why bother to do anything? Just George Castanza the whole thing and phone in work.

No, I'm stating that the they are willing to take extreme risks for extreme profits, because their price for failure is negligible. In other words, even when the company is taking ridiculous risks, that means little to nothing to them.

And who would hire them after that company tanked, knowing that their goal was to loot the company and leave?

They could sit on any number of boards. Do you think most of the Enron execs are doing without these days? Here's a 2006 article on where many of the traders went - right back into commodities. And they refer to the "Enron Mystique"... Citigroup, Lehman Brothers, Bear Stearns and others picked up people who had been involved in Enron trading during the market manipulation.

"Employers look at having worked at Enron as a risk-management experience, and they think people might have learned from the Enron mistake and those traders might have become better," says Michael Karp, chief executive of Options Group, an executive-search firm that works for many banks and hedge funds. The traders' renaissance comes as some Enron executives from other areas of the company have forfeited assets and begun serving prison terms. Even Enron trading veterans whose reputations were tarnished by criminal and civil probes are making inroads.

My bold.

I also want to point out that you changed the intent of my statement. I stated that your assumption that they would not adopt overly risky strategies due to the possibility of failure in a free market was wrong because they would still guarantee their personal financial security. But that's not an intent to "loot the company". With that statement, you changed the meaning of my argument to something I don't mean.

Again, when the leaders of the company can isolate themselves from failure, the free market forces don't affect them. They can afford to lose just as if the government were backing them up, with similar results. That problem is not fixable in a true free market environment, which is one of it's weak points.

Robear wrote:
You're stating anyone who is very wealthy is not interested in continually making money, i.e., not interested in the future of their company. Given your premise and corollary, why bother to do anything? Just George Castanza the whole thing and phone in work.

No, I'm stating that the they are willing to take extreme risks for extreme profits, because their price for failure is negligible. In other words, even when the company is taking ridiculous risks, that means little to nothing to them.

You're saying they're uninterested in their companies future -- they're willing to bet it all because they're set for life.

Your premise is correct, but your corollary is not. They are affected by failure, because they no longer collect checks (until they get rehired). Just because they can retire on what they already have doesn't mean they don't either want more money or want to keep working.

Your premise applies to the head of almost every major company in every industry, and yet most of these CEOs have avoided slamming their companies into the ground. Why? What keeps these people from rolling out of bed and betting it all on black?

Most of the CEO's of what companiies. 20 some odd banks were run into the ground last year. If you are saying that the CEO of Amazon or Google will not run their business into the ground, you are correct. But let's just pretend that some of these bank presidents and officers were not as ethical as Jeff Bezos. How do you help pull off the best scam in US history? You callude with your own regulators, lobby to get the laws written just so in your favor, manufacture a fake real estate and devivitaves market, so you and a dozen people like you can have wealth unimagined.

Amazon's business model is retail, data distribution. Google is in ads and software. Many of these banks built their business by skirting lax laws, cheating their patrons, and creating a housing market inflated by as much as 50 percent in many areas. Our society helped create a system that bred criminals.

Your premise applies to the head of almost every major company in every industry, and yet most of these CEOs have avoided slamming their companies into the ground. Why? What keeps these people from rolling out of bed and betting it all on black?

Because the financial sector is different. I've worked in it. These guys are always looking for the Next Big Score. They literally could care less about the trader or exec in the next office, much less the company, unless they are one of the ones who has to sign over *everything* to get a partner position. And even then, the exit strategy is all important.

When you've got $5M a year for three years guaranteed when you leave, even if the company fails, and you're getting $10M or so a year from the profits of your company's positions in weird instruments, and you're already worth $50M... Do you really think that person is going to worry if the golden goose dies? Because there's another one three floors up just dying to get hold of his expertise.

Gordon Gecko was a piker. These guys are the real deal. To put it in perspective, AIG was due to pay over $500,000 to each of about 400 employees in the same financial division that destroyed them, out of their bailout money, as retention bonuses. $235M. These guys essentially destroyed the company, and they get salary and half a million each in the worst year since 1929 for financial firms. Care to imagine what a good year looks like?

And trust me, retention bonuses are nowhere near salary levels. With this kind of money, you don't get people who think in the usual ways.

Ron Paul might be right. We may have to get rid of the Fed.

The reason these guys get paid so much money is that financial services are an arcane art to some degree and only a few highly trained people understand the complexities. Of the people that do, even fewer can actually sell these complex financial deals to investors. That leaves a very small pool of "talent" that can do these jobs. You got to be smart and you got to sell. A lot of people saw the crash coming. It is inevitable, everyone knows it. The rational is to make as much money as possible while times are good to hedge the losses when the markets crash. It is A LOT like gambling. The art of gambling is not the cards you get, but the timing and size of your bets.

I'd say they make so much money because there's so much money there. When you're dealing with trillions in assets, skimming 2% for compensation adds up to a hefty amount. The question is, how did so much money get there in the first place? People in the sector used to make decent money, but the obscene money didn't really start until all these trillions came rolling in. The easiest way to make several million is to start with a couple trillion.

The FIRE (finance, insurance and real estate) sector is different than any other profit making sector. Not because of greed or any other moralistic views you want to put on it. It is different because it is the only sector where you make money off of money.

All other profit making sectors you either have to sell a tangible product or a service.

Hence we have to treat it different than other firms.

Robear wrote:

When you've got $5M a year for three years guaranteed when you leave, even if the company fails, and you're getting $10M or so a year from the profits of your company's positions in weird instruments, and you're already worth $50M... Do you really think that person is going to worry if the golden goose dies? Because there's another one three floors up just dying to get hold of his expertise.

These people get out of bed and go to work for a reason. I don't really get what that reason is, but having somewhere to go is a crucial aspect, and the financial employment shell game of crashing companies and getting rehired can only continue for so long. I maintain the fear of real failure exists or can be instilled in these people. Nothing like a generational crash to do that.

I`m not american but I one thought has been nagging me all this year, looking at these kinds of reports and numbers- if americans don`t use their guns now, they don`t really deserve the right to own them either.

That sounded quite revolutionary of me, heh. Truth is, I`m more inclined to the "you dont really need your guns".

When I worked on Wall Street (primary securities dealer, futures broker) the bulk of the business we did was internal trades for our parent company. Despite this, the traders received daily reports displaying commission as if all trades were outside business, and I believe they were paid accordingly. In fact, the commission calculations were incredibly complicated because some of the best traders had insisted on a particular commission formula (generally whatever the formula was from their last job). It didn't matter that we could come up with a single unified approach to calculating all commissions that would give them the same amount--it had to be their particular one. In short, good traders can pretty much write their own contract because they can get a job anywhere. Companies are willing to put up with this because if they don't they'll lose their best traders. Bonuses are just a part of the culture, and people tend to rely on them as if they were normal salary. As an example, one year I even had my boss apologize for my bonus only being a quarter of my yearly salary, explaining that it was because the company had lost money that year... and I worked in the back office, "executive" title or no. For a trader, that small a bonus may mean having to scale back by selling a vacation home (!). I imagine things are probably a bit less crazy these days, but would expect that the same mindset still prevails.