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Regulation, Bonuses, and Politics

by: John Jansen October 13, 2008    

John Jansen

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The intervention by the Treasury and the Federal Reserve at the time of the collapse of Bear Stearns shall henceforth be celebrated by economic historians as a punctuation point in American financial history. I believe that historians will mark it as a watershed event which began the dismantling of the unregulated free market philosophy which has been the hallmark of the American government since Barry Goldwater espoused that philosophy over 40 years ago. (And went down to ignominious electoral defeat in 1964.)The discredited Goldwater philosophy, though, brought to power Ronald Reagan and since 1980 the conservative ideal has for the most part flourished. In the years when it did not flourish, it still succeeded in defining the debate.

This election appears to be the advent of another defining moment. We are about to re-regulate in a very big way. I think that one of the unintended results of the financial crisis will be an even greater regulatory impulse. I say that because the public coffers will be bare and I think that our elected representatives will have enough common sense to refrain from imposing tax increases which might threaten an already fragile economy. I also think that they will realize that the same common sense demands that spending should be restrained as well.

The unintended consequence will result as the Democratic majority will find that the only game in town will be the vengeance game. In my opinion business, and the financial sector particularly, will be scapegoat for all of the ills of the last eight years. I think the blame should be borne by all of us and there is nothing partisan about the causes of this calamity. The cause can be found in human nature and is greed.

Greed led to imprudent risk taking and I do have a proposal on regulating trader behavior which I think will lead to more sensible bets.

In the current framework, a trader’s focus is only on the fiscal year in which his bonus is determined. As each new year begins, individual traders cash their bonus checks and start the year “tabla rasa”. The motivation for a trader is to maximize the current year bonus.

I think that this can lead to perverse risk taking, and probably did as the initial subprime mess unraveled. I offer the hypothetical case of a proprietary trader who had been eminently successful for several years in a row and chalked up large bonuses. We are well into a hypothetical 5th year and things are not going so well as the trade sours big time. Rather than unwind the trade and take an acceptable loss, the current system encourages a big risky bet. It encourages doubling down or adding to a bad position because there is no penalty for a big bet gone awry.

So in this instance a trader who has enjoyed considerable success and has banked large bonuses might look at the situation and take inordinate risk because the worst outcome is that he returns home as a full time member of the rentier class and he clips his coupons until he finds his next gig.

I would suggest that each year a portion of a trader’s bonus should be held back and that it should be placed in an escrow account of sorts for five years. Let it earn the interest on the 5 year note.

If however, the trader loses some amount of money above some predefined trigger level, then some of those losses should be paid for from the trader’s prior year bonuses.

I think that this would align traders with shareholders and would reduce sloppy risk and sloppy risk control.

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This article has 4 comments:

  •  
    Oct 13 04:39 PM
    Ok, maybe this would work for some problem areas but, who needs socialism and an almost communistic control over what you can make and how you make it?
    If traders are the problem, why not stop their toys, the software programs that operate automaticly to buy, sell, and hold stocks and the other traded items they are designed to optimize the users profits.The most successful market in the world is managed manually, open for two hours a day for three days a week and ni one of the most dangerous parts of the world.
    If the markets are operating as a self regulated body with the interest of investors as the prime opertive, then we would have never had any of the many problems that plague the markets and industrial complex.
    I think we would do much better recovering from our problems if we force individuals to think for themselves about the actions they are taking. Although people want to get rich quickly this has caused problems that have repercussions around the world.
    Reply
  •  
    Oct 13 05:19 PM
    This is nice, but not going to happen. Trading is a risk taking business and we want that emotion driving their lives. We should not hesitate to punish miscreants but not the normal animal spirits and the prizes that reward performance.

    As for what the democrats might want to do, I suspect that ethos gets played down as we approach the day for a decision; Congress loves the largess of the lobby and they will fall quickly into their prior ways. Maybe something will change, but it will be cosmetic.
    Reply
  •  
    Oct 13 09:19 PM
    Citigroup and JPMorgan Chase were told they would each get $25 billion; Bank of America and Wells Fargo, $20 billion each (plus an additional $5 billion for their recent acquisitions); Goldman Sachs and Morgan Stanley, $10 billion each, with Bank of New York Mellon and State Street each receiving $2 to 3 billion. Wells Fargo will get $5 billion for its acquisition of Wachovia, and Bank of America the same for amount for its purchase of Merrill Lynch.
    Reply
  •  
    Oct 14 01:51 PM
    "I think the blame should be borne by all of us. The cause can be found in human nature and is greed."

    what BS!
    If I'm part of the blame, does that mean I have to help pay for it. of course.

    The financial sector did this. We should have learned from the S&L fiasco that it doesn't take much with high leverage to screw things up. All it took then was a simple tax change.

    Sure, greed played a part. Offer someone a house and they'll take it if it costs less than the apartment. That's human nature, unfortunate but true.

    The real malevelant greed was in the institutions that ignored sound lending rules and threw risk out the window to the next up the food chain. Yeah, the agency problem. Then they multiplied the leverage with MBS & CDO. the smart ones that realized eventually it would go down created swaps to profit from their knowledge. these are all derivatives aka WMD (Buffet).

    I don't like regulation, but a key element in this basically fragile fractional reserve scheme is leverage. Derivatives leverage the leverage. The only regulations I would favor are KISS. Keep it small (enough to fail) and simple (limit leverage).

    Oh yeah, let the banks get sucked down the black hole they created without golden parachutes. Best lesson they could learn as they're sure to be back (Paulson). Notice the smart banks are still around. They can pick up the slack from the faux liquidity crisis. That sound you hear isn't the economy seizing up from lack of credit, it's the bankers all whining for a bailout. I sure as hell don't want to pay for it.


    Reply
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