Deus Ex Macchiato

The NYT gives us very good news on compensation in that most unlikely jurisdiction, Switzerland:

Swiss citizens voted Sunday to impose some of the world’s most severe restrictions on executive compensation, ignoring a warning from the business lobby that such curbs would undermine the country’s investor-friendly image.

The vote gives shareholders of companies listed in Switzerland a binding say on the overall pay packages for executives and directors. Pension funds holding shares in a company would be obligated to take part in votes on compensation packages.

In addition, companies would no longer be allowed to give bonuses to executives joining or leaving the business, or to executives when their company was taken over.

Of course you can bet that right now there are smart people devising A/B share structures where the votes go to the (tightly held) As and the divys to the Bs to get around this, but still, it is a strong and helpful signal.

Posted in: Compensation by David /
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A mixture today:

From a Bloomberg story as part of their America’s Great Payroll Giveaway series:

“There’s a mythology promulgated by people in administration that you have to pay competitive salaries to attract the best people,” said Benjamin Ginsberg, political science professor at Baltimore-based Johns Hopkins University and author of a book detailing how universities are adding administrators even as state funding drops. “In point of fact, no one can show there is any relationship between what these people are paid and the quality of the work they do.”

From a story in the Securities Lending Times on CCP ownership:

Research firm Finadium interviewed major CCPs worldwide to find out how they view the role of collateral for both risk management and as a potential competitive lever in the marketplace.

Its subsequent report—CCPs and the Business of Collateral Management—was released on 15 November.

Stock, options and futures exchanges own 60 percent of recognised CCPs, said the report. “This ownership structure makes CCP activity part of the strategic direction of the exchange itself; decisions made at the exchange level trickle down as opposed to CCP decisions trickling up.”

Boards of industry representatives or outside parties run the remaining 40 percent.

“These ownership structures complicate the process of categorising the intentions of the CCP community; some CCPs operate truly as utilities for the benefit of their users while others are inclined towards market growth through acquisitions and new product development. Further, many exchanges including the CME, ICE and London Stock Exchange are competitive, publicly traded entities, putting their fully owned CCP functions in a competitive position as well.”

From Jesse Eisinger’s new article on US mortgage finance:

…with little planning and paltry public discussion, the government has almost completely taken over the American home mortgage market. Banks and other for-profit financial services companies lend money to homeowners, but without the guarantees and other support the government provides, the housing market would barely be functioning now.

Fannie Mae and Freddie Mac, the taxpayer-controlled housing giants, guaranteed 69 percent of new mortgages in the first nine months of the year, up from about 27 percent share in 2006, according to Inside Mortgage Finance. Meanwhile, the Federal Housing Authority and the Department of Veteran’s Affairs currently back another 21 percent of mortgages, up from just 2.8 percent in 2006. Altogether, 9 of every 10 new mortgages are backed by the U.S. taxpayer, up from three in 10 in 2006, when the government share hit a decade-low, according to the publication.

From a BIS working paper Global safe assets by Pierre-Olivier Gourinchas and Olivier Jeanne:

…a convincing link can be established between macroeconomic shortages of safe assets and some of the most disturbing features of our recent global financial history… a natural way to eliminate the financial instability arising from the asset scarcity consists in supplying public safe assets. In turn, the safety of public asset may require a monetary backstop. We show that this backstop can increase significantly the safety of public securities, with minimal or no consequences in terms of price stability.

Posted in: Clearing and Collateral, Compensation, Mortgages by David /
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Rhymes With Cars & Girls suggests

the biggest free-lunch to be had in corporate America is to shutter all the “HR” departments and meanwhile cancel the contracts for the stupid keyword-matching resume-parsing software. Just let team leaders call up & hire directly all their friends and people they like – which is what ends up happening anyway. the biggest free-lunch to be had in corporate America is to shutter all the “HR” departments and meanwhile cancel the contracts for the stupid keyword-matching resume-parsing software. Just let team leaders call up & hire directly all their friends and people they like – which is what ends up happening anyway.

