Bill Totten's Weblog

Tuesday, March 24, 2009

Is Obama Running Interference to Protect Bankers' Pay?

by Rolfe Winkler, CFA

Option Armageddon (March 22 2009)

According to the New York Times, the administration is considering all kinds of new rules in the wake of the AIG bonus scandal. These include tougher rules for mortgage lenders, new oversight powers for the Fed, and a new exchange/clearinghouse for derivatives trading. Most interesting in terms of intra-governmental politics, however, may be Obama's proposed restrictions for executive pay (emphasis mine):

"The Obama administration will call for increased oversight of executive pay at all banks, Wall Street firms and possibly other companies as part of a sweeping plan to overhaul financial regulation, government officials said …

"The new rules will cover all financial institutions, including those not now covered by any pay rules because they are not receiving federal bailout money. Officials say the rules could also be applied more broadly to publicly traded companies

No specific policy proposals have been made yet, so it's tough to offer firm opinions about the above. Nevertheless, I'd like to chime in with early thoughts on the pay proposals. In a nutshell, I think Obama may be trying to wrest control of the pay debate from pissed off Senators and Congressman. This is a shame because Congress, in all its outrage, might actually have stumbled onto sensible policy …

The administration's proposed pay restrictions sound to me like a rearguard action. Friday the House passed a bill that would essentially confiscate bonuses paid to all employees making over $250,000 at companies that have received $5 billion+ of bailout money. You know Timmy Geithner and Sheila Bair don't like the sound of that. Both have made clear that Wall Streeters should get paid whatever amount appropriately incentivizes them to clean up their own mess. How to compromise with angry lawmakers that want stricter restrictions? Perhaps by cutting a wider swath in terms of companies affected while limiting the restrictions at any one company to only its most prominent corpulent felines.

The House proposal, remember, confiscates bonus income (including, potentially, non-cash bonuses!) for everyone making over $250,000. It would only impact a handful of companies in particular, but the total number of affected employees would run well into the thousands.

Contrast that with Obama's nascent plan, which, according to the New York Times, affects executive pay. "Executive" tends to be code for the top guys listed in the proxy: CEO, CFO, General Counsel, COO, those types. To placate House members who want more sweeping restrictions, the administration says it would regulate "all financials" and possibly other publicly-traded companies - not just those receiving the biggest bailouts.

The House's version is superior for two reasons: It hits the right companies and is appropriately draconian.

First of all, government has no business making compensation decisions on behalf of the private sector, which is what Obama would do by subjecting so many companies to executive pay restrictions. The House bill doesn't do this. By hitting only those companies that have received over $5 billion of bailout money, it dodges the private sector entirely. How so? The companies that have received the lion's share of bailout money really aren't in the private sector any longer. For one thing, they continue to draw breath thanks to TARP, FDIC and Fed life support; they owe their lives to forgiving taxpayers who've not yet chosen to pull the plug. For another, the risks on their balance sheets have ostensibly been socialized. For all intents and purposes, this makes their staffers public sector employees. As such they should be subject to whatever pay restrictions taxpayers' representatives see fit to establish.

And the pay restrictions are so draconian they might accomplish needed banking reforms simply by driving those most responsible for the bank crisis out of the business. At the very least, it would reduce individuals' incentives to take big risks.

In recent years the biggest profits - and the biggest bonuses - were generated by largely dubious activities. To take two examples, investment bankers and propriety traders have been vastly overpaid relative to the value they've added.

Investment bankers intent on maximizing fee income basically abuse their companies' balance sheets in order drive deal flow. They leverage their leverage. They aren't paid to care about the quality of their deals, or the risk borne by the boss's balance sheet. And far more often than not, their deals destroy value anyway. As for propriety traders, they are little more than ultra high-stakes gamblers. It's beyond foolish that we allow them to make their bets with the same balance sheets responsible for generating the majority of the economy's credit. Of course some are great traders, but it's a zero sum game. For every Boaz Weinstein (vintage 2007 and before anyway) there's a Ralph Cioffi. The industry's collective balance sheet isn't strong enough to withstand the failures - counteryparty risk anyone? - so the profits earned by the good ones are largely a mirage.

Trading and investment banking need not disappear of course; they just need to be gone from the commercial banking sector, for which the only remaining charge should be the prudent allocation of credit. If bulge bracket banks face the severe pay restrictions outlined in the House bill, they probably would lose much of their rock star "talent". Fantastic. I can think of no better indicator of progress on bank reform than to see the industry return to its stolid past.

In the old days, when Wall Street firms were still partnerships, everyone took a hit when times got tough, including top producers. They all understood it was a survival issue for the firm.

Now that survival is not a question (government: "there won't be any more Lehmans") these employees have the luxury to retain their sense of entitlement. "But we earned these bonuses". Nonsense. But for taxpayers, their firms would have gone horizontal months ago. Is $250,000 not significantly better than $0?

Yves Smith from Naked Capitalism notes "everyone used to complain about welfare queens. What would you call this level of entitlement? They are every bit as much wards of the state as welfare recipients, and fail to recognize it. No wonder the public is furious."

Perhaps the best indication that the House bill is good policy: bulge bracket bankers are vociferously opposed …

Bill Totten


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