It DOES take a village...

I have written extensively about bringing back the partnership investment bank (also see previous posts here, here and here). Now consider this NY Mag account of John Mack's of when he first began working at Morgan Stanley [emphasis added]:

Back when Mack started as a bond trader at Morgan Stanley, in 1972, things were a little different. “There were only 350 people,” he says. “They had $6 million in capital. Any time we priced a deal, every partner at the firm came to the meeting.” is first brush with disaster came during the 1987 stock-market crash.

The key quote is every partner came to the meeting when they priced the deal because the partners' money was on the line. Do you think that today's Morgan Stanley behaves in the same way when the senior directors are playing with Other Peoples' Money?
 
I see two problem in the structure of today's financial services firms. First, rewards are asymmetric. Today, if they win, bankers make out like bandits, but if they lose, someone else takes the hit. If a partnership investment bank loses, the partners lose their houses, their cars, their kids education, etc. That kind of double-edged incentive system makes people far more sensitive about risk control.
 
The second is this underlying belief of the superstar who can do it all and thus needs to be rewarded. Yet, as Tom Brakke wrote, the myth of the superstar is largely a myth:

When Chesley Sullenberger landed Flight 1549 in the Hudson, he was hailed as a hero, but bringing the plane down and getting the passengers off safely was a team effort. Co-pilot Jeffery Skiles somehow had completed restart attempts on both engines and was also able to run through most of the procedures to ditch the airplane — “something [the crash investigators] found difficult to replicate in simulation.” And the flight attendants (Shelia Dail, Donna Dent, and Doreen Welsh) ensured that 150 people were able to get out of the two of four exits that were viable, within three minutes.

A organization that has a superstar has to bear the cost to its corporate culture:

As anyone who has spent time around investment stars knows, the kind of culture that is created to support them usually doesn’t lend itself very well to the investment equivalent of landing in the Hudson. Instead, the environment can be much like that which Gawande has seen in operating rooms, where a head surgeon rules the day and is rarely challenged. Few are willing to speak up, leading to “a kind of a silent disengagement, the consequence of specialized technicians sticking narrowly to their domains. ‘That’s not my problem’ is possibly the worst thing people can think,” but it happens all the time (even in the investment world where people tend to be smart and opinionated).

I wholeheartedly agree with that characterization. Early in my career, I personally witnessed a "star" investment banker who was allowed to run wild blow up a major investment bank, much to the detriment of his partners.

Brakke wrote that, most often, there is a team around the star:

The star system isn’t universal in the business, but it is dominant. And often one of the stars is also given the title of chief investment officer at some point along the way, a further acknowledgment of their track record — and a position for which most are wholly unprepared. Oh, the part of it where they are supposed to opine about the market? That they can do and do well. But the real work, of creating an organization that builds on an array of talent and a confluence of ideas to meet the needs of clients? Not so much.

This study published in the Harvard Business Review shows that, in the business of investment management, the top firms are built around teams:
 

 
Success if predicated on teamwork, built on trust and the right incentive structures. In investment banking, that also means creating the right incentive structures, not only to make money for the bankers, but to put the right risk controls in place so that society doesn't bear the cost of failures.
 
Dare I say it? In investment management and banking, it does take a village to succeed.
 
 
 
Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
 
None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

What's wrong with personal integrity?

I got an unusual amount of hate mail after my post Would you bet on pro wrestling? In that post, I wrote that the Goldman Sachs affair had demonstrated that Wall Street had lost its way is in the process of destroying its own franchise of trust.

While I did receive some praise, I found that I was also confronted with Libertarians brandishing their Road to Serfdom like so many Red Guards during the Chinese Cultural Revolution holding Chairman Mao’s little red book. They seemed to be reacting instinctively and believed that my answer called for more regulation. They hadn’t even spent time to read the post and their objections didn’t even address my proposals:

• Bring back the partnership investment bank. Such a structure makes the risk and return symmetric for investment bankers. If bankers want to do something stupid and foolish, then let them. However, I have found in the past that having virtually all of your net worth tied in a firm makes you think a lot more about risk control and how you make money.
• Require all derivative contracts to be listed on a centralized exchange. Greater transparency would create more transparency and allow market participants to better price risk. While the likes of AIG could repeat its adventure in derivatives, but greater transparency could allow the market to restrain AIG’s actions through the risk pricing mechanism.

