Monday, January 21, 2008

Just When I Thought I Was Out

... they pull me back in."

The Godfather: Part III

The Financial Times continues to do an outstanding job of ruining my long holiday weekend here in the States by dragging me back into the vexed and contentious issue of banker pay. This morning, they have goaded me into a response by posting a comment left by former economist/Harvard poohbah and current hedge-fund-honcho/commentator-without-portfolio Larry Summers on the FT Economist's Forum, wherein the Fine and Lofty have been debating Martin Wolf's recent provocation on the subject.

While I truly begin to tire of this issue, I feel it would be irresponsible to my Faithful Audience not to share with you the comment I left on the Alphaville blogsite (and Mr. Wolf's subsequent "response"), just in case you wanted to see more of my flashing teeth on the subject. I fear these words will fall on deaf ears among the F&L, but perhaps some among you will be able to perceive the validity of my arguments amidst the vitriol of my delivery.

This is what I wrote this morning:

This horse just won’t die, will it?

I find it both instructive and amusing to read the thoughts of the great men (no women yet) on the FT Economist’s Forum. The scent of academe lies heavy upon the conversation, whereas I could find little evidence that any of those learned men have actually spent any time earning a productive living in the finance sector, which might give me more comfort that they know what the hell they are talking about.

“Clawback,” as Mr. Rajan originally proposed and Mr. Summers seems to tentatively endorse, is both a ludicrous notion and so impractical as to rank only slightly above unicorn horn as a likely cure for the current financial ills Mr. Wolf and others so lament.

How, pray, would you implement such a scheme? Set up a government-supervised escrow account, into which all affected traders and bankers deposit a majority of their annual pay, which is only released over time when the regulators decide it is safe or appropriate to do so? To whom among the legions of individuals within the finance sector–whose jobs and responsibilities are so multifarious as to make the US Federal tax code look like a one-page precis–would it apply? Who would decide, for example, when it is safe to release the 2007 bonus for a mortgage trader, and on what basis? How about that for a CDO structurer, or a commodities trader? An M&A advisor? A senior executive? (Minor point: how in God’s name would you propose taxing such earnings?)

The mind boggles both at the size and complexity such a regulatory scheme would require and the self-delusion of those among its proponents who believe that Wall Street and City bankers will not innovate rings around such a system within the first six months of its establishment.

And why should investment and commercial banks be the only entities involved in such a scheme? I can think of many economic actors who had a direct hand in the frenzied bubble behavior behind the current credit meltdown and real estate crisis who are at least as influential and culpable in the resulting mess as bankers. Let’s set up compensation clawback mechanisms for them, too, by all means. Real estate brokers, fixed income portfolio managers, German savings banks, Australian municipalities, central bankers, and–dare I say it–economic prognosticators should all join the party, by this calculation.

Furthermore, if we agree the assets and securities being traded carry long-term risks of value diminution, why don’t we extract protection directly from the sellers of those assets? After all, the seller of a house, a mortgage portfolio, or a common stock share has absolutely no continuing exposure to the potential future reduction in value of that asset, and they typically make a lot more money off the sale than the banker who arranged the transaction. Outrageous! If we want to protect the financial economy from panics, crises, and destruction of value, why don’t we “incentivize” all sellers of financial assets not to sell any assets which have a risk of declining in value in the future? That’ll simplify things, mightily.

This is, and remains, nonsense. There are vast swathes of our global economy where people earn a living conducting transactions in which their pay has no long-term vesting mechanism even though those very transactions have substantial long-term economic risk to their participants. Wall Street, frankly, is one place where it does, through the cleverly designed market mechanism of deferred compensation tied primarily to the stock price of the individual banker’s employer.

Until and unless the economists of the world propose to set up a compensation scheme wherein their current compensation is deferred until we have had the opportunity to judge the correctness and efficacy of their economic forecasts and policy proposals over some multi-year time period, I will consider such proposals as these as no more than empty posturing.

Subsequently, Mr. Wolf was pleased to climb down briefly from his ivory tower and post a response for all of us unwashed commoners to chew on:

I find it impossible to take seriously someone who froths anonymously, though I suppose that, like most economists, I would be happy to take delayed pay in return for bankers’ levels of remuneration. The fundamental point, however, is that banks are already differentially regulated and for very good reason: they are the central institutions of the credit system, as this crisis has proved once again. And, as the central institutions of the credit system, they are uniquely protected and supported by the state.

It is perfectly reasonable for regulators to ask whether the incentives of those who operate these institutions are aligned with the public interest that the regulators exist to protect. Of course, it is quite likely that regulators will soon be looking at how other industries (real estate brokers, for example) have performed. But that was not my concern.

“Academic” is often used as a term of abuse. But pretty well all the fundamental ideas in modern monetary and financial economics were invented by academics. So it is a term of abuse I am delighted to accept.
* * *

I have rarely marveled at such an impressive cartload of arrogant, willfully misunderstanding codswallop as this. Mr. Wolf apparently persists in believing against all evidence that I am attacking his premises—that banks are central to the global economy, that their centrality justifies differential regulation, and that regulators have a valid interest in understanding the incentives which guide and influence banking market participants' behavior and actions. I am not. What I am attacking, however, is the proposal he has put forth to do something about it, which I find ill-considered, poorly thought-out, and completely impractical. Furthermore, as I alluded to in my post, the minute you start proposing the regulation of pay in one sector of the economy which concerns the destruction of value, you open the door for demagogues and scoundrels to revisit the compensation schemes of others. That way lies communism, Mr. Wolf, and I think few among your readership would follow you even a few steps down that road.

Finally, I find it impossible to take seriously someone who will not engage in the rough and tumble of the marketplace for ideas because his interlocutor chooses to conceal his identity. I am enough of an "academic" myself, Mr. Wolf—a moniker, by the way, which I in no way consider to be a term of opprobrium—to believe that the important points in a debate are the ideas under discussion, not the pedigree or position of the debater. Should you choose to discover it, you can know enough about me as matters: I am a practicing investment banker who has worked in the industry for almost two decades. That, and all else about me, does inform my argument but is frankly irrelevant to it. I have no other dog in this fight.

And, as far as "frothing" goes, Mr. Wolf, I think you will find that most of my readers are well able to extract whatever pearls of wisdom there may be in my arguments from the exaggeration, sarcasm, and humor in which I encase them. The academic virtues of dryness and moderation in discourse are not superior or even preferable to other forms of exegesis in all circumstances. Nor does my employment of the rhetorical arts lessen the force of my criticisms of the ideas you and others have put forth on the subject of banker pay.

Feel free to hide yourself in the cloistered echo chamber of the Economist's Forum, if you will. There, I am sure you can convince yourself that all disagreement is centered upon modest refinements to your most excellent idea. I, on the other hand, will continue to live and work in the real world, where ideas live or die based solely upon how well they work in practice.

And, in the common parlance of my country, Sir, your dog won't hunt.

© 2008 The Epicurean Dealmaker. All rights reserved.