But what does seem clear is that the plunge was exacerbated by the markets’ heavy reliance on computerized trades—both explicit “stop market” sell orders (that is, orders to sell a stock once it hit a certain price) and algorithmic trades that dictate buying and selling depending on different market factors.

and

I don’t think yesterday’s crash is evidence the market is irrational. It’s more that it’s a-rational: the computers aren’t panicking or herding. They’re just following simple rules. I think this is bad for the collective intelligence of the market, which really depends on diversity of thought and independence of action. But what happened yesterday isn’t, I think, quite the same as the crash of 1929 or the stock-market bubble of the late nineteen-nineties. It’s an example of the dangers of a-rationality (to coin a word) rather than irrationality.

Felix Salmon thinks this is an opportunity for a financial transaction tax

There’s a very sensible idea going around that a simple way to deal with nearly all of these problems, at a single stroke, would be to implement a tiny tax on financial transactions. Historically, people have complained that such a tax harms liquidity, which is true. But the fact is that it harms the bad kind of liquidity — the liquidity which dries up to zero just when you need it most. Liquidity, if it’s spread across multiple electronic exchanges and can disappear in a microsecond, does very little actual good, and in fact does harm during tail events like this. Let’s tax it, and raise some money for the public fisc at the same time as slowing down markets and making them think before doing a trade.

I think a financial transaction tax is a good idea. It is politically more doable at this time than any other time in the future. India already has one and it seems to do no harm to liquidity.

If you think about it, sales tax is a transaction tax. Why is it that there is no demur to a transaction tax on sales of goods (except on online commerce, which again is inexplicable), but financial transactions being taxed will bring about the end of capitalism?

Related posts:

1. Financial Transaction Tax
2. Wall Street Bonuses are Not the Real Issue
3. Innovation and Complexity in Finance

.. Those who shorted the housing market shorted the country.

There were many things that went wrong with the housing market – people were being given loans who had no chance of repaying it, homeowners were outright lying and the lenders were encouraging them or looking the other way, Wall Street was concocting securities that were several layers of complexity away from the real, underlying assets and the credit rating agencies were designing their models so that they could stamp their approval on these securities. And a bunch of other stuff related to Fannie and Freddie and the absence of any regulatory checks.

But the thing that was not going wrong, enough, was that there weren’t enough people shorting the heck out of these securities. An asset bubble is created when there are too many people in the market willing to buy at higher and higher prices and not enough people betting on the prices to go down.

Goldman Sachs and Paulson & Co. made money as the sub prime market was collapsing around it. Good for them. There’s nothing wrong with that. Goldman didn’t make much since they were late in the game. Paulson made out like a bandit because he was betting against subprime when no one else was. Unless these deals involved cheating or fraud, there is nothing wrong with making money in a collapsing market.

To the common voter, this won’t make sense. It isn’t fair, it isn’t right to be able to make money off of other folks’ misery. To get huge bonuses when people are losing their houses. You can almost see the special feature on CNN – an interview with an old couple who lost their home and their savings immediately followed by some charts on average bonuses at Goldman Sachs (assuming that nobody at Goldman will be stupid enough to give an interview to CNN on this subject).

This is the narrative that is playing out across the US today. Also perhaps the UK, Iceland, Spain, Ireland and a few other countries where the housing crash was particularly severe. This makes the task of lawmakers very difficult (or very easy, depending upon how you look upon your job as a lawmaker).

If the healthcare debate involved complex issues, financial regulation is almost impenetrable to the voter. If you were a lawmaker and wanted to simply do Joe Blow thinks should be done, you’re going to end up banning short sales and capping banker compensation. Neither is useful and thankfully are unlikely to be implemented.

If lawmakers chose to ignore Joe Blow, and none of them had any scruples, Wall Street would have a field day. They can throw so much money at this thing that the lobbyists will make sure that all that comes out is a bill that sounds ground breaking, but does very little in terms of real reform.