These proposals allow the market to work. Does this sound like heavy handed regulation?


In praise of good government
Unlike the Libertarians, I appreciate the role of good government and I don't regard government as evil. Good government is invisible and we don’t appreciate it until something goes wrong, much like how husbands may not appreciate their wives making them dinner every night...until there is no dinner.

Government establishes a structure for the system to work. Government is the mechanism that created a system of weights and measures. It assures us that when we buy a pound of meat or a gallon of gasoline, that we get something that is indeed a pound or is a gallon.

Government is a traffic cop. It compels drivers to stop at red lights and go on green lights so that there is no chaos on the roads. Similarly, it directs traffic in the skies through a system of air traffic control when we fly.

We should be grateful for these invisible functions, which we never think of and take granted. These functions of government make our everyday lives easier.


Political backlash is building
Already, I see the political backlash building. Respected figures, who are hardly on the fringe, are speaking out. Todd Harrison, founder of Minyanville, believes that Goldman Sachs is the poster child for class warfare. Also read Kurt Brouwer’s account of the conflicts on Wall Street and why he left Merrill Lynch. Barry Ritholz at the Big Picture is proposing a commercial in support of financial reform bill.

The peasants are gathering with their pitchforks. Wall Street needs to clean up its act. Any political backlash has the potential to get out of control and the social consequences won't be pretty.

Readers will recall that I concluded my previous post with the comment that:

In finance and in life, all you have in the end is your name and your reputation.

In all of the objections that I've heard, there is one thing that I don't understand. What’s wrong with valuing personal integrity?

Would you bet on pro wrestling?

I have been a longtime advocate of thinking about your assumptions before taking action or coming to a conclusion about a situation. The Goldman Sachs affair makes me take issue with the dogmatic defenders of Ayn Rand and her ideas about efficient and self-adjusting free markets. What bothers me is that the Goldman Sachs defense boils down to "buyer beware, the investors are all big boys" and "as long as it's not illegal it's ok."

I have not always been a fan of the Obama White House, but I agreed with President Obama when he admonished the bankers last week (full text here):

I believe in the power of the free market. I believe in a strong financial sector that helps people to raise capital and get loans and invest their savings. But a free market was never meant to be a free license to take whatever you can get, however you can get it.

While I agree with Obama that there is a problem, I believe that the Volcker approach favored by the White House is overly heavy handed. A better approach is this.


Examine your assumptions
Let me make this clear. I do believe in free markets and I do believe in the ability of free markets to efficiently allocate resources, but those principles only hold under certain conditions and assumptions.

Those of us who remember the basics of microeconomics know about the elegance of supply and demand curves. Underlying the elegance of these mathematical models (and that’s all they are) are assumptions about the symmetry of information and the rationality of human behavior.

Math majors all know about proof by counterexample. You can disprove an axiom if you can show a counterexample that violates it. So here are some proofs by counterexample.

Consider how the Dederot effect spur people to spend beyond their means. Also consider this example of how Costco breaks long cherished microeconomic assumptions about human rationality. Closer to home, read this account of the manipulation of the silver market. Behavioral economics show that people aren’t necessarily rational at all, but biological and chemical:

Despite what we’ve been led to believe, the market isn’t rational or efficient at all—it’s all about feelings. The major plot points of the crisis largely turned on emotion: Dick Fuld was too egotistical to sell Lehman Brothers when he had the chance, so his pride drove it into the ground; Bear Stearns hedge-fund managers lost huge sums of money on subprime mortgages despite the fact that they suspected the worst (“I’m fearful of these markets,” Ralph Cioffi e-mailed a colleague back in 2007); Merrill Lynch was the “fat kid,” as the investor Steve Eisman has put it, so desperate to be like Goldman Sachs that it barreled into every dumb investment imaginable and had to be bailed out by Bank of America. Almost every single bank chief doubled down on mortgage junk at exactly the wrong moment. Emotions led otherwise intelligent men—because, let’s face it, all of them were men—to make terrible decisions.

