Politics,Regulation,and Bonuses

October 13th, 2008 1:17 pm | by John Jansen |

The intervention by the Treasury and the Federal Reserve at the time of the collapse of Bear Stearns shall henceforth be celebrated by economic historians as a punctuation point in American financial history. I believe that historians will mark it as a watershed event which began the dismantling of the unregulated free market philosophy which has been the hallmark of the American government since Barry Goldwater espoused that philosophy over 40 years ago. (And went down to ignominious electoral defeat in 1964.)The discredited Goldwater philosophy, though, brought to power Ronald Reagan and since 1980 the conservative ideal has for the most part flourished. In the years when it did not flourish, it still succeeded in defining the debate.

This election appears to be the advent of another defining moment. We are about to re-regulate in a very big way. I think that one of the unintended results of the financial crisis will be an even greater regulatory impulse. I say that because the public coffers will be bare and I think that our elected representatives will have enough common sense to refrain from imposing tax increases which might threaten an already fragile economy. I also think that they will realize that the same common sense demands that spending should be restrained as well.

The unintended consequence will result as the Democratic majority will find that the only game in town will be the vengeance game. In my opinion business, and the financial sector particularly, will be scapegoat for all of the ills of the last eight years. I think the blame should be borne by all of us and there is nothing partisan about the causes of this calamity. The cause can be found in human nature and is greed.

Greed led to imprudent risk taking and I do have a proposal on regulating trader behavior which I think will lead to more sensible bets.

In the current framework a trader’s focus is only on the fiscal year in which his bonus is determined. As each new year begins, individual traders cash their bonus checks and start the year “tabla rasa”. The motivation for a trader is to maximize the current year bonus.

I think that this can lead to perverse risk taking and probably did as the initial subprime mess unraveled. I offer the hypothetical case of a proprietary trader who had been eminently successful for several years in a row and chalked up large bonuses. We are well into a hypothetical 5th year and things are not going so well as the trade sours big time. Rather than unwind the trade and take an acceptable loss, the current system encourages a big risky bet. It encourages doubling down or adding to a bad position because there is no penalty for a big bet gone awry.

So in this instance a trader who has enjoyed considerable success and has banked large bonuses might look at the situation and take inordinate risk because the worst outcome is that he returns home as a full time member of the rentier class and he clips his coupons until he finds his next gig.

I would suggest that each year a portion of a trader’s bonus should be held back and that it should be placed in an escrow account of sorts for five years. Let it earn the interest on the 5 year note.

If however, the trader loses some amount of money above some predefined trigger level, then some of those losses should be paid for from the trader’s prior year bonuses.

I think that this would align traders with shareholders and would reduce sloppy risk and sloppy risk control.

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  1. 24 Responses to “Politics,Regulation,and Bonuses”

  2. By MW on Oct 13, 2008 | Reply

    “Sloppy risk control” is a risk management issue, not just a trading issue. If risk is subservient to trading because it’s a cost rather than a profit center then you get…UBS!

  3. By JWP on Oct 13, 2008 | Reply

    I think the general idea is correct. When a trader has an asymmetric payoff, as is generally the case, the most sensible thing to do is maximize volatility around the payoff. Many hedgefunds structure their deals with some portion of compensation deferred over the five years you suggest. That doesn’t always discourage risk taking on an individual book because large and diversified funds dilute the effect of the deferral.

    Similar short term thinking affects the management of large institutions. They P&L on a quarterly basis and are driven to maximize profits by share holders. Remember the Chuck Price musical chairs quote? I’m not sure what you do about that. Investors really liked the profits coming off structured desks when times were good and I think they would have worked to oust any CEO who didn’t lead his company into that field.

  4. By Todd_NYC on Oct 13, 2008 | Reply

    It’s not exactly the same, but what happened at the major i-banks over the last decade or so is that more and more of their big bonus compensation, sometimes up to 50%, was indeed held back – but in company stock, not an escrow account. The thinking was that if the big producers had a lot of restricted stock, it’d be harder for them to shop themselves around. Did it align trader’s incentives along with stock holders? I don’t know. Ask Jimmy Kean.

  5. By doc holiday on Oct 13, 2008 | Reply

    The immediate problem I see with all the global bailouts, is the somewhat sad fact that accounting irregularities, the lack of derivative regulation, the corruption and collusion — will all take a backseat to the thrilling excitement of stocks popping up 500 points, or maybe a dream-like 1000 point spike in just a day … and yah gotta love a casino winner, and baby needs new shoes and the its time to shoot the moon and back up the truck… etc.