Even if you did want to do the right thing, it is terribly difficult to regulate the market in a way that protects the good stuff while preventing the bad stuff from happening. Always assuming that our legislators really understand the issues at hand. After all, what amounts to the fog of finance for Joe Blow, at the minimum is reduced visibility driving for the Senator.

I am not very hopeful that a good bill can come out of this fog. Another thing that makes me pessimistic is that the most important consequence of this bill, the one that voters really care about, is the avoidance of the kind of crash that would need government bailouts. Whether the bill achieves that or not cannot be determined immediately. Or even in the next three years. If you assume that all politicians want is to be reelected, there is almost no incentive to make a law that really achieves that objective.

On the other hand, punishing Wall Street is popular and the payoff is immediate. So it is in Wall Street’s interest to protest, express pain and anguish and ultimately sullenly take their medicine or appear to do so. And it is in the lawmakers’ interest to appear to be combative and outraged at Wall Street’s excesses while watering down the bill. In this regard the divisions between the left and the right are almost a side show. It might be played up but only to take attention away from a weak bill. Of course there is the matter of the media and experts and what they say about the bill. It’s easy to spin the news networks, especially since they know even less about this stuff than legislators. Experts and financial bloggers are another matter. But then how many voters read Brad Delong?

I will be quite surprised if a good bill comes out of this. There is still some ways to go, and perhaps I should be more optimistic, but politicians as a class are trained to raise expectations and then disappoint.

Related posts:

1. Innovation and Complexity in Finance
2. Why is the Financial Industry this Big?
3. Wall Street Bonuses are Not the Real Issue

Here are a couple of observations about the Goldman Abacus deal. All parties involved – Goldman, ACA, IKB, ABN Amro and Paulson – are financial firms. While the assets being packaged into the CDO were mortgages, they were far removed from the houses that were bought using mortgages. There was no purpose that this deal served in the “real” economy.

George Soros in an op-ed in the FT today:

Whether or not Goldman is guilty, the transaction in question clearly had no social benefit. It involved a complex synthetic security derived from existing mortgage-backed securities by cloning them into imaginary units that mimicked the originals. This synthetic collateralised debt obligation did not finance the ownership of any additional homes or allocate capital more efficiently; it merely swelled the volume of mortgage-backed securities that lost value when the housing bubble burst. The primary purpose of the transaction was to generate fees and commissions.

The deal was a complex deal. So complex that ACA and IKB didn’t understand it well enough to ask the right questions. Neither of them are bit players. ACA was happy to let Paulson pick the mortgages that went into the structured product since they thought he was long and on the same side of the deal as they were. IKB, similarly didn’t look at the underlying assets too closely because they thought Paulson was investing too.

There are many occasions in business when trust compensates for an incomplete understanding of the parameters of a deal. In such situations you prefer working with a specialist with a reputation, like say IBM for technology. But in this case, ACA and IKB, both financial firms, couldn’t deal with the complexity of the transaction and trusted (or at least ceded control to) Goldman. And they got taken to the cleaners. ACA is no more and IKB had to be bailed out by the German government. ABN Amro is now part of RBS which was bailed out by the British government.

And here’s my point. Maybe there is such a thing as too much financial innovation. Maybe too much of this innovation is to create complexity for its own sake, to keep changing stuff just to keep clients confused and uninformed. Low information clients are the most profitable clients.

In the consumer finance world complexity creates fine print. Fine print creates profits. Credit cards, banks – they don’t make money by being upfront and transparent. With financial institutions the game has to change, since they have lawyers who can read the fine print. So what do you do? You “innovate”. You create structured products that are mind-bogglingly complex. You avoid transparency. You avoid instruments that can be marked-to-market.

Besides clients and counter parties, constant financial “innovation” also keeps the regulatory bodies confused. They don’t understand these new financial instruments to effectively regulate or police them. In the meanwhile, the smart players on Wall Street are raking it in.

Which is why Wall Street doesn’t like exchange traded derivatives. Products would have to be simplified, standardized. Change would slow down. Spreads would come down and so would bonuses.