In my view this is to misunderstand the true role of HR in most businesses. It seems to me that HR exists firstly to provide useful cover when a ‘manager’ hires friends and people they like, and secondly to create a smokescreen of performance appraisal so that ‘managers’ can pay their staff what you want to and claim to have some kind of justification other than pure prejudice for it. Or perhaps I just an old cynic…

Posted in: Compensation, Organisational Culture by David /
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This weekend’s Bloomberg view column seems to have generated some controversy.

Let’s look at what the column says:

The Basel III banking rules … require banks to finance their activities with more equity, or capital, as opposed to debt. The equity helps guarantee that the bank’s own shareholders will absorb any losses, instead of turning to taxpayers for bailouts.

As we have said before, not quite. More capital helps a bank absorb losses in insolvency (or resolution). It does not help to absorb losses on a going concern basis, as this capital is not available for that purpose.

the capital requirements aren’t terribly burdensome. For the biggest banks, including JPMorgan Chase, they amount to somewhere between 3 percent and 5 percent of assets

I suppose ‘burdensome’ is a matter of judgement. But what isn’t is the gap between where banks are now and where they will need to be post Basel 3. The gap is hundreds of billions of dollars. So who, exactly, is going to buy all this news bank equity knowing that their returns will be capped in the single digits by regulation?

To be fair to Bloomberg, they have an answer:

Average U.S. wages in finance are about 70 percent higher than in other industries. Erasing that compensation gap—it didn’t exist 30 years ago—would cut operating costs just about enough to raise a typical bank’s capital ratio from 5 percent to 10 percent without increasing lending rates and without impairing shareholders’ profits.

So the suggestion is that the extra core Tier 1 capital will come from retaining more earnings and paying bankers less. I don’t find that particularly objectionable. But for it to work, the banks do actually need to make enough money that they can retain sufficient earnings to raise their capital bases. This is by no means certain. Worse, it provides a bigger incentive to concentrate on the most profitable business at the expense of important but dull activities; like, err, SME and middle market lending. And that, in this worryingly bad economy, might not be a good thing. Banking reforms like this should be implemented when times are good.

The best research available, from a group of researchers led by former Morgan Stanley (MS) economist David Miles, has found that even extremely high capital ratios—as high as 50 percent—would actually be good for the economy, because the benefit of reducing the frequency of financial disasters far outweighs any costs. Optimal capital would probably be about 20 percent of risk-weighted assets, equivalent to tangible equity of 7 percent to 10 percent. That’s double the level in Basel III.

Who says that this ‘is the best research available’? In particular, does this research assume that higher capital is actually available to absorb losses? If so, what mechanism do the researchers propose by which a capitally inadequate but solvent bank will retain the confidence of the funding markets for long enough to survive through a crisis?

The [Basel] risk-weighting system is also far too complex and too easily manipulated to provide a reliable picture of how much capital a bank really has. For a large bank such as JPMorgan, coming up with a risk-weighted ratio requires sorting assets into more than 200,000 different buckets. Even unintentional errors can skew reported capital ratios by several percentage points. That’s a problem when the starting point is only 10 percent.

‘Several percentage points’ is a high, but I will agree that RWA mitigation can materially affect a capital ratio. But when we are at 10% anyway, and there are backstops such as the leverage ratio and stress testing, that should not be a major concern.

Bloomberg suggests that not to ‘go far beyond Basel’ in imposing capital requirements would ‘truly be anti-American’. I disagree. America has a self image that includes the promotion of innovation and a healthy economy. You can’t do either without a functioning credit system. Much higher minimum capital requirements would further stiffle credit and do little for financial stability.

Posted in: Basel, Compensation by David /
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From the excellent Chrystia Freeland interviewing Cornell Economist Robert Frank:

CHRYSTIA FREELAND: If the super-talented are getting super rewards, maybe in the past they were not getting the appropriate rewards. I mean, maybe this is really American capitalism working the way most Americans want it to work…

CHRYSTIA FREELAND: People don’t work for money?

ROBERT H. FRANK: They do work for money. So if you didn’t give them any money, they — but there’s this odd vision that if the forty vice presidents of a big corporation who want to be CEO faced a slightly higher tax rate, they’d all knock off on Friday and play golf in the afternoon. There are lots of reasons to want to be the CEO of a big company. After-tax pay is not the primary one among them.