    IMHO, we will see nothing positive from this credit event in terms of reform and although I’m not cheering for a full crash, I honestly would love to see wall street living in fear rather than seeing this systemic crisis turned into a period of speculation, which rewards the people that caused this stress!

  6. By Dan on Oct 13, 2008 | Reply

    Investing is about pricing risk, we don’t need revised compensation structures. When an investor allocates capital to a manager he made a trade…end of discussion.

    If you want to restructure a compensation model how about targeting the blowhards in the broker-dealer/advisor space who sweep 1-2% to spread around mutual fund names. Now that’s a racket!

    The stress in the markets has everything to do with people believing in dollar cost averaging and the market always goes up doctrine. The people dropping money into the market under that philosophy don’t deserve to keep their money.

  7. By John Jansen on Oct 13, 2008 | Reply

    Dan,

    I do agree that the buy and hold dollar cost averaging philosophy is moribund.

    Someone told me the other day ( and I wish I could prove this) that the total return on the 10 year note has beaten the total return on the S and P since 1991.

    Which if it is true is a powerful reversion to mean.

  8. By Mangesh on Oct 13, 2008 | Reply

    Can either Dan or John further elaborate on the shortcomings of dollar cost averaging?

  9. By JD on Oct 13, 2008 | Reply

    Although I am generally not a fan of government regulation, there are some instances where prudent regulation can level the playing field and add to price discovery. As an option market maker, I regularly traded in illiquid pits where the bid/ask spread afforded some breathing room…a little vig. On more than one occasion, OTC transactions between institutional firms overwhelmed these markets. A variance swap or dispersion trade is essentially an institutional bet on equity volatility. Because there is no reporting requirement, these transactions regularly traded through the listed markets for illiquid products. One side would then ‘correct’ the listed market and bring the implied volatility into line with the swap trade. As a market maker, you quickly learn to look for signs of these trades, getting out of the way before you are run down by ‘big firm’. In the process, you sometimes mistake actual customer orders for these trades; reacting to what is simply a larger trade for the relatively illiquid product. The customer pricing suffers as a result. This nefarious OTC world between large institutional players causes these market distortions. Only a handful of players on the larger desks get ‘shows’ and actually know someone is shopping these trades around. OTC transactions not only impact the market but the broader economy as well. We wouldn’t be talking about regulation otherwise. Clearly, any transaction that has the power to cause job losses on ‘Main Street’ needs to be publicly disclosed, regulated on an exchange, and/or margined. Regulation is coming. The OTC swap markets need MUCH greater tranparency.

  10. By John Jansen on Oct 13, 2008 | Reply

    Mangesh,
    Dollar cost averaging only works if the average prices ultimatey ends up higher. To answer your question I looked at a 10 year chart of Dow. We are back at 1999 levels. So al the stuff you purchased when it was trading in the 11,000s and above is underwater.

  11. By M on Oct 13, 2008 | Reply

    Francis Fukuyama has an interesting letter in some newspapers (am sorry for not having ready where) about the changes of times, which echo some of the things you mention. Reagans conservative ideal worked in the context of the 80’s but it is now time for a new model for the new time. Best not to read me but do a search for it and read it.

  12. By Gallifrey on Oct 13, 2008 | Reply

    “…I think that our elected representatives will have enough common sense to refrain from imposing tax increases which might threaten an already fragile economy.”

    Representatives have common sense? Really? This is news! Could someone please tell Congress?

  13. By Anonymous on Oct 13, 2008 | Reply

    You state that “I also think that they will realize that the same common sense demands that spending should be restrained as well.” I don’t understand that “common sense”, and would like you to explain it to me.

    The bailout will mean an extra 700 billion of expenditures this fiscal year. If that bailout amount were reduced to 600 billion, would that allow for an extra 100 billion spending on, for example, infrastructure? If the bailout were increased to 800 billion, would we have to cut defense spending by 100 billion?

    My own guess is that the 700 billion was both too small to fix our banking problems, and too large to avoid future inflation. But accepting the 700 billion, and maybe more in the future for the bailout, while calling for restraint on other programs, is something I don’t understand.