According to a new breed of researchers from the field of behavioral finance, Wall Street’s volatility is really driven by our body chemistry. It’s the chemicals pulsing through traders’ veins that propel them to place insane bets and enable bank executives to make risky decisions—and those same chemicals tend to have the same effect on everyone, turning them into a herd of overheated animals. And because the vast majority of these traders and finance executives are men, the most important chemical in question is testosterone.

How the Street lost its way
Goldman Sachs and others on Wall Street used to believe in getting rich slowly. You serve your clients well and you will be well rewarded in the end.

Somewhere along the way, the Street lost its way and sacrificed client relationships in its search for short-term profits. Tom Brakke at Research Puzzle wrote about how this attitude affected his relationship with his brokers when he was on the Buy Side [emphasis mine]:

To be clear, no one ever tied me down and made me buy anything, but I developed a general wariness of the Street and its practices. Even though my firm generated tons of trading business and those on the sell side were adept at acting like intermediaries, their actions were often those of adversaries.

The firms (the majors especially) often knew facts I didn’t know or figured the odds better than I did. That’s not surprising, since they were full of talented, well-paid hard chargers who were placed perfectly at the center of the flow of ideas and money. I expected that to be the case. What I was slower to understand was that even as a big client they weren’t going to tell me the whole truth if it meant extra profit for them.

The credo at Wall Street firms went from “serving our clients well” to “hey they are big boys” and “if it’s legal it’s ok”. Tom Brakke continued [emphasis mine]:

The practice of skirting the edges of regulations, client relations, and possible conflicts of interest, so much a part of the Wall Street model of yore, needs rethinking, even at the cost of near-term profits. It simply hasn’t worked, other than to allow for outsized payoffs for the edge-pushers (until the inevitable retrenchment due to enforcement action or market failure). It’s not long-term greedy, it’s long-term stupid.

In the pursuit of short-term profits, Wall Street has destroyed its own franchise of integrity and client service. Todd Harrison put it best when he reflected that [emphasis mine]:

Ruby Peck was my grandfather and the bond we shared is difficult to describe. He was my guiding light, my inspiration, my role model and my best friend.

He taught me how to be a man and what a man should be…We used to take walks and hold hands as he passed his pearls of wisdom to me:

“What goes around, comes around.,,
And, above all else, “All we have is our name and our word.”

And it’s coming around. Wall Street may have irreparably damaged its own franchise and the resulting loss of confidence could bring the whole edifice tumbling down. While the Ayn Rand followers may rail about government regulation and the destruction of the finance industry that is essential to America, they missed the boat when they kept silent while Wall Street dismantled its own reputation.

Let me put it another way. You may bet on professional boxing because you enjoy the sport and believe that the matches are fair and not fixed, but would you bet on professional wrestling?

In finance and in life, all you have in the end is your name and your reputation.

James Grant gets on the train

I see that James Grant came around to my point of view to bring back the partnership investment bank that I wrote about back in early 2009:

Happily, there's a ready-made and time-tested solution. Let the senior financiers keep their salaries and bonuses, and let them do with their banks what they will. If, however, their bank fails, let the bankers themselves fail. Let the value of their houses, cars, yachts, paintings, etc. be assigned to the firm's creditors.

Such a proposal would have prevented many of the recent excesses that we saw on Wall Street. If the bankers want to pursue short-term profits at the price of big long-term risks, let them! To paraphrase the old adage: The prospect of being bankrupt has a way of focusing the mind.

