THE BEAR'S LAIR The zombification of Wall Street
By Martin Hutchinson
For free-market enthusiasts, the Barack Obama administration's US$500,000
remuneration limit for US banks receiving public bailouts is less obnoxious
than it seems at first. Most obviously, it provides a useful incentive against
further recourse to taxpayer funds - even the near-deadbeat Citigroup is not to
be subjected to it until it asks for yet more money. More interesting, it may
result in a restructuring of the financial services business in a way that
moves it closer to the economically ideal.
It has been obvious since at least the 1980s that Wall Street's compensation
structure was cuckoo. Whereas the $150,000 typical base salary for a Wall
Street partner was a decent upper-middle-class wage in the early 1970s, the
last time Wall Street
had a run of bad years, by the late 1980s it had become an amount that a senior
investment banker, locked into obligations such as an expensive Manhattan
apartment or townhouse, could not conceivably live on even in a down year.
Naturally, bonuses were 10, 20 or even 100 times this amount, but this brought
distorted incentives into the picture. Notoriously, Wall Street bankers were
tempted to play games with year-end valuations in order to maximize their bonus
payout. What has been less publicized, but has always been clear to those in
the industry, is that employers played political games with bonuses in order to
minimize payouts to the disfavored, thus maximizing the amounts available for
the in-crowd.
(Disclosure: My own experience with bonus schemes, never anywhere near the top
Wall Street scale, was pretty unpleasant. Of eight years I should have been
eligible for bonus awards - my first employer, a merchant bank, didn't give
them - I received only two, in spite of making at least some net profits for my
employers every year. Tricks included moving the disfavored to a different
department in November, deciding unilaterally that no bonuses would be given at
all that year [twice, with different employers, after my two most productive
years], and firing the disfavored on Christmas Eve, relenting only after the
New Year.)
It's one thing when bonuses earned but not received represent 10% to 25% of
one's income; it's quite another when they represent almost all of it. Thus I
have considerable sympathy for at least some of the recipients of the $18
billion in 2008 Wall Street bonuses about which President Obama is so
exercised. If the base salary is not remotely appropriate for a senior
executive, and a senior (but not top-management with overall responsibility for
disaster) banker has worked very hard and successfully on a couple of big deals
in 2008, bringing the firm substantial revenues (which were then eaten up by
trading losses), it seems unfair to deprive him of a bonus altogether, making
him, even with a relatively modest Manhattan lifestyle, run at a substantial
loss for the year.
The solution to the problem is thus obvious: pay higher base salaries - and by
all means, much smaller bonuses. This will increase company loyalty, since the
banker will receive a nice juicy paycheck each month, rather than running up
debt in the hope of a huge payoff. It will not significantly de-motivate him,
since bonuses will remain large enough to be "interesting" - and if it means he
works 70-hour weeks instead of 100-hour weeks, the quality of his work and his
ethical standards will both substantially benefit, as will his mental health.
It will also remove significant arbitrariness from his remuneration, an
arbitrariness that unscrupulous bosses will use against him, and the threat of
which causes unproductive and unpleasant office politics as well as accounting
shenanigans.
Obama's $500,000 limit, which will apply only to those banks that have drunk
more than once from the well of the Troubled Asset Relief Program (TARP) but
should ideally apply to all staff within those banks, is a significant move in
this direction. Senior bankers will no longer work for $150,000 base if their
remuneration is to be capped at $500,000; even in a down market, they will
demand a base at or close to the cap. Thus the most counterproductive feature
of the Wall Street remuneration, the disproportion between base remuneration
and bonus, will automatically diminish or disappear.