Innovation in services is hard to pin down – is it useful or is it smoke? Again, looking at credit cards business, developing a product that allows your teenage son to use your credit card at certain merchants to a certain limit – that’s useful innovation. But a product that has low APRs but gives you only 5 days to pay your bill before hitting you with late fees – that’s innovation that is designed to make more money off of customers who don’t read the fine print.

The problem is that it is very, very difficult to make rules such that the good kind of innovation is unimpeded while preventing the bad kind. That’s why we need ethical business leaders. Today, the credo in the corporate world and especially on Wall Street is – maximize your bonus without committing an unlawful act. In many cases this is stretched to “without getting caught”. Regulation can’t keep up with this. There has to be some self regulation.

We need more companies like Google. “Do no evil” might sound corny but it says that the company tries. That’s more than you can say about Goldman Sachs.

Related posts:

1. Does Complexity Have Regressive Social Effects?
2. Wall Street’s Chickens Come Home to Roost
3. Why is the Financial Industry this Big?

Lehman had a boatload of assets on its balance sheet supported by a thin slice of equity. To hide their huge leverage, they did deals with counterparties which were essentially short-term (like a week or two) loans against collateral (which they had plenty of). Except, that they didn’t show these as debt on the balance sheet against collateral. Instead they showed them as sale of assets so that the balance sheet at the end of the quarter wouldn’t look as leveraged as it was. Terrible, terrible stuff. The accounting magic may not have been at the scale of Enron, but the end result was the same – a once proud company, bankrupted, it’s shareholders left with nothing.

With all the noise around it, it is almost certain that Dick Fuld, the former CEO will be prosecuted. But what I am unable to fathom is why Ernst & Young gets away with it. Enron brought Arthur Andersen down. Of course they did a lot of other bad stuff like trying to shred the evidence. But does that make so much of a difference to E&Y’s culpability? If the shareholders of Lehman bring a class action lawsuit against Ernst & Young, that could be worth billions in damages.

But that doesn’t seem to be the case. If anyone has a better understanding of this, please leave a comment.

Update: I think I found the answer to my question. From the New York Observer:

Also read Felix Salmon’s post on Wall Street bankers still living on a different planet.

No related posts.

Well, no longer. The President in a hard hitting speech blamed Wall Street for financial crisis and the ongoing economic slump. He then laid out what he called the Volcker Rule, as a nod to Paul Volcker, former Fed chief, who has suddenly become very influential. While the details were scant, the thrust of the Volcker Rule was two-pronged.

One, separate the deposit taking banking business from risky proprietary trading, hedge funds and private equity.

If financial firms want to trade for profit, that’s something they’re free to do. Indeed, doing so responsibly is a good thing for the markets and the economy. But these firms should not be allowed to run these hedge funds and private equities funds while running a bank backed by the American people.

Two, limit the size of all financial firms by preventing consolidation beyond a point.

In addition, as part of our efforts to protect against future crises, I’m also proposing that we prevent the further consolidation of our financial system.

No doubt, there is politics behind this. After a very important loss in the Massachusetts senate race, the healthcare bill is in trouble. Financial reform is popular and the Republicans will find it very difficult to fillibuster it. On healthcare, he wasn’t driving, either by choice or out of necessity, Congress was. Now, he can take back the initiative on something that is popular and substantive.

There are no details yet, but needless to say, the financial media and the blogosphere are all aflutter. The Financial Times today had about a third of the paper devoted to this issue. Most commentators are saying “What took you this long?”. But there is criticism:

On thread of criticism is that the proposal doesn’t do enough. The crisis was not centered on banks. All financial players were involved. Toxic assets and leverage created the danger that there would be a systemic meltdown if one or two large financial firms went under. Separating risky businesses from deposit taking bank protects the banking customers, but that doesn’t address the systemic risk issues. Limiting the size of all financial firms by just preventing further consolidation is thought to be too weak. Although it would be difficult to think of any other practical solution.

Another problem is that proprietary trading is “in the eye of the beholder”. It is (or can be made) indistinguishable from trading for clients. So how do you separate it from the deposit taking bank?