A reader pointed out to me that the implementation of this proposal would not have prevented the AIG debacle. I agree. I would therefore amend my proposal for financial reform as follows:

• Bring back the partnership investment bank
• Require all derivative contracts to be listed on a centralized exchange

The latter requirement would bring much needed transparency for market particpants to better assess the level of risks any firm is taking. That way, market discipline would not have allowed AIG, Fannie and Freddie would not have been able to take the outsized bets that they did.

A counter-trend rally led by Financials?

The massive selloff seen last week broke a number of key support levels and it now appears that the bears are now in control of the stock market. In the short run, the market is now short-term oversold and poised for a rally.

The spark for a rally may come from a re-assessment of the Obama proposals to limit banking activity. Simon Johnson's post Is the "Volcker rule" more than a marketing slogan? suggests that the Obama proposals may be more sizzle than steak. Go and read it in full.

Now that the bears appear to have gained the upper hand and have an (over)valuation tailwind at their backs, my inner trader tells me to wait for the oversold bounce before taking significant short positions in this market.

Incentive mis-alignment on Wall Street

I see that Barry Ritholtz at Big Picture sees my point about the mis-alignment of incentives on Wall Street, but he hasn't taken the next leap about my suggestion to bring back the partnership investment bank:

I always found it an amazing coincidence that none of the private partnerships got into any trouble. Coincidence? Perhaps not — from page 136, Bailout Nation:

More importantly, banks started adopting the “eat what you kill” compensation systems. The bonus structure, replete with short-term financial incentives, began to dominate banks. Throw in monthly performance fees and annual stock option incentives, and you end up with a skewed business model suddenly embracing quicker trading profits.

“This had an enormous impact upon the ways investment banks approached business generation and risk management. Like many public companies, they became increasingly short-term focused. “Making the quarter,” in Street parlance, meant pulling out all the stops to hit your quarterly profit figures, by any means necessary. Incentives became misaligned with shareholders’ interests, as risky short-term performance was rewarded with huge bonuses. Not surprisingly, this worked to the detriment of long-term sustainability.

But short-termism was only part of the equation. Of greater concern was how these firms’ internal risk management changed. Unlike in public corporations, partners are personally liable for the acts of any of the members of the partnership. If any one of a firm’s partners or employees loses a trillion dollars, every last partner is on the hook for that money.

Putting a supertax on banker bonuses will not solve the problem. The problem is the lack of incentives to pay attention to risk management. Partnership structures will do that.

Has anyone noticed that partnerships, such as lawyers and accoutants, rarely blow up? Even if they did, e.g. Arthur Anderson, they didn't bring down the system?

Bookstaber goes to the SEC

I see that Richard Bookstaber is moving to the SEC. Good for him!

I hope that this is the start of some adult supervision by the regulatory authorities. Consider what Bookstaber had to say about the banking system in an older post on his blog:

The last thing a bank wants is a competitive, efficient market, because then it would not be able to extract economic rents. So the incentives are to create innovative products that reduce market efficiency, not enhance it.

How is this done? Well, I can quickly think of two ways. First, by creating informational asymmetries, by having products that are difficult for the users to understand and price. And, second, by designing innovative products, which, due to their non-standard nature, allow the banks to extract higher transaction costs.

There is a lot of asymmetries in the i-bank business, according to Bookstaber:

Innovative products are used to create return distributions that give a high likelihood of having positive returns at the expense of having a higher risk of catastrophic returns. Strategies that lead to a ‘make a little, make a little, make a little, …, lose a lot’ pattern of returns. If things go well for a while, the ‘lose a lot’ not yet being realized, the strategy gets levered up to become ‘make a lot, make a lot, make a lot,…, lose more than everything’, and viola, at some point the taxpayer is left holding the bag.

If we were to look at the sorts of strategies employed by large investment firms and banks, my bet is we would see a bias toward short volatility, short gamma, short credit and short liquidity. All facilitated with innovative products – you can’t really do the first two without derivatives – and all leading to these sorts of return characteristics.

