Tuesday, November 8, 2011

Eliminate Wall Street Bonuses?

There is some talk that to prevent further financial meltdowns and taxpayer bailouts, we should simply eliminate or ban bonuses at banks.

Whenever someone says "ban" something to solve a problem, warning bells go off in my head.  For example, people say that the Fed is the cause of all financial crises in the past few decades.  So, eliminate the Fed!   Well, OK.  Some argue that the Fed is run by unelected officials and hold more power than elected officials.  But then you have to think, after their competence in running FNM and FRE, do we really want congress to control interest rates and the money supply?

OK, that's another issue.

Ban bonuses at banks?  On the face of it, it sounds reasonable.  Outsized bonus potential incent bankers to take outsized risk that eventually blows up a bank and taxpayers have to come in to bail them out.

This is true to some extent for sure.  But on the other hand, I happen to remember one of the biggest bubbles and blowups in history that a country hasn't recovered from yet:  Japan.  Japan had the biggest bubble of all time up until then; bankers made hugely risky and stupid loans.  Even manufacturers took huge risk in "zaitech" (where they used their own balance sheet to speculate in the financial and real estate markets to boost earnings).

And guess what?  Japan in the 1980s did not have anything close to the outsized bonuses or salaries that Wall Street has had for decades.  Japanese management bonuses were and are tiny.  Traders and other risk-takers at various banks, investment banks and zaitech-ing manufacturers were not paid big bonuses for their profits.  (By the way, this applies to derivatives too.  People are all bent out of shape about derivatives and how that is the cause of all problems in finance.  However, derivatives in my mind played a very small part in this financial blowup.   Japan had very little derivatives during the bubble.  The 1929 crash had very little to do with derivatives.  The tulip bubble had very little to do with derivatives etc...  When the financial crisis came, JPM was the first domino that was supposed to fall because of it's GDP-like notional derivatives exposure.  Nope.  Also, European banks are in big trouble now.  Derivatives?  Nope.  Simple, straight sovereign debt.  Big bonuses caused that problem?  Probably not.)

And yet, the bubble happened.  I also wonder about the 1920s too, in the U.S.  That was quite a bubble.  Was it outsized bonuses then?  I think not.

So what can we do about it? 

Whenever we talk about these things, I am always baffled that nobody talks about the simplest answer.

The answer is quite simply that if the U.S. government (taxpayer) is going to come in to bail out these big financial firms, then we have to get paid for it.

Sure, banks pay FDIC fees and things like that.  If the FDIC loses money on bailouts, it means, quite simply, that the FDIC fees are too low.  (But I think the FDIC has *not* lost money over time, and the TARP money was paid back for most of the large banks.  I think the money lost that people keep talking about include AIG, FNM and FRE which haven't paid back their TARP money).

The problem, as usual, is pricing.  If deposit guarantees are priced correctly, it doesn't matter who does it.  U.S. government?  Fine.  Then let's set a fair price.

Ban proprietary trading?  Don't get me started on that.  Prop trading, in my mind, had nothing to do with the recent financial blowup.  They want to ban prop trading, which include startegies that firms like Och-Ziff does but allow customer facilitation and market-making functions.

Well, if you look at the multi-billion blowups in 2008/2009, I tend to think those losses were not on the proprietary desks, but the customer faciliation/market-making desks.  At Merrill, it was loans warehoused for future sale that did them in.  It was not a proprietary trade, but a huge inventory of loans bought for the purpose of repackaging for future sale.  That's a customer business, not a prop trade.

I think it was probably the same at Bear.  Morgan Stanley too.  I think all of these 'trades' would be allowed under the Volcker rule. 

What can you not do under the Volcker rule?  Stat arb.  Convertible arb.  Index arb. Special situations.  In other words, strategies that had nothing to do with the financial blowup.

Anyway, back to bonuses.

Eliminating bonuses, I think, will do nothing to reduce risk.  We don't know what the unintended consequences are.  When they taxed heavily pay over $1 million to clamp down on excess executive pay back in the 90s, it gave birth to the multi-billion dollar stock option pay outs.  Oops.

So instead of banning this and banning that on a one-shot basis based on one-dimensional thinking, I think it's probably wiser to get to the essence of the problem:  Proper pricing of risk!

Forget bonuses.

Is the bank taking a lot of risk?  Fine.  Then they have to pay more FDIC fees.  It's silly to have a fixed fee regardless of the risk profile of the bank.  If life insurance companies can set the rate depending on whether you smoke cigarettes, go sky-diving every weekend and race formula one cars, then why can't the FDIC set rates according to how risky the bank is?

The fact that they don't even consider that and instead choose blanket bans makes no sense to me. 
(This is another rant, but why can't health insurance companies charge more for people who smoke and don't exercise?  I think the health insurance market can be much cheaper and more efficient if this was allowed.  Because it is not, the rest of us have to pay ridiculous premiums; the unhealthy have no incentive to get healthy)

I'm a free market guy and that's my solution.  Pricing, pricing, pricing.

This solves a lot of other problems too.  Should the federal government guarantee mortgages?  People always seem to argue yes they should or no they shouldn't.  The real question is, yes, why not if it is priced correctly?  If it is priced correctly, then it doesn't matter who does it.  If it is priced incorrectly, then nobody should.

I was always baffled at the fixed nature of mortgage guarantees too.  They charge a fixed rate to guarantee a mortgage seemingly without regard for any risk factors (like price of house compared to affordability).  A mortgage guarantee cost the same whether the house was cheap or very expensive.

Anyway, back to banks and bonuses.  Instead of banning proprietary trading and banning bonuses or doing anything so simplistic and silly, why not just change fees according to risk?  I am a big believer in setting proper incentives, not legislating/banning this and that.

If you make all of your money in proprietary trading and very little on loans (and your balance sheet is allocated accordingly), you pay a very high FDIC fee.  If you make all of your money on loans and do no proprietary trading at all and you have a low levered, conservative balance sheet, then you pay a very low FDIC fee.  Maybe even zero.

So Citibank would pay a much higher FDIC fee than, say, M&T Bank.  Why not?

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