There is also the matter of international banks who are not subject to US law in this matter but operate in the US. Finance is global now and when you talk about systemic risk it is not limited to the US only. But this may be less of an issue. The Conservative party in the UK which is expected to win the next election has already said that they favour legislation similar to what Obama has proposed.

And then there are those who say that the Volcker Rule will never see the light of day. Bills are passed in the Congress and Senators need a lot of money to get elected. And Wall Street has that money.

To top it all, yesterday the Supreme Court, struck down a 63 year old limit on corporate spending on elections. The coincidence is quite ironical. No wonder the President is gearing up for a fight

So if these folks want a fight, it’s a fight I’m ready to have.

Related posts:

1. Wall Street Bonuses are Not the Real Issue
2. Why is the Financial Industry this Big?

Matt Yglesias and Maxine Udall write about how talent, like capital, has been preferentially allocated to the financial sector in the last two decades during which the financial industry has grown from about 20% to above 40% in its share of corporate profits. It dropped sharply as Wall Street bled money in 2008 but if recent earnings results are any indication, they are headed back up there quickly.

The financial sector’s average pay has steadily increased where it is now close to 200% of the national average. This of course doesn’t sound too big because it also includes consumer finance and banking, not just wholesale capital markets.

In any industry that is growing like the financial industry did, pay automatically goes up. The real question is – is the natural, unsupported share of the financial industry closer to 20% or to 40%?

Sure there has been a lot of innovation in the financial industry, and you could argue that innovation has driven the expansion of the financial industry, just like the technology industry.

But there are significant differences. The tech industry has a business model that supports super sized growth and profits. There are the entry barriers – copyrights, trademarks and patents. And the marginal costs can be pretty low. This is not to say that the tech industry isn’t hyper competitive. Not every company makes money. But it is a fact that the winners in any product-market make out like bandits.

The financial industry is not like that. Yes brand matters, and size matters but in wholesale banking and fee based services these things should matter less. Yes innovation matters but business practice innovation is not much of an entry barrier. A new derivative can be quickly copied.

Yes people matter. Other things being equal, you’d rather hire a smarter management consultant or work with a better investment banker. But price also matters.

So why did the financial industry become so big relative to the economy? Is it because that is its rightful place? That the efficient allocation of capital is so important that it rightfully occupies 40% of economic activity? Or can at least part of it be explained by the special nature of the industry?

I can think of at least two ways in which capital markets are different and which allow it to expand seemingly without any limits.

1. Preferential access to information. Trading profits come from preferential access to information. This includes the Galleon type illegal insider trading, which happens more than you think. But it also includes legal ways in which the professional trader gets information and acts upon it. In the stock market it has become increasingly difficult to make money this way but there are many other securities which are just not as regulated. Even in the stock market, most of the capital invested contributes fee-based income to the financial company. The money from principal trading is far more nimble and better-informed because this is trading income for the company.

I am not as familiar with other securities markets, but I would aver that the same principal trading vs managed money difference plays out there as well.

2. Taking a cut from capital flows is easier. Much of financial service revenues come out capital flows. They don’t appear as an expense on a company’s income statement. When a public company raises capital, the investment bank takes a 6% commission out of the public issue, that commission comes out of the hides of the shareholders. The company retains the bankers but is completely insulated from the costs of it. Competing on cost therefore becomes meaningless. [Update: the IPO bankers' fees are paid by the company and charged to the income statement. But as a one-time non-operating expense the charge is largely going to be ignored by the market. (Krishna thanks for the correction).]

Even for a retail investor, the 1% or so you pay as management fees to a mutual fund, psychologically is not an expense. It is a reduction in your capital gain (or increase in capital loss). Most consumers don’t pay it as much attention as an equivalent increase in say the price of gasoline. Although the popularity of ETFs points to the fact that retail investors are wising up.

Regulations can and do squeeze out the advantages that financial firms enjoy because of these two reasons. Take the equity markets. The SEC and other agencies have been in a constant battle against Wall Street with insider trading enforcement, Reg FD and most recently Flash Trading. But the fact that the SEC often is sleeping at the wheel and the New York DA’s office has had to take the lead points to the fact that Wall Street enjoys the benefits of the complacence, if not connivance of the SEC.