CHRYSTIA FREELAND: You don’t think you would have a sort of Atlas Shrugged-esque strike of the super-competent?

ROBERT H. FRANK: Absolutely you wouldn’t see that. Let one of those forty vice presidents go on strike. The other thirty-nine will silently cheer. “That means my chances of moving up just went up a little bit,” they’ll say.

Now of course we all know those 40 would go to golf anyway and bill the company, which is to say the shareholders, for that trip – team building you know – but that is beside the point. Let’s call those VPs bluff, tax them, and see how much more golf they decide play.

Posted in: Compensation, Politics by David /
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Aditya Chakrabortty writing in the Guardian rightly points out the dangerous tendency for CEOs to act more like cult leaders than managers. He gives Steve Jobs as the architypical example of this tendency:

Jobs is part of a widespread trend among chief executives to put themselves forward not as managers, but as leaders. Follow the coverage of the Davos summit this week and count the number of times a corporate finance officer for some accounting-software company or other is described as a business leader…

If this were just self-delusion, then the consequences would not be too bad. But of course it has been used to justify the enormous increase in CEO compensation compared with the average worker:

The result has been a tremendous boost in chief-executive power, according to Dennis Tourish, an academic at Kent University. He points out that just before Enron imploded it was run like a cult, with Jeff Skilling exercising huge control and influence over who was recruited, how they worked – and who got laid off. And while Enron was an exception, Tourish points out that Jack Welch as boss of General Electric had similar power. “Business leaders typically only have yes-men – no one to stand up to them.”

These days you get to the top by taking bold decisions – which bold decisions doesn’t matter much as it is pretty much luck what will work – and then claiming the credit for whatever goes well while ruthlessly supressing talk of failures. Do that enough, and with luck you will get to the point where it becomes (for a while at least) self sustaining. You’re now a leader so you should be paid millions, right? Not so much…

Posted in: Compensation, Decision Making by David /
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I promise to address the comments to the repo collateral post shortly but meanwhile, I wanted to share this lovely illustration of the convexity of income inequality from the New York magazine.

Take Brad Pitt. Compared to your average schlub, Brad Pitt appears totally rich. He was No. 30 on Forbes’s list of the highest-paid celebrities last year and is worth an estimated $150 million. That’s a lot of money! But compared to Mayor Bloomberg, who is worth $18 billion at last count, Brad Pitt is pathetically poor. Poor poor poor. If he felt like it, Mayor Bloomberg could probably come up with an offer that would make Brad Pitt actually consider working as his personal butler for a year.

OK, it’s funny. But it is also true, and a lot easier to understand than any number of log/log graphs. The problem isn’t how many wealthy people there are: it is how much more wealthy the high percentiles are than the next ones down. This is something the tax system is terrible at fixing, as paying tax appears to be optional if you are in the top 1% of income. Laudable though initiatives like the Buffett/Gates giving pledge are, they are not the only policy response we need to this issue.

Posted in: Compensation, Politics, Taxation by David /
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The idea of paying bankers’ bonuses in stock or stock options always struck me as odd. After all, equity is a call on the value of the firm after debt has been paid, and you maximise the value of the call by increasing volatility. Stockholders, then, naturally prefer risky high leverage structures – hardly the behaviour you want in a banker. It would make a lot more sense to force the banker to write the bank a put, so that they are incentivised to prevent disaster.

Now, according to Reuters, Barclays might be about to do just that. Specifically they are apparently looking into paying bonuses partly in contingent convertibles:

These securities are bank bonds that turn into equity when things go awry, for instance when losses mount and the bank’s equity capital ratios fall, thereby boosting capital. So, in essence, adding CoCos to the bonus mix would be a novel way for BarCap to force bankers to contribute some of their loot to their employer’s capital cushion, thereby helping to minimize political opprobrium over pay.

OK, this is not quite as good a paying them in reverse convertibles, but it is a good start. Throw in a five year vesting period, clawback provisions for individual malfeasence, and you have the start of something interesting and worthwhile.