Government support = regulation
If banks want to pursue these asymmetric strategies and get the government to backstop them, then they have to accept some form of regulation. David Merkel at Aleph Blog, has just put up a good post on the nuts and bolts of how to approach banking regulation.


Otherwise bring back the partnership i-bank
The other alternative is to bring back the partnership investment bank and eliminate government support. Having most of your own net worth tied up in your business will focus the partners on the risk side of the business a lot more. Isn’t it funny that partnership based entities like legal and accounting firms generally don’t have the same problems as investment banking? The last time we had a big blowup (Arthur Anderson), we didn’t see accountants running to the government for a bailout.

Narrow banking can be the solution

Martin Wolf has an article entitled Why narrow banking alone is not the finance solution. He writes that one of the solutions proposed by John Kay in a pamphlet for the London-based Centre for the Study of Financial Innovation to the banking crisis is to create “utility” banks and “casino” bank. Regulate the “utility” bank, Kay says, and let the “casino” bank take risks.

Wolf then goes on to criticize this approach:

A more profound issue is whether a financial system based on narrow banking could allocate capital efficiently.

Here there are two opposing risks. The first is that the supply of funds to riskier, long-term activities would be greatly reduced if we did adopt narrow banking. Against this, one might argue that, with public sector debt used to back the liabilities of narrow banks, investors would be forced to find other such assets.

The opposite (and greater) risk is that the fragility of banking would be re-invented, via “quasi-banks”. This is what has just happened, after all, with “shadow banking”. In the end, those entities, too, have been rescued. The big point is that a financial structure characterised by short-term and relatively risk-free liabilities and longer-term and riskier assets is highly profitable, until it collapses, as it is rather likely to do.

The answer to the second dilemma is to make banking illegal. That is to say, financial intermediaries, other than narrow banks, would have the value of their liabilities dependent on the value of their assets. Where assets could not be valued, there would be matching lock-up periods for liabilities. The great game of short-term borrowing, used to purchase longer-term and risky assets, on wafer-thin equity, would be ruled out. The equity risk would be borne by the funds’ investors. Trading entities would exist. But they would need equity funding.

A better solution
Martin Wolf has written many cogent and insightful analysis of finance over the years. This is one of the rare cases where I disagree with him. The problem isn’t one of defining a regulatory framework for a “casino” bank, but that the incentives for the management of the “casino” bank are asymmetric and mis-aligned.

Instead of building a convoluted regulatory environment for banking, just bring back the partnership investment bank.

Allow market forces to work. If the partners at the "casino" bank want to pursue short-term returns at the cost of excessive long-term event risk, let them. The ones with adult supervision will survive, the ones without will blow their brains out and their failure will serve as an example to others.

The trouble with Wall Street regulation

There has been a lot of hand wringing lately about how the efforts to regulate Wall Street have gone nowhere (see example here). We’ve had the likes of Paul Volcker weighing in on what banks shouldn’t be allowed to do because of the effect on systemic risk. There have also been various proposals on regulating compensation on Wall Street.

The approach is all wrong.


Wall Street = Pure capitalism
Wall Street investment banks are the embodiment of capitalism in its purest form. The question is: “How do you prevent systemic risks from building in the system and encourage innovation at the same time?”

One example of recent innovation is the attempt by some investment banks to package and trade life settlements. David Merkel of Aleph Blog thinks that it’s a bad idea. Widespread trading of these instruments will create unintended effects:

Think about it: you as the insurance company did your best job to estimate the risk involved. You did it assuming that policies could not be sold, whether really or synthetically. You already knew that those who were healthy in the future would surrender and seek another carrier, but thought the those who were less healthy would persist to some degree. Well, with life settlements, the unhealthy persist at a much higher level, which bites into profits.