Another example. If you were to make the commission on public equity offerings to be accounted for as an expense on the income statement of the company raising money, you can bet your pension, price competition will bring that commission down in a hurry. Online dutch auctions, which have never worked, will become the rule rather than the exception. Investment banking salaries will plummet as they cease to be the Masters of the Universe.

But don’t hold your breath for that to happen. The investment banks protect their fees ferociously. As does the industry its profits. As long as they can make supersize profits for their companies, nobody can touch the bankers’ compensation. Maybe for a year, like in the UK. But no more. The order of the universe will remain unchanged.

Related posts:

1. Financial Transaction Tax
2. Wall Street Bonuses are Not the Real Issue

Be Invested

The most important factor in getting a good return on your portfolio is to be invested. Leaving cash in a checking account just because you haven’t decided what to do with it, or because you are just too lazy to do some research to figure out where to invest it, can significantly erode your returns in a good year. This doesn’t mean that you can’t plan to have some part of your portfolio in cash, if that is what you intended for the cash. But if your year-end bonus comes in and sits in your bank account for 6 months before you even transfer it to the brokerage account or open a CD, that’s like overpaying for your flat screen TV at a retail store instead of buying it from Costco (I’ll bet that got your attention. For more on us cheap Indians search for Russell Peters on You Tube.)

Asset Allocation

How to allocate your money between different asset classes – stocks, bonds, real estate, commodities – is a serious, higher order question that must be answered first. The world changed for many of us in the second half of 2008. The stock market, we learnt, can be a very fickle asset class. But it is also true that many major asset classes turned out to be terribly correlated. Even so, think hard about your goals in managing your money and then decide on the right asset allocation. I have 40% of my portfolio into fixed income. Investing in bonds has become a lot simpler via ETFs and so there’s no excuse to not following a prudent asset allocation strategy.

ETFs vs mutual funds vs individual stocks

You are deceiving yourself if you think you can pick stocks to beat the index. The boasts that you and your friends make over lunch on how much money they made on Apple or Google will generally miss the important detail that you made a 200% gain on one stock which was less than 5% of your portfolio. The lunch table chatter will never be about how much money you lost on that dog that you invested in last year because you didn’t think it could go any lower. Face reality, you aren’t a stock picker. You’re just giving in to that gambling streak in you. Don’t bet your family’s future on the casino. If you must bet on individual stocks, set aside some play money to indulge yourself.

Investing in mutual funds is better but it is still a mug’s game. Do you know anybody who can beat the market consistently? I have spent a lot of time with smart money managers and I can’t say that I have. Not because the people I met weren’t smart. It’s just that beating the index consistently is just too, too difficult. Especially, net of fees. Read this if you need some convincing.

The reason I love ETFs is because they give me diversification with very low fees. And with the proliferation of ETFs, you have a vast array of investment options – stocks, bonds, commodities, different markets, even leveraged bets and shorting the index. Passively managed index funds are similar in nature though they don’t have as wide a variety.

For asset classes other than stocks, ETFs are even more compelling. ETFs are traded on a stock exchange. They are very liquid and you know what they are worth at all times. Owning bonds or commodities used to be much more involved in the past. ETFs make dead simple. ETFs also allow you to easily allocate a part of your portfolio to international markets. Owning individual international stocks or bonds is much tougher.

Emerging Markets

I have great faith in emerging markets. They will be volatile, but the long-term fundamentals are good. You can get emerging market exposure in both stocks and bonds. You can go by market or buy into all emerging markets with something like EEM. I also own EMB which is an emerging market bond ETF.

Measurement

Your broker – online or full-service is typically not going to have the tools to measure how you are doing except for the simplest of situations. I have never quite understood why. The computation and the tools required are pretty trivial. Is there like a platinum level of membership with Schwab where these tools get unlocked?

