March 19, 2009

The Necessity of Making People Owners

Bankers are being excoriated as examples of how greed corrupts. On this point I have a strong opinion: There are greedy people in every industry and walk of life, and you don’t have to be rich to be self-indulgent.

There’s no doubt, however, that self-interest runs amok at Wall Street firms, a condition that has led to behavior that’s harmful to the marketplace and Main Street America. You would think it’s a problem we should fix. Yet, from where I sit, I see none of the TARP money and threats about increased regulation aimed at correcting what will amount to an ongoing series of excesses and subsequent corrections. The problem, you see, isn’t the amount of compensation Wall Street pays its people, but how that compensation is determined.

To make my point, consider how an auto company executive (let’s say his name is John) eventually proves his worth to his employer. John is given an assignment to design a new body style for a line of cars. It’s an important responsibility and he works diligently to fulfill its requirements. After a period of time, he offers several style options, one of which is chosen based upon market research and lengthy internal discussion. Before the design can be put into production, however, some of the major components—the engine included—must be modified. In other words, a considerable length of time ensues before the first newly designed car rolls off the assembly line. Furthermore, it will take many more months—years perhaps—to determine whether the change leads to increased sales. In short, John and his managers won’t know how successful his design will be until years after the project is completed.

Now, let’s look at how Jim, a proprietary trader, seeks to make a name for himself. Jim is told to look for arbitrage opportunities and so he examines the marketplace for cheap securities and uncovers a five-year maturity bond that is paying 5%. He decides it offers extraordinary value, so he purchases $100 million of it, using cash that he borrows at 3% interest. Jim is suddenly making a spread of 2% (5%-3%) on the $100 million, or $2 million per year. Pretty neat, huh? But that’s not all. A salesperson comes to him and says he has a client who needs a guaranteed $2 million per year for the next five years and is willing to pay $8 million today for that annuity stream. The trader says, “You’re done,” and money changes hands. He has booked a nice profit.

This is a simplified example of a trade known as a swap. In reality, a swap is far more complicated and can involve an exchange of cash flows based upon multiple currencies, credit events, indices, and interest rate movements. However, the simplification doesn’t obfuscate key points to be made.

  • While the auto executive’s contribution to his company’s bottom line isn’t discernible until years have passed, the trader knows immediately and unambiguously how well he is doing on any given day.
  • While the trader has generated $8 million—which immediately flows through the company’s income statement—he also retains other positions, namely: a $100 million bond (an asset), a $100 million loan (a liability), and an obligation to pay $2 million each year for the next five years (another liability). These appear on the company’s balance sheet and their values are subject to change.
While all companies try to compensate employees on the basis of individual contribution, few are able to track performance in the way of a Wall Street manager by simply glancing at the tally in a trading ledger. From this perspective investment bankers are like ballplayers and actors: Trading gains have their corollary in home runs and ticket sales as an irrefutable and real time metric of success. High contributors, therefore, have considerable negotiating leverage. On the other hand, there is no tolerance for individuals who don’t perform. In fact, a Wall Street manager’s primary responsibility is to determine who among the workforce should receive walking papers prior to bonus season. Layoffs are expected each year and are meant to reduce the number of ways the bonus pool is split.

That being said, there’s a problem in how trading profits are calculated and you might have noticed it already—particularly if you consider what has happened at AIG. In the example above, the trader booked $8 million in profits today, but he still holds positions that can turn on him tomorrow. In particular, the $100 million liability is huge in comparison to the profit he booked. To demonstrate what can go wrong, let’s say the asset (the bond) defaults. The trader no longer receives the 5% payment from the bond, but he’s still required to pay: 1) the 3% on the borrowed money and 2) the $2 million a year on the swap. In addition, when the loan comes due in five years, the trader will have to repay $100 million and may not receive any money from the maturing bond. In short, while he made $8 million today, he exposed the company to a potential loss that could be in excess of a hundred million dollars.

So where am I going with this? The way Wall Street employees are compensated is based upon income in a given period and doesn’t fully reflect the residual risks of their positions. This encourages traders to book as much income as possible today and deal with future problems only as they arise. After all, getting a multimillion dollar payout this year will go a long way to easing the disappointment of getting canned the next. Do you think those AIG swap traders will shed tears if the company doesn’t survive? I’m sure they’ll cry all the way to their yachts.

And that’s the problem in a nutshell. The traders were compensated in such a way that they were encouraged to book income today that subjected the company (and the entire marketplace) to enormous risks for an extended future. One might say that they felt ownership for the periodic income, but not so much for the risks in the positions they retained. If we really want Wall Street to act with more integrity and prudence, bankers must be made liable for their mistakes. Forcing companies to reserve against leveraged positions and restricting bonus payments until trading positions mature or are unwound is the right direction. That would accomplish more than any other regulatory change to the industry.

Furthermore, on a broader scale the notion reemphasizes a point I’ve made in earlier blogs: When we make people owners of creative resources and value-generating processes they are more likely to act with a social conscience.


Matt's brain said...

This to me just sounds like making money out of nothing. Here I was thinking that money is made by selling products or services.

By the way, did you ever consider becoming a financial journalist? Jon Stewart is on a crusade to convince financial journalists to do a better job. Did you see his interview with Jim Cramer?

Alan Bahr said...

I didn't see Stewart, but he's on the right track. I don't know any journalists who really know what they're talking about.