This is the box that life insurers are in. They can’t lock in policyholders, but policyholders can hang on, refinance (so to speak), or sell off their obligations. That is a tough equation for life insurers to work through, and to the degree that life settlements are allowed, premiums will have to rise to compensate for the loss of profitability.

People respond to incentives
Right now, the Wall Street incentive system is overly asymmetric. Instead of constraining banks on what they shouldn’t or shouldn’t do, regulator should set up a system that more naturally regulates behavior.

The solution is really simple: Bring back the partnership investment bank. Consider this old article about the partners of Goldman Sachs discussing the issue of whether the firm should go public [emphasis mine]:

Others, including John L. Thornton, a member of the executive committee, spoke with equal determination against any public sale of shares, people there said. The prime fear was that a public company could never replicate the close-knit culture of a partnership, where financial rewards are measured in lifetimes instead of months…

Every company talks of teamwork, but Goldman elevated it to a commandment, bankers there say. Because partners' own money is at stake in every deal, the firm operates by consensus, with top executives often able to trust other partners implicitly. Scores of Goldman people participate in decisions that one or two bosses might make in other firms.

Investment banks lost their way once they became public companies. The compensation of its traders and executives became more and more asymmetric. In effect, they were given call options on the cash flow of the firm. Being human beings, they behaved accordingly. At the same time, there were fewer and fewer incentives to exercise adult supervision.

Society should be telling Wall Street the following: "You are free to innovate and make piles of money. If you make the wrong bet and take on too much risk, then you are free to blow your financial brains out. But if you blow out your (metaphorical) brains, don’t splatter it all over my living room so that I have to clean it up. "

Bringing back the partnership investment bank solves most of those problems.

Do current incentive structures make sense?

On the weekend my family went to the new Star Trek movie. As I watched the film, I reflected on the effects that popular culture has on the incentive pay system, which has been a hot topic lately.


Should we looking for heroes?
The archetype of the hero in the movie is Kirk, the rebel and maverick who flouted the rules to get things done against the odds. He succeeded and became the captain of the ship. Playing against Kirk, we have the character of Spock, the logical and reasoned thinker (who will never become the captain of a starship). The Kirk hero archetype is a common feature in many Hollywood films and a common characteristic of heroes in American popular culture.

When we extrapolate those popular culture notions to how investment banks pay bonuses, does Kirk sound like the star producer and Spock is the risk manager?

This kind of thinking that as permeated not only American culture, which migrated across the Atlantic, has created a winner-take-all mentality. As a former colleague of mine once remarked, “It’s like an Olympics out there, if you’re not in the top three you are nothing.”

In support of this philosophy, Paul Kedrosky noted:

Well-timed conservatism is a fine thing, but there is something to be said for taking risks. Among the reasons why Bill Gates dropped out of university and started Microsoft and made billions when you know you're the same age as he is and you know he's not really that smart and Windows sucks and you can't stand the guy, is that he took a risk and you didn't. Elevating uber-conservatism into the highest virtue is no path to growth and wealth and all good things capitalism.

But do we really want to elevate the hero archetype that way? Is this the best way to incentivize everyone?


Sauce for the goose
Take the issue of compensation for government workers. Would Dwight Eisenhower have done a better job in World War II had he been given incentive bonuses to win the war? What about Norman Schwarzkopf during the Gulf War?

Do you get what you pay for?

Aldrich Ames turned over the CIA’s network of spies to the Soviets in exchange for a total of about $2 million. The initial payment that he received in 1985 was $50,000. Should the U.S. government be paying their people better? Had the CIA been giving people substantial incentive bonuses, could they have forestalled this intelligence disaster for roughly twice of what the CEO of Credit Suisse paid his ex-wife in interest in a divorce settlement?


Mediocre cavalry officers in charge of nuclear bombers
Dominic Connor, a headhunter, recently commented on the culture within banks [emphasis mine]:

A clear factor in the recent calamities has been the lack of expertise at the very top levels of banks. Reviewing the publicly available lists of board members at many firms, I observe that most of them not only have never taken an active role in trading, analysis or risk management, but that today few would even be accepted as a trainee in a less prestigious organisation than they ran into the ground. In effect we had mediocre cavalry officers in charge of nuclear bombers.

