via naked capitalism de Yves Smith le 18/12/08
A New York Times story today, "On Wall Street, Bonuses, Not Profits, Were Real," makes its most important point in its headline, and managed to get some good data points on how rich investment bank compensation was in the peak years, but otherwise glosses over the fundamental nature of what went on.
It was looting, and it is high time the media starts describing it in those terms.
Let us turn the mike over to Nobel Prize winner George Akerlof and Paul Romer. From the abstract of their 1993 Brookings paper:
Our theoretical analysis shows that an economic underground can come to life if firms have an incentive to go broke for profit at society's expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations.
Bankruptcy for profit occurs most commonly when a government guarantees a firm's debt obligations. The most obvious such guarantee is deposit insurance, but governments also implicitly or explicitly guarantee the policies of insurance companies, the pension obligations of private firms, virtually all the obligations of large or influential firms. These arrangements can create a web of companies that operate under soft budget constraints. To enforce discipline and to limit opportunism by shareholders, governments make continued access to the guarantees contingent on meeting specific targets for an accounting measure of net worth. However, because net worth is typically a small fraction of total assets for the insured institutions (this, after all, is why they demand and receive the government guarantees), bankruptcy for profit can easily become a more attractive strategy for the owners than maximizing true economic values...
Unfortunately, firms covered by government guarantees are not the only ones that face severely distorted incentives. Looting can spread symbiotically to other markets, bringing to life a whole economic underworld with perverse incentives. The looters in the sector covered by the government guarantees will make trades with unaffiliated firms outside this sector, causing them to produce in a way that helps maximize the looters' current extractions with no regard for future losses...."
Re-read the key phrase: "pay themselves more than their firms are worth and then default on their debt obligations." This has happened en masse in what formerly were investment banks who have now become wards of the state.
But no one is willing to call this activity for what it was. In fact, some are still urging that we not squelch "financial innovation," which Martin Mayer described as
... a way to find new technology to do what has been forbidden with the old technology....Innovation allows you to go back to some scam that was prohibited under the old regime.
But we digress. Dick Fuld reportedly spends much of his days allegedly wondering why he didn't get a bailout. He should instead be thanking his lucky stars he is not in jail. Bankruptcy fraud is criminal, and fraudulent conveyance is subject to clawbacks. How could Lehman possibly have been producing financials that showed it had a positive net worth, yet have an over $100 billion hole in its balance sheet when it went under? No one has yet given an adequate answer on where the shortfalls were.
Commonwealth countries have a much simpler solution. If a company is "trading insolvent," that is, continuing to do business when it is in fact broke, its directors are personally liable.
We have said repeatedly that one of the triggers for the crisis was permitting investment banks to go public (prior to 1970, no NYSE member firm could be listed). We had dinner with one of our long-standing colleagues who was responsible for Sumitomo Bank's investment in Goldman Sachs and had (and continues to have) close and frequent dealings with the firm. He said that the change in the firm's behavior after it went public was dramatic. Before, it would deliberate (one might say agonize) important business decisions,. Waiting two years to enter a new field was not unheard of. But after the partners cashed in and were playing with other people's money, the firm quickly became aggressive in its use of capital in expanding the size and scope of its activities.
But the New York Times article gives an anodyne portrayal:
As regulators and shareholders sift through the rubble of the financial crisis, questions are being asked about what role lavish bonuses played in the debacle. Scrutiny over pay is intensifying as banks like Merrill prepare to dole out bonuses even after they have had to be propped up with billions of dollars of taxpayers' money. While bonuses are expected to be half of what they were a year ago, some bankers could still collect millions of dollars.
Critics say bonuses never should have been so big in the first place, because they were based on ephemeral earnings. These people contend that Wall Street's pay structure, in which bonuses are based on short-term profits, encouraged employees to act like gamblers at a casino — and let them collect their winnings while the roulette wheel was still spinning...
For Wall Street, much of this decade represented a new Gilded Age. Salaries were merely play money — a pittance compared to bonuses...
While top executives received the biggest bonuses, what is striking is how many employees throughout the ranks took home large paychecks. On Wall Street, the first goal was to make "a buck" — a million dollars. More than 100 people in Merrill's bond unit alone broke the million-dollar mark in 2006. Goldman Sachs paid more than $20 million apiece to more than 50 people that year, according to a person familiar with the matter. Goldman declined to comment.
The bulk of the piece is about Dow Kim, former co-president of Merrill's fixed income business, and does deliver some detail about how Kim and his subordinates were paid. But it fails to delve into how the profits were illusory, the bad decisions made, how the fixed income area in particular lead to the end of Merrill's independence. Perhaps the author, Louise Story, assumed the tale has been well told elsewhere. However one effort to demonstrate the business was on the wrong track, falls woefully short. It discusses a CDO deal that went bad, but fails to establish whether Merrill took losses by virtue of retaining a big interest ("The losses on the investment far exceed the money Merrill collected for putting the deal together" does not clearly say that Merrill, as opposed to investors, suffered. One assumes so, but the drafting is ambiguous).
Even more glaring, the story mentions Merrill's disastrous, end of cycle $1.13 billion acquisition of mortgage originator First Franklin, without mentioning that deal came a cropper (Merrill shut the unit down only a year and a couple of months after it completed the transaction).
Other stories have given some of the sordid details about Merrill's ill fated mortgage expansion (a Wall Street Journal piece, "Merrill Upped Ante as Boom In Mortgage Bonds Fizzled," is one of many examples), Giving short shrift to the staggering level of strategic errors and lax risk oversight means the article fails to pin responsibility clearly for the mess on Kim and his fellow business heads. The article simply assumes the connection, but by talking about the profits without giving sufficient detail on the colossal errors, it makes Kim and his lot seem far more innocent than they really were.