In the meanwhile, I pull down the data and compute my own XIRR. I always choose to reinvest dividends, which helps keep the computation simpler. It can get a little messy if you accumulate over time and then sell over time. But since you are doing this for yourself all you need to know if your investment is meeting the criteria you set for it or not.

Discipline

I can’t say that I have a long track record of disciplined investing. But in just this year, there has been enough temptation to break my asset allocation rules. The US markets kept climbing and here I was stuck with a self-imposed 40% allocation to bonds. But I held fast and I plan to stick it out in the future as well. Changing your asset allocation in response to an attractive investment option is exactly the kind of thing that gets you in trouble. You don’t have the dampeners in place when an asset bubble bursts.

That doesn’t mean you can’t change your asset allocation or investment strategies. But it should be done as a long-term shift in strategy rather than to spike returns in the short-term.

Next year it’s going to be tough to make a decent return in almost anything. It’ll be a good test for my new investment methodology.

In the meanwhile, I hope you find this useful. Again, I don’t mean for this to be investment advice. What will work for you depends entirely on your context.

Related posts:

1. Why is the Financial Industry this Big?

As could be expected, the issue of Wall Street compensation raised its head again. And this time there is the weight of the federal government behind it. Banks that have taken TARP money will see their executive compensation capped. And the Federal Reserve has suggested that all large banks that fall under its jurisdiction will be reviewed on on going basis to ensure that executive bonuses do not produce risk taking behavior that could put the banking system at risk.

There are several memes that get mixed up in any discussion about Wall Street compensation in the media. Add a lot of emotion from a distraught public and it becomes for a tangled mess where the media feeds the furore but there’s no real understanding of the underlying issues. Let’s see if we can parse the issues out.

These are the issues as they are played out in the media
- Issue #1 – The taxpayer bailed out Wall Street. How can they pay themselves these kinds of bonuses.
- Issue #2 – The rest of the country is going through agonizing pain – high unemployment, pay freezes and cuts – how can these people pay themselves what they do?
- Issue #3 – Their companies have been (and some still are) hemorrhaging cash. How can they pay their investment bankers so much?

I don’t think any of these issues merit any attention from lawmakers. #1 could be argued many ways but at the end of the day, if the bank has taken TARP money and hasn’t yet returned it, the federal government as shareholder with special rights, can do as it pleases. Politics dictates that compensation should be curbed and so it will be. #2 amounts to appealing to a cold corporation’s heart – a futile endeavor. #3 is the company’s call. They have a board and shareholders. If they think that they need to pay top dollar to retain talent, then that’s what they need to do.

In my mind there are two fundamental issues that need consideration. One, is related to risk increasing compensation practices. The second is a larger issue of high, untrammeled growth in the capital markets in the last two decades.

On the first issue, everyone agrees that Wall Street’s bonus bonanzas encourage traders and management to pile on the risk, collect their super size bonuses and when things turn south, leave the shareholders to pick up the pieces. And when things go really really bad, like what happened to the markets last year, let the federal government foot the bill.

What is not clear to me is why the shareholders just stand there and let this happen. The expectation that the bank is too big to fail and that the fed will bail you out, doesn’t explain it. If you were a shareholder in Citigroup and held the stock prior to the crash, even though you were bailed out, you probably lost your shirt on Citi.

I am not sure what the answer to this is. It could be that in the normal course of things, shareholders don’t really exert any influence on the board of the company. Election of board members and votes on CEO compensation, need to see a lot more vigor in the shareholder meetings, especially in the US.

Or it could be that shareholders think they’re smart and will be able to get out before the stuff hits the fan – a variant of what the trader or management thinks – except that the employee just loses her job, the shareholder his savings.

It could be that there isn’t enough disclosure. That Wall Street companies, on the pretext of not revealing proprietary information on trades and investments, is actually throwing a cloak on dodgy, heads-I-win-tails-you-lose schemes.

There could be other things going on that only behavioral economics can explain. Thinking that if everyone has been doing risky trades for so long then maybe its not that risky, is both irrational and perfectly natural.