While it is important to create compensation and incentive structures so that originality and innovation are not stifled, we should not forget Paul Volcker’s comment that the most important financial innovation for most people years has been the automated teller machine.

We are all socialists now

Richard Nixon once famously said “We are all Keynesians now.” Within a decade of that comment, Keynesian ideas had become largely discredited. Now, the world is turning Left after a long period of embracing free market ideas. Avner Mandelman noted with some indignation on this Leftward lurch:

What did Mr. Obama say? He said he stands with the unions against Wall Street, and vehemently faulted hedge fund bond investors for insisting on their legal rights in a bankruptcy.

I am not sure if you grasp how momentous this is. A U.S. president effectively said the law be damned, the sanctity of commercial contracts be damned, if such constructs cause pain to unions.

Indeed, the Economist recently commented that:

Rather than challenge dirigisme, the British and Americans are busy following it: Gordon Brown is ushering in new financial rules and higher taxes, and Barack Obama is suggesting that America could copy some things from France…

Is America that much a bastion of the free market? Barry Ritholz wryly made these observations about the differences between Europe and the US and asked "Who is the Welfare State":

-Europe has cradle to grave health care plans, generous unemployment benefits, and free or subsidized college costs.

-The US gives away public assets (oil, gas, mineral rights) for pennies on the dollar, has huge subsidies and tax breaks, and bails out reckless speculators.

Is the free market system, as it’s set up, broken? Tyler Durden over at Zero Hedge, claims to have found an article by Deepak Moorjani, formerly of Deutsche Bank, who wrote on the socialization of risk:

Our asymmetric incentive structure is fundamental to our problems. The question remains: Do we maintain the status quo and naively hope for better results, or do we begin to implement structural reforms in order to align the incentives? If taxpayers are forced to pay for the losses from bad trades, this socialization of risk adds to the moral hazard problem. This socialization of risk actually encourages more aggressive behavior in the future.

The call-option bonus structure has led to the ascendency of sales over risk management. Maintaining the status quo is not a smart bet, and we cannot afford to ignore the fundamental issues of structure and compensation.

I have written before on how to fix the asymmetry problem – bring back the partnership investment bank. Meanwhile, nothing changes on Wall Street. Paul Krugman recently commented:

Does anyone remember the case of H. Rodgin Cohen, a prominent New York lawyer whom The Times has described as a “Wall Street éminence grise”? He briefly made the news in March when he reportedly withdrew his name after being considered a top pick for deputy Treasury secretary.

Well, earlier this week, Mr. Cohen told an audience that the future of Wall Street won’t be very different from its recent past, declaring, “I am far from convinced there was something inherently wrong with the system.”

For too long, the Right hid behind the principles of the free market when it was to their advantage and now the chickens have come home to roost. This wave of socialization will pass in time. In the meantime, please stand and join in a singing of Internationale.

Is Cuomo just piling on Merrill?

In the news earlier in the week, New York attorney general Andrew Cuomo accused Merrill of misleading Congress about bonuses:

Merrill Lynch & Co may have misled Congress in representing last November that it planned to pay out bonuses at year end, when in fact it decided to accelerate those payouts, New York Attorney General Andrew Cuomo said on Wednesday.

He added that [emphasis mine]:

The attorney general also said Merrill traders may have delayed taking hefty losses late last year until after the company decided to pay out $3.62 billion of overall bonuses.

I qualify these remarks with the disclosure that I worked at Merrill’s research department until early 2007 and I don’t personally know any of the people involved.