At a senior level, once business rebounds, $500,000 won't be enough to keep
good investment bankers or traders, if the restriction remains in place for
more than a limited period. However, $500,000, if it is mostly base salary, is
a perfectly adequate remuneration for retail bankers, corporate lending
officers and even for retail brokers, as well as for top back-office types and
IT specialists. One can - I speak from long experience - live quite well on it,
although a pay-restricted top management might reasonably wish to move the
institution's headquarters out of Manhattan. Thus institutions that remain
under the restriction for a lengthy period of time will find themselves
surviving quite nicely, but metamorphosing into much less risky entities.
If those entities are large, $500,000 will not attract aggressive,
entrepreneurial top management in today's market. However, the public should
not want aggressive entrepreneurial top management at the head of any
institution that is deemed "too big to fail" or is otherwise liable to land the
public purse with huge losses. Fannie Mae and Freddie Mac were perfectly solid,
albeit economically useless, bureaucracies until somebody came up with the idea
of paying their top management tens of millions of dollars. Had their top
management remuneration been capped at $500,000 - more than for any purely
public sector job - they would have continued guaranteeing only prime home
mortgages, without acquiring a large portfolio on their balance sheet and
without venturing into the subprime sector. It must surely be crystal clear
that the US economy, in that event, would be in much better shape today.
By capping salaries at $500,000, and ensuring that any loopholes found are
closed, Obama would zombify the senior management of affected institutions.
Instead of competing ferociously for new and ever riskier ways of rent-seeking,
leveraging the huge pool of capital they controlled, the management cadre would
over time collectively lose all initiative, competing un-aggressively, with
capabilities only in the well-trodden, low-risk financial product groups that
comprise 90% of the sector's economically useful transactions.
Zombie management would be much cheaper than entrepreneurial management, so the
zombified banks would in those product areas out-compete banks whose management
remained on the traditional pay structure. That would force those banks also
towards government intervention. Banks that were "too big to fail" would thus
be zombified rather than bankrupted, to the great economic benefit of the US
economy. Financial services sector rent-seeking would largely disappear and its
share of gross domestic product would be reduced towards 1970s' levels, about
half those of 2007.
While the hugely capitalized "too big to fail" banks would become zombies,
entrepreneurial skills and financial innovation would not disappear from the
financial services sector. It would simply migrate to smaller institutions,
such as investment boutiques. Those would not be able to tap the rent-seeking
opportunities from deploying huge amounts of outside shareholders' money, and
would never have the balance sheets of the current behemoths. They would,
however, provide the full range of advisory services, as well as developing new
financial products and providing value-added financial solutions in areas left
fallow by the zombies.
To the extent they required underwriting for a large financing, they would be
able to obtain it from the zombies and from large passive pools of investment
capital such as insurance companies and pension funds, both of which would make
modest additional incomes from underwriting securities in which they would
normally invest.
The function most seriously affected by the new structure would be trading. In
well-established areas such as bonds, foreign exchange, top-tier equities and
straightforward derivatives, this could be carried on by modestly paid staffs
in the zombie banks, which would have no incentive to take great risks.
High-rollers would work for hedge funds, whose capital is specifically
dedicated to taking risks; there seems little need to have a separate group of
high-risk trading-desk institutions for the hedge funds to fleece.
To the extent (very limited, in my view) that additional returns were available
from exotic trading strategies, hedge funds would be well placed to achieve
them. "Principal trading", which in the present Wall Street consists largely of
profiting from a firm's insider information and connections at the expense of
its customers and the market, would no longer be a significant factor in the
zombies' operations because their controls would be too tight and their staff
would not be capable of undertaking it profitably.
As a populist gesture, Obama's new restrictions are odious banker-bashing. As a
general principle applied to business as a whole, as suggested by House
Financial Services Committee Chairman Barney Frank (D-Mass), they would be
hugely economically damaging, taking the United States a long way towards the
failed experiments of socialism.
However, as a corrective to the "too big to fail" doctrine they have
considerable merits. Obama is a very clever man; he may have found a way,
without draconian legislation, to remold Wall Street, producing a downsized and
economically efficient structure.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-09 David W Tice & Associates.)
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