Posted in: Capital and Contingent Instruments, Compensation by David /
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Bloomberg reports that Morgan Stanley CEO James Gorman said recently at a SIFMA conference:

some individuals “who in many cases were frankly pretty average” made as much as 10 times that of people in other industries …

Fixing the culture will require “creating a compensation system that better aligns or balances shareholders’ interests and the broader society’s interests with the individual’s interests, and changing the perception that it’s the individual that’s the hero,” Gorman, 52, said. “As an industry, we can have larger-than-life personalities, but individuals don’t make institutions.” …

“The more you have this hero individual status, and lots of things written about them by journalist friends in the paper, the more likely that they are going to act out, because they start to believe it,” Gorman said.

“You can put on a large trade, and if it works, you make out like a bandit, and if it doesn’t, you might get fired, but you’re not paying back,” he said. “So you have asymmetric risk, you either come out zero or you come out positive. That’s imbalance.”

This all seems perfectly reasonable.

However, Bloomberg then helpfully adds that Gorman

was paid $15.1 million in salary and bonus for 2009.

Ummm…

Posted in: Compensation by David /
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The Guardian yesterday had a tacky little article, Why bankers aren’t Cristiano Ronaldo. The eponymous question could of course be answered simply by pointing out that most bankers are a good deal more honest than Ronaldo, a good deal less ostentatious, and rather better drivers.

Let’s review the vitriol.

When pushed, those who attempt to justify exorbitant pay in the corporate world often use comparisons between great sports players and their own “star” performers… But the comparison is disingenuous, if not duplicitous. When we watch Ronaldo score a spectacular goal, we know the only way we can do the same is in our dreams.

Now I don’t claim that everyone in an investment bank who gets a bonus is in any way special. But the big numbers do tend to go to people who have made a lot of money. And making a lot of money is not easy, given how much competition there is. Most people could only structure a convertible, or price a CDO, or build the book for an IPO in their dreams too. In fact you might argue that being a really talented banker is even more unusual than being a footballer (even one as bad a sportsman as Ronaldo) in that we can easily imagine what it might be like to be able to kick a ball well, whereas most people can’t even imagine what it is like to be an MD at Goldman.

The way to reduce distasteful bonuses isn’t to bad mouth hard working bankers, however little contribution to society they make. It is to stop banks making so much money. That is boring. It does not involve creating an artificial pariah class – rather it involves lots of detailed regulation and market structure reform. But it would do a lot more good in the long run than victimising some people who happen to have been talented (and lucky) enough to actually succeed at banking.

Posted in: Compensation by David /
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This table, from Yahoo via the Big Picture, might well at least do the first part. These are just stock holdings, not total wealth. One should probably assume that the people who run Goldman have some level of financial sophistication and understand the importance of diversification, so their whole wealth is unlikely to be in Goldman stock. Therefore Lloyd Blankfein is presumably worth a good deal more than $274 million. Perhaps it shouldn’t, but the fact that the CEO of Goldman can be worth that much makes me angry.

I ask again, why is investment banking so profitable? Is it not the fact that it is one of the major – perhaps the major – cause of our current problems? Without excess profitability, the incentive to take too much risk declines, the bonus debate becomes unimportant and clever people are not sucked into socially useless activity. Understanding and fixing the sources of investment bank profitability is the key to making the financial system more stable.

Let me end with a nice insight from Martin Taylor, ex CEO of Barclays, in today’s FT. He points out that megabonuses are quite new, with the real boom period in compensation being 2004-2007.

Observers of financial services saw unbelievable prosperity and apparently immense value added. Yet two years later the whole industry was bankrupt. A simple reason underlies this: any industry that pays out in cash colossal accounting profits that are largely imaginary will go bust quickly. Not only has the industry … been spending money that is no longer there, it has been giving away money that it only imagined it had in the first place.

Taylor suggests that the sources of these imagined profits include ‘unrealised mark-to-market profits on the trading book’ and ‘the net present value of streams of income stretching into the future’. In other words, fair value gains which were not certain. No distinction was made between genuine earnings, and these conjectured profits. Taylor then points out

Paying out 50 per cent of revenues to staff had become the rule, even when the “revenues” did not actually consist of money.