There are ways of showing a profit and temporarily hiding losses in complex derivative books but Cuomo’s accusations of traders manipulating their own P&L for to boost their own bonuses is a serious charge. It is certainly possible given this characterization of investment bankers, the obscene bonuses paid before the BofA takeover and how risk is managed at investment banks. I believe that the business model of Wall Street i-banks needs reform, but for Cuomo to level these charges without substantiation seems like a case of politically piling on to me.

We need specifics, Mr. Cuomo. Who? When? What did they do?

A proposal for reforming Wall Street

The fact that there is a culture of greed and excess on Wall Street is no secret. The blogger Cunning Realist wrote that in his experience, Wall Streeters are not exactly rocket scientists (and being a rocket scientist has its own problems) but focuses on how to be a BSD:

The culture rewards speed, opportunism, and quite often recklessness. It does not reward what most people consider "intelligence" -- advanced mathematics ability, or knowing or caring about the difference between Shia and Sunni.

Efforts to rein in risk are not working because of the culture of revenue generation. A recent survey shows that risk managers are still second-class citizens at banks despite the onset of the financial crisis.


A case of misaligned incentives
The downfall of WaMu, Bear Stearns, Lehman and so on can be laid at the feet of the agency problem. If you work at a bank or broker, your compensation is tied to revenue generation and not risk control. It’s not your money!

Compensation payoffs on Wall Street, whether it’s at an investment bank or hedge fund, are asymmetric. If things go right, the investment banker, broker or hedge fund manager gets a disproportionate part of the upside and the investor gets a limited part. If things go wrong, the investor bears virtually all of the downside.

There is a really simple answer to all this. Bring back the partnership investment bank. Let Goldman Sachs and all the i-banks be partnerships again. That way, it’s the partners’ money again. If the partners want to lever the balance sheet up to 30-1 or 40-1, let them. If it doesn’t work, the partners get personally wiped out and some may have to declare personal bankruptcy. In the end, the return function becomes symmetric and the net aggregate effects will be positive. I don’t believe that partners of i-banks would collectively be willing to take those kinds of risks again, nor would they be willing to sacrifice long-term liability for short-term profits.

I would like to say that Rubin's departure from Citigroup marks the end of this era of greed, but until until the incentives are made symmetric and a large portion of future Bob Rubins' personal wealth are tied up in the investment bank, nothing will change.

Greed is still Good

I received this picture in my email inbox, titled I finally got the Christmas lights up last night. While amusing, this seems to be a metaphor for how Wall Street behaves these days: All sizzle and no steak.

No contrition at all

After the recent train wreck in the world financial markets, you would think Wall Street would be a little bit contrite and be more careful about what kinds of products gets pushed. Apparently, they are only paying lip service to that concept. I encountered this article last week, indicating that bankers were selling FX-based structured products as places to park short-term funds[emphasis mine]:

Clients in the private bank space are already starting to trade some of the new ideas. Amanti says that BarCap is marketing ideas that take advantage of the increased volatility, which is at unusually high levels. Typically, currencies don't move much, but today the volatility on many currency pairs is similar to the vol levels on equities a year ago. Even at those levels, it is still possible to take advantage by using, for example, products that offer a very large range around a spot level or that take a view that the spot will not move as much as the volatility implies.

"Also, given the current high volatility environment, the idea of selling volatility, either within capital protected structures or taking some principal risk, can be very attractive and these ideas are gaining more and more traction," says Amanti.

They are now getting clients to sell volatility to enhance returns? Do these “sophisticated” clients understand the risks, like they understood the risks with the CDO and CDS markets? There are many good discussions of volatility, David Merkel at The Aleph Blog is a good example:

Implied volatility estimates as applied to option pricing formulas are a fall-out. No one thinks they are true, but they are a paramater used to keep relationships stable across options of similar expirations.

Intelligent hedgers hedge options with options; they don’t try to apply the theoretical equivalence that lies behind the traditional Black-Scholes formula and do dynamic hedging with the common stock itself.

Do these bankers have no shame? Having bankrupted little municipalities in Ohio and elsewhere, bankers are now looking for new suckers?

Greed is still Good.