Limiting Bankers’ Pay Completely Misses the Point

Before I turn to health care later this week, I wanted to return to a topic that I have written about before, namely compensation on Wall Street. Over the past few days, much has been written about Ken Feinberg’s decisions on the pay packages of the 25 highest paid executives of the seven companies who have received, and still retain, the most TARP funds (e.g., Citigroup, Bank of America and A.I.G.). There has been much discussion about the optimal way to pay Wall Street firm employees. What is the optimal ratio of guaranteed cash to stock? How long should the stock take to vest? Should the companies be required to put claw back provisions into their employment agreements with their bankers and traders so that if the employee’s investments go bad, the company can get their compensation they paid out back? But all of this misses the point in my mind.

When I think about how to tackle this problem—properly incentivizing bankers and traders—I think back to the problems that arose at AIG. There, members of the Financial Products Group sold credit default swaps to bond holders and other speculators to insure against companies failing to pay interest or principal to their lenders (bond holders). Because the group’s model said that these insurance policies would never be triggered, AIG never “reserved” against them as they would do with traditional insurance policies such as D&O policies are CGL policies. Members of this group were given hefty bonuses for gains on the sales of these insurance policies even though those gains were only on paper. AIG did not wait for the insurance policies to expire and where it would know exactly how much profits it had made before paying out the bonuses. Rather, they acted like many hedge funds, paying out bonuses based on the paper gains of their investments. This meant that the employees collected enormous bonuses based on mark-to-market gains while potential liabilities stayed on AIG books.

When the insurance policies got triggered years later, for example, when bonds backed by subprime mortgages defaulted, AIG was left holding the bag with billions of dollars of losses. The worst that happened to the employees was they were fired and maybe their remaining AIG stock was virtually worthless. But if the employees’ bonuses were paid in cash or if they had monetized their stock, the employees made millions of dollars on investments that caused AIG to become insolvent and require a $85 bn in taxpayer bailout.

In my mind, there are possible four solutions to this problem.

First, the firms can payout bonuses based on these investments only when they are liquidated and the final profits are known. This will eliminate the mismatching of timing of bonuses paid on paper gains where the companies still have potential liabilities sitting on their books. But this won’t eliminate the problem of heads the employee wins, tails the employer loses. Even if the firm waits until the investments are liquidated, a portion of the gains will be paid out to the employees, but losses will be borne only by the employer. The employee won’t be financially punished if the investments go bad beyond losing their job or not getting a bonus.

Second, to get around this problem, firms can claw back all or a portion of the compensation it has paid previously, even for liquidated investments, to make up for losses incurred later. But there are many problems with this. First, once the money is paid, it will be hard to get it back, especially if it is spent. Second, even if the firms were able to claw back all of the compensation it had paid, it most likely never equal the amount of potential losses. Therefore, the firms will still most likely be sitting with significant amount of losses. Knowing this, the firms will be forced to monitor and reduce the amount of risk their employees are taking on. And this is exactly what should and should have happened previously. But given the firms’ recent track record, I am highly skeptical they will rein in their employees. If a firm knows it is “too big to fail” it will just take on more and more risk, because it keeps all of the upside with minimal downside.

Third, to make sure that firms do not take on to much risk the government can regulate them. For example, the government can limit the government could mandate capital ratios as they do for traditional commercial banks. For example, for every dollar at risk in a mortgage or commercial loan, the government mandates traditional banks keep 30 cents of reserves in its “vaults.” Therefore, if things went bad, the banks would have a cushion to absorb losses. While more than 100 of these traditional banks have failed this year, the FDIC has taken them over, made sure depositors still had access to their money, and found new owners. Minimal impact was felt by the public. While I am more confident than most that government can do many things, I do not think they will be able to regulate the hedge fund or investment portion of investment banks and firms like AIG and Citigroup. They simply do not have the expertise or information needed to set proper capital ratios for these types of firms.

Therefore, I think the only solution is to separate the hedge fund-like groups from the core commercial and investing banking groups. This means that investment banks will only service their clients by providing trading and advisory services such as M&A advice. Other firms will invest their own money for a profit. As I said before, the service groups did not cause the problems we saw over the past two years. Rather, it was these groups who invested the firms’ capital in risky securities. What brought down Lehman and Bear was not the traders who bought and sold securities for clients, but rather traders who bought and sold for the firms’ own accounts. If you eliminate the investment arms of these firms, much of the problems would go away. Would all of the problems, go away, no. Citibank would still have the power to write bad commercial and home mortgage loans. But they would be limited by the capital ratios that the FDIC and Fed impose. As I said before, here, the government has been more successful in monitoring banks’ activities and resolving failed institutions. Only during the 1980s when the Reagan administration lifted many of the restrictions on S&Ls but left in place insurance, did the banks run into problems.

With more firms, such as BofA, Citi and Goldman Sachs, insured by the FDIC and having the ability to borrow from the Fed, it makes no sense to allow them also to invest in highly speculative investments. Because I do not believe that the government can adequately monitor or restrict their investments, like a normal insurance company could, I believe that the government should just prohibit these firms from investing their capital like hedge funds. It seems the government and Citi have already recognized this when Citi sold its energy investing unit to Occidental Petroleum after the government protested bonuses paid to traders.

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One Response to “Limiting Bankers’ Pay Completely Misses the Point”

  1. J.A. Says:

    Can I tell you what happened in the Yankees game?

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