Whatever, the reason behind it, this nexus between risk and compensation needs to be tackled head on. It is going to be a very tough problem. But not addressing it is not the answer.

The other question is also a big one. In the last two decades, the capital markets have grown much faster than the rest of the economy. The chart here shows that the profits in the US Financial sector went from about 15% of total corporate profits in 1998 to over 40% in 2007. When an industry grows at that pace, the competitive intensity is low and margins are high. The use of technology raises productivity further increasing margins. In the capital markets the only significant cost is the cost of people. When there is no or low downward pressure on prices, compensation has no place to go but up.

But is the ‘natural’ size of the industry as a share of GDP what it is today or what it was two decades ago? Can an industry that essentially allocates capital, and doesn’t really make anything, have such a large share of the GDP? Is there something in the laws of the land that make it so? For instance the credit rating industry, many say, is a creation of legislation and would not have existed at least in this twisted model of today, had it not been for an easy regulatory environment. Are there other such areas that would wilt in the face of an openly competitive field or lower entry barriers?

I don’t know the answers to these questions. But I do know that if the world has a problem with Wall Street traders, bankers and CEOs making tens of millions a year, not just in today’s recession, but beyond as well, we will need to look at taming the industry, not capping salaries. If that’s even the right thing to do. Or possible at all.

No related posts.

The political heat around this is intense. The one thing I’d like to get my hands, but probably won’t, is the contract that requires AIG to pay these bonuses out.

The first question I have is what is the nature of these bonuses? Are they committed compensation, but just deferred to the end of the period? That doesn’t make sense. If they are committed why not pay them out as you go. OK, then are they discretionary? It appears not. Otherwise there wouldn’t be this hullabaloo. So it must be a formula-based bonus much like a sales commission plan. The law takes a fairly narrow view of a commission dispute between employee and employer. So I understand why AIG feels that it is legally required to pay out the bonuses.

However, what is inexplicable is the way this bonus plan was written. How can a bonus pool be funded when the unit, AIGFP, made a whopping loss? When the company just posted the biggest quarterly loss in the history of mankind? Right after the federal bailout, the first thing they should have thought of was fixing the compensation plan. And don’t tell me that they couldn’t have changed the bonus plan, prospectively, in the middle of the year.

There were enough reminders about how sticky the issue of Wall Street compensation had become. First Wall Street CEOs gave up their bonuses for 2007 – it was all over the papers. Then the auto CEOs were given a tongue lashing for their corporate jets. Then the Merrill Lynch bonus thing happened. All this while, the AIG management was reading the newspapers, I presume. Why didn’t they change their bonus plans?

It’s possible that the bonus payments pertain to 2008 (unfortunately, as in all such issues, it is difficult to extract facts out of all the noise). But I haven’t heard AIG saying that the bonus plans have been changed from such and such date onwards. It’s not much a defence but it’s something. I don’t really think that’s been done.

Poor compensation practices are at least partly responsible for the mess we are in. I have written about it before. The prevalent compensation practices on Wall Street incentivize the manager to expose the firm to long-term risks because his compensation is tied to short-term goals. In AIG’s case, not only did the managers pile on the risk, but as these bonuses indicate, they just plain raked it in at the expense of the shareholders.

Related posts:

1. Wall Street Bonuses are Not the Real Issue
2. Why is the Financial Industry this Big?

• The media gleefully uses [word] in its headlines, the opposition in Congress and interviews.
• The government refuses to acknowledge that they have any plans to [substitute with loaded word] and come up with new words to describe what they are doing.
• In all this, the public has only a vague idea about what is going on.

‘Bailout’ was one such word. Remember George Bush refusing to admit that what the federal government was doing amounted to a Bailout. Here’s an earlier post of mine on Bailouts.

Well, Nationalization is the latest politically loaded word.

Just so we understand what we are talking about, here’s how the Economist describes Bank Nationalization.

This involves several steps: ascertain which banks are insolvent, take them over, sever the most toxic assets and sell them over time or hold them to maturity. The good parts would be sold to the public or a strategic buyer as quickly as is feasible. These healthy banks would be fit to lend, benefiting the overall economy. The taxpayer may even avoid losses.

