Trader’s Narrative

Executive compensation is one of the glaring issues at the heart of the financial crisis. We haven’t even come close to dealing with it in a meaningful way as the powerful Wall St. lobby moved quickly to throw obstacles in the path of any regulation or even discussion of the matter.

The most common argument that is trotted out to defend the obscenely disproportionate compensation packages on Wall St. is that the bonuses, salaries and stock options are needed to keep ‘talent’. But no one is able to ask how ‘talent’ that nukes the global financial system and brings down once mighty investment banks is worth even a shiny dime.

A look at the global bank CEO compensation also throws cold water on this non-sequitur:

Source: Reuters

The only non-US bank that approaches lofty compensation levels is Santander. Since the graph above shows the compensation and the market capitalization of each bank, I thought it would be interesting to show the relative compensation, so here is a graph of that:

There is incredible variation in executive compensation around the world with many very large banks being run by CEOs who are paid next to nothing (compared to US counterparts). So are they stupid to stick around? or is the North American mindset wrong?

I’m not really in favor of a government cap on compensation. But regulation is needed to bring salaries and bonuses in line with performance. And they clearly are not right now. The industry itself nor the market is going to deal with the agency issue at the heart of the matter. Shareholders theoretically are in control but in reality, there is so many layers of bureaucracy insulating them and the compensation committees appointed by the CEOs that no one really believes in this free market fairy tale anymore. A third objective party needs to step in and rescue Wall St. from themselves for the good of all.

This is a response to Smith’s essay in the Wall Street Journal on February 7th, 2009 titled “Greed is Good“. In the essay Smith, a former partner at Goldman Sachs argues that bonuses are a necessary part of compensation on Wall Street and that changing this would damage the competitive nature of firms as the best and brightest would leave for greener pastures. Smith uses exhortations and an anecdote from his own past to make his case:

I was … horrified to learn that my annual take-home pay would be limited to my small salary, which accounted for about a quarter of my previous year’s income. Fortunately the partners decided to pay a small bonus out of their capital that year to help employees like me get by.

This was 1973, a time of tremendous economic shock for the average American. What Smith conveniently leaves out is just how much his salary was. I’m willing to bet that even without the bonus (that he did end up getting) he wouldn’t have had to rely on food stamps like many of his fellow citizens.

Of course, the problem is that unlike the story he recounts from the 70’s, current investment banks are not private partnerships but public enterprises which have a fiduciary responsibility to their shareholders. When you look at the amount of shareholder wealth that has been nuked and compare it to the billions that were paid in ‘bonuses’ to generate these losses, you get a glimpse into the lopsidedness of things. Oblivious to reality, Smith expects Wall Street firms to act as if they are still private partnerships when in reality they are public.

We seem to be living in an altered reality: one where a $700 billion ‘blank cheque’ can be written to corporations based on nothing more than the flimsy support of vague promises on 3 pages, while a similar amount for everyone’s benefit has to run the gauntlet of Congress and go on for hundreds of pages in detail. One where banks claim that bonuses are needed to keep ‘talent’… yes, the very same so called ‘talent’ that replaced Wall St. with a giant maw. One where capitalism’s banner is raised proudly when the money is flowing in but where it is hastily lowered and stowed away for CEOs to play the mendicant. One where a person receiving welfare has to jump through hoops and tolerate intrusive government involvement in their personal lives but where banks rage against even the smallest concession when receiving billions of tax-payer’s money.

Camel-Birds
The best analogy to describe this is a Persian parable that I grew up hearing when I would make excuses to evade sacrifice or hard work. As preamble, in Farsi, the word for an ostrich is shotormorgh, a composite of two words: camel (shotor) and bird (morgh).

The story goes that an ostrich was approached and asked to help carry a load. It balked saying, ‘How can you ask this of me? Can’t you see I’m just a bird?’. Then it was asked to fly and take a message for a faraway town. To which it then replied, ‘What? you ask me to fly even though you can see clearly that I’m a camel?’

This insistence to have it both ways has become a hallmark of Wall Street. Just recently there have been a spate of hedge funds that have decided to simply shut down when faced with large losses. Prentice Capital and Tontine Associates are two of them with losses of 88% and 60% respectively. Rather than work hard at earning back the money they lost to clients and reach their high-water mark, they want to start a new fund and start to earn 2/20 commissions right away. Heads, I win - tails, you lose.

As far back as 12 years ago the Bank of England saw the inherent problem with a system that compensated employees for profitable risk-taking, but refused a consequence for any potential losses. Daniel Davies, a senior economist at the Bank of England wrote in 1997:

Employees’ contracts almost always involve limited liability; they may share profits from favorable trading outcomes but it is difficult or impossible to make them compensate their employers for losses…

The recommendation was to stretch out the time period for bonuses but it was firmly rejected by the City who saw it as intervention and an attempt at regulation. Of course, now these same laissez-faire disciples have no problem demanding that the taxpayer rescue them. The Royal Bank of Scotland is 68% owned by the UK government and yet, they are fighting tooth and nail to keep their bonuses.

Heads, I win - Tails, you lose
But beyond this paradox the lesson here is that greed is not good. That may be an odd thing to read on a blog about trading but I say that because, in fact, anything taken to excess will, eventually, create its own downfall. This is a truth that is self-evident. To all, that is, that choose not to ignore it. The rampant excess, hubris and sense of entitlement on Wall Street would make Caligula blush.

The obvious answer is if you want a market economy, then you take your losses along with your profits. If you want to bask in a performance based compensation, then you can’t be compensated as a star when you are the biggest loser. These watershed moments are what underlie cultural shifts. It isn’t just coincidence that the number one movie in the US is Slumdog Millionaire a story of a poor young man triumphing in a society where the rules are written by the wealthy, not the sequel to Wall Street.