  14. By troy on Oct 13, 2008 | Reply

    depending on your title @ Bear for me (Senior Managing Director, highest) were supposed to give circa 30% in BSC, plus another few points in charity stuff, it came straight out of your check. This was only if you made over $1MM, however a lot of us left before they blew and we hedged our left over holdings. then again it didnt matter, even if you loose 30% of $1MM a month its not that bad :)-

    However, thanks to America for those that didnt hedge you got a handsome $10 a share. The american dream at its best!!!

  15. By John Jansen on Oct 13, 2008 | Reply

    Regarding lawmakers and common sense I cringed when I wrote it but left it in because as a citizen I want to believe that they will recognize that there is more at stake than partisan and parochial gain.

    I get your point though.

    And to your point anonymous, I think that circumstances necessitate the current expenditures. I am not sure if it will work. No one is. I am not sure at what point we are at the limit but it sure seems that we are approaching it and so any one with a modicum of sense would recognize that before we venture off into some new grand scheme.

    As I think about it, maybe we are about to face the prospect of a lower standard of living here as we deal with this mess

  16. By kid dynamite on Oct 13, 2008 | Reply

    your idea is more or less what unvested stock is supposed to do – and it also makes it harder to jump from firm to firm.

    the most absurd thing about our industry is that guys who blow up and lose hundreds of millions, if not BILLIONS of dollars are given a second chance! and then a third chance… you can’t blame the system on that – you have to blame investor greed and ignorance.

  17. By Dan on Oct 13, 2008 | Reply

    The fundamental issue is a misallocation of resources. Currency, in any form represents a standardized unit of productivity to lubricate exchange in the economy. With that understanding, debt represents an advance on one’s future productivity. The issue with debt is that there is a cost and one has to be productive enough to service the borrowed future productivity as well as cover the productive cost of the debt. What has happened is that we loaned a bunch of unproductive people money (productive units) to fund the purchase of non-producing assets (homes) and with the refinancing options (HEW/2nds) that were available people were able to blow the borrowed money on even more non-producing expenditures.

    Funding all of these expenditures requires further debt that goes not towards productive activities, but towards shoring up holes. Since the additional debt is not funding productive activity we just confiscate more of money from those who are still net-producers (wealthy) and make them more unproductive…

    Anyway, you get the point.

    In that context it is easy to see that the system will collapse, it’s just a question of how long until then. We are attempting to address a problem that is growing geometrically and is VERY diversified in a linear fashion.

    “Houston we have a problem!”

  18. By Dan on Oct 13, 2008 | Reply

    To clarify my last statement, the problem is geometric and diverse…our solutions are only linear in scope. The only theoretical solution is an adjustable dollar-bill that we can write-in whatever we need. That is of course hyper-inflation and does not solve the practical problem.

  19. By barry on Oct 13, 2008 | Reply

    I seem to have lived in some alternative universe. The essence of Reaganomics was use of government resources opportunistically to help advance GOP interests and to help select firms.

    We can start with the nationalization of Continental Illinois Bank in 1984 (in the middle of an election) and use of government funds to bailout all depositors for the full amount (not just the FDIC limit).

    We can continue with the seizure of Franklin Savings and Loan (a healthy financial instituion with never a losing year) on the grounds of improprer ‘hedge accounting’. The assets of the institution were sold at a discount to connected Wall Street firms.

    We can go onto the ‘sale’ of a bunch of Texas banks to Nationsbank for a pittance and with a put option. The government gave Nationsbank a free call option (an option that belonged to the shareholders of the Texas banks and the taxpayer).

    E. F. Hutton is an amusing diversion. Here was comapany charged with everything from check kiting to wire fraud. The Reagan Justice Department was reluctant to move against them. State Attorney Generals in NY and PA were about to get indictments in state court. The Feds moved with amzaing rapidity. E. F. Hutton (the company) pleaded guilty to various crimes in a court room in Wilkes Barre, PA (not Philly or NYC where there would have been media). Not a single officer of E. F. Hutton was charged. E. F. Hutton should have lost its broker/dealer license but the SEC swiftly came in with an exemption. The CFTC should have debarred E. F. Hutton but another exemption was forthcoming. E. F Hutton’s President, one Scott Pierce was happy. He called his sister Barbara and thanked her. She said that she would pass on the good news to her husband, George Bush.

    We could go on and on. But the statement that Ronald Reagan had something to do with free markets seems divorced from reality.

  20. By Amicus on Oct 13, 2008 | Reply

    barry, thanks so much for that. It made my day.