There are many supporters of Nationalization – Paul Krugman and Nouriel Roubini – to name just a couple. Many pundits object to calling it ‘nationalization’ and prefer the word ‘conservatorship’ or ‘temporary nationalization’. Naturally, since Nationalization has entered the lexicon of politically loaded words, less politically damaging alternatives will be explored.

Ben Bernanke doesn’t believe they will be headed down the path of Nationalization.

Nationalisation to my mind is when the government seizes the bank, zeroes out the shareholders, and begins to manage and run [the] bank, and we don’t plan anything like that.

President Obama, as you can expect from the man, speaks to us as adults who don’t pretend to understand high finance.

Sweden, on the other hand, had a problem like this. They took over the banks, nationalized them, got rid of the bad assets, resold the banks and, a couple years later, they were going again. So you’d think looking at it, Sweden looks like a good model. Here’s the problem; Sweden had like five banks. [LAUGHS] We’ve got thousands of banks. You know, the scale of the U.S. economy and the capital markets are so vast and the problems in terms of managing and overseeing anything of that scale, I think, would — our assessment was that it wouldn’t make sense. And we also have different traditions in this country.

Meanwhile, the latest at Citigroup is that the feds have converted their preferred shares into common equity effectively giving them 40% of the voting stock in the company. . ‘Creeping Nationalization’ is what some people are calling it.

Over there in the UK, the government under certain conditions could now be said to own more than 90% of the RBS. As a friend of mine, who works in investment banking business for RBS quips – It was a dream of my father, a civil servant in India, that I should follow in his footsteps and become a civil servant. And so I have, albeit for the British government.

The thing I don’t get is, why is ‘nationalization’ such a loaded word in the US? Perhaps it is my formative experience in the Indian business environment that makes me quite comfortable with the notion of public sector banks. But to my deformed way of thinking it seems like today Joe Public should be concerned about things in this order:

1. 1. Is my money in the bank safe?
3. 2. We are pouring tax dollars, some of which are mine, into these banks because we need healthy banks to support the economy. Are we trying to minimize the cost of the bank bailout?
5. 3. This recession could be long and deep. W need to return banks to health and get credit flowing again before the economy recovers. Are we doing the right things to hasten a recovery?
7. 4. America is about capitalism. Business must stay in private hands.

You can have a substantive, rational debate about #1 to #3, but there is no argument against #4. At this time, it seems, #4 above is trumping #1 to #3 combined.

President Obama says in the same interview

Sweden has a different set of cultures in terms of how the government relates to markets and America’s different. And we want to retain a strong sense of that private capital fulfilling the core — core investment needs of this country.

I can understand that nationalization comes with huge administrative problems – how do you decide which banks are insolvent and need to be nationalized, the need to nationalize all of them together or see their share prices go to zero, how does the federal government manage so many banks even if it is for the time they are stripped of their toxic assets and then privatized again. And since, while you are cleaning up the banks you still have to run their business, this is no doubt a mammoth undertaking. It should give the administration pause, if not make them sick to the stomach just thinking about it.

But I don’t understand the ‘cultural’ thing – the resistance to nationalization that comes from the notion that it is against American values. I believe that you will find that the American public is much smarter. They may not understand what a ‘preferred convertible share’ is, but they will understand and support a program that fixes something that is essential to fix before the economy can recover.

Meanwhile, I have put some of my cash into CDs at SBI New York. It took many, many phone calls for us to confirm that the CD deposit had indeed been accepted. When we finally got to the right person, she didn’t check in some computer or anything prosaic like that. Instead, she shouted “Arre Vidya Pradhan ke CD ka kya hua?” Ah…the joys of dealing with an Indian public sector enterprise right here in America!

You may laugh, but there’s one thing I know – my money is safe with a public sector bank. Until, of course they Privatize Indian banks. Privatization – there’s another politically loaded word.

Photo Credit JasonBechtel

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