Perhaps accounting matters quite a lot after all.

Posted in: Accounting, Compensation by David /
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The vexed topic of bonuses is provoking lots of people: see for instance here for a news story about windfall taxes, or here for Alistair Darling’s latest.

A lot of ink has been split and a lot of pixels lit on this topic. So just two thoughts from me.

First, if banks did not make so much money, bonuses would not be an issue. Banking is after all one of the few genuinely socialist industries: the workers really do share in the benefits of production. So if there were fewer benefits, there would be rather less money to pay them, and all would be if not well, then at least less controversial. Perhaps we should be asking how it is that a few institutions are able to make so much so reliably. Perhaps it is because the large banks together constitute a functional monopoly in many areas of finance?

Second, I find it hard to begrudge a share of the profits to the most talented risk takers. Someone who can run a large trading book and make solid realised profits (not just mark to market ones) is valuable, at least as the financial system is currently set up. But what is bizarre, at least to me, is the trickledown effect. In some firms the back office people get six figure bonuses: the secretaries, five figures. It isn’t just the people who make the money who get large bonuses, it is more or less everyone who has worked for an investment bank for more than a couple of years. And remember a £30K bonus might be laughably low to a trader, but it is still more UK median earnings. There are a lot of people in financial services who get this level of bonus, so actually quite a bit of the total bonus pot is soaked up by people who do perfectly ordinary jobs in a bank rather than another type of company. If you are from the left, should you celebrate that sharing of rewards or decry the bonus culture? If you are from the right, how do you feel about the lack of any credible lever for shareholders to stop this money – money that would otherwise go to them – being paid out?

Posted in: Compensation by David /
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From Bloomberg: Morgan Stanley set aside 72 percent of its second-quarter revenue for compensation and benefits, more than Goldman Sachs Group Inc. or JPMorgan Chase & Co. Why on earth do the shareholders tolerate this? That’s nearly three quarters of their money, money that they as owners of the firm deserve, that is going out the doors again to employees. If I owned Morgan Stanley stock I would be outraged. Instead probably most of them have so little sense that they are probably buying wrapping paper for really large piles of money as you read this.

Posted in: Compensation, Photography by David /
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The best comment on bonuses and social inequality so far:

(HT Jonathan Hopkin.)

Posted in: Compensation by David /
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I almost fell off my chair laughing when I read this. Which is not a very sober response to a very sensible proposal: Credit Suisse is going to use $5 Billion of Illiquid Assets to pay Bonuses. As Bloomberg reports:

The bank will use leveraged loans and commercial mortgage- backed debt, … to fund executive compensation packages.

Assets in the facility will remain on Credit Suisse’s balance sheet and will be held in the company’s fund management division, the people familiar with the plan said. The new structure will mean that any mark-to-market losses or gains on the assets will be offset by identical gains, or losses, on the bank’s liability to employees.

Employees will receive semi-annual coupon payments on their investment in the Partner Asset Facility at the London Interbank Offered Rate plus 2.50 percentage points. The ultimate value of the facility will be determined over the next eight years as the loans and securities mature or default, the people said.

This is a really really good idea in fact. If bankers know that this can happen, they will be strongly incentivised not to originate illiquid assets. But you can just imagine the looks on the faces around the CS trading floors…

Posted in: Compensation by David /
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Suppose you are a trader in an investment bank. Suppose the world is fair, so you get paid for every pound you make over your budget. In options terms, that means you have a call on the P/L struck at the budget. How do you increase the value of a call? One way is to make a lot of money: raise the forward. But another is to raise volatility of the underlying: make the P/L more volatile. Taking bigger risks is good for this. Now, was this the kind of behaviour we wanted to encourage when we designed the bonus programme?

It gets better. Suppose you manage traders. You get paid for every pound your group of traders makes over budget. So you have a call on a basket of P/Ls. How do you increase the value of a call on a basket? Well, the two methods above work, but so does increasing correlation – get everyone who works for you to take the same risks. Hmmm. Not quite what we wanted there either…

Posted in: Compensation, Rules by David /
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