    Why focus on traders bonuses? It makes it sound like most are “rogue”, when, in fact, managements quite frequently know what is going on (wasn’t Bear, Stearns “Chaos Trade” know to the highest levels?). On the other hand, it appears that the AIG management were … hands off, almost clueless.

    In general, from a systemic-risk perspective, keep an eye out for the ‘weak links’ in the system (every industry, arguably, has them). These are the desks (not necessarily at banks, any longer, or even in country, any longer) that do things like take up the toxic part of a deal, for a huge, upfront fee, so that the rest can go through, to the likes of pension funds, et. al. Once they get set-up, these weak links ride the pony as long as they can, and disappear to Argentina, proverbially, when the gig is up.

    “Catalysts” or “enablers”. In other industries, these are the ones that water the cement, so to speak, making it hard to get proper business done and put competitive pressure on sensible managements.

    Anyway, smoothing of payouts is probably something that few would object to, I’d guess, as long as it is truly an escrow account (managements can obviously abuse them, by firing people before they draw down a large amount from “escrow”).

    Filling up escrow accounts by paying in script is .. eh. Giving stocks to people is probably insufficient to create a workforce to act in the collective interest. There is *no substitute* for firm culture, in that regards, especially among senior and mid-level management. In fact, passing out a lot of stock locked up in restricted accounts to employees (ESOPs) was historically a way to protect *managements* (from takeovers, etc.), as much as anything.

  21. By Bond newbie on Oct 14, 2008 | Reply

    Barry’s historical review is accurate but incomplete. Indulge me with some Democratic “contributions” to kleptocracy:

    1979, Carter administration, government bails out Chrysler corporation.

    Feb. 1976, filibuster-proof Dem majority in Senate, Dem House, weak GOP Pres in Ford: Penn Central bailout/Amtrak boondoggle begins with Railroad Revitalization Act.

    1994, Clinton administration, 56 Dems in Senate: US bails out Mexico with $50 billion bailout from Tsy Secy Robert Rubin’s side pocket, the Exchange Stabilization fund. (Same side pocket Paulson used to prop up money market funds that Congress was “outraged by” and banned in EESA.)

    Barry’s “alternate universe” of Reaganomics is really just one of two movies with major script flaws and plot holes: one Democrat, one Republicans. There’s plenty of blame to spread around.

  22. By Bond newbie on Oct 14, 2008 | Reply

    John, I can’t verify the 10yr has beaten S&P since 1991 (not at my Bloomberg) but the Barclays Equity-Gilt study showed the 10-year historical returns ended 12/31/07 indicate Tsy and gilts outperformed S&P and FTSE, respectively. The terrible 2008 performance means you can extend it to 11 years. If ten years isn’t long enough to be “long-term,” then you’re not going to win a lot of 44-year-olds the “just buy and hold equities” philosophy by promising them good 20-year returns, just in time for retirement at 65.

    The Barclays study is $pay only$, but here’s a link from the FT citing it:

    http://www.ft.com/cms/s/0/0b9449c8-e2fb-11dc-803f-0000779fd2ac.html?nclick_check=1

  23. By MW on Oct 14, 2008 | Reply

    Ace Greenberg on dollar cost averaging: “the dumbest thing I have ever heard”…the only thing thing that $ averaging does for you is…you keep buying as the stock goes down and when the company goes into Ch 11, you’re the largest shareholder…if that’s your goal then $ average…

  24. By Amicus on Oct 14, 2008 | Reply

    I’d concede Chrysler, despite that ‘deal’ having ‘worked out’ okay for taxpayers.

    The Mexico bailout was so obviously the first choice, I won’t concede that one. It was far more obvious that … sending the Marines to … Granada, “just in time”.

    The long history of the railroads and of eventual deregulation of transportation (signed by Carter, actually), we could argue about for an afternoon, I suppose.

  25. By T.Love on Oct 14, 2008 | Reply

    All compensation over 1 mil annually should be invested in company stock, then paid out in monthly payments over 96 months. Each month, 1/96 is sold at the market price and paid as compensation.

    The root cause of the risk taking is agency costs gone mad. There are lots of others but this is at the top. The current annual compensation system with no clawbacks will produce this behavior over and over and over.

    People conform their behavior to their real compensation systems with great precision. It makes perfect sense to reach for beta every moment, put bonus elsewhere and try again next year until it blows up, you spend a while on the bench, and then try again.

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