DISQUS

dfriedman · 5 months ago

I don't disagree with you about the sanctity of contracts but it is overreaching to say that Citi shareholders know about Philbro, its star trader, the size of his contract, or even that they have "benefited handsomely" from his skill.

You give shareholders of companies too much credit when you assume that they have this much knowledge about their investment's internal operations. I can tell you from having worked at Citi that there are employees who have worked there for 20 years who have never heard of Philbro.

infoarbitrage · 5 months ago

Dave, isn't Andy Hall one of the top 5 highest paid employees, therefore being disclosed in Citigroup's SEC filings? That is what I meant, not that shareholders had a biblical understanding of Phibro. Only that it's head was being paid big coin.

dfriedman · 5 months ago

Well, that's a fair question. I just looked in their 2008 annual report and don't see any mention of his name.

But, realistically, how many shareholders of Citi (or any other stock) look at the annual report or quarterly report, let alone more obscure SEC filings? My guess is very few.

In any event, I think your larger point about the sanctity of contracts is an important one. But I also agree that compensation schemes need to be rethought.

Bob Brill · 5 months ago

Alignment of incentives: trader compensation in cash and reflected as an increase in the accreted value of their capital account. Thx Roger for sharing thoughtful insights.

Anal_yst · 5 months ago

How many i-bank domiciled traders blow up and/or incurr significantly large losses every year? How many have done so in the past 25 years or so? I don't disagree that the compensation/incentive structure has the characteristics to encourage excessive risk-taking, but at the same time, if a bank trader blows up, everyone knows about it, and his/her chances of gaining further equivalent employment are seriously diminished, no?

infoarbitrage · 5 months ago

Well, yes and no. Remember Howard Rubin at Merrill? Drop $377 million (hide a few trade tickets in a desk, etc.), get a new job as head of the Bear Stearns mortgage desk. It happens all the time. There is a twisted perception on Wall Street that if someone has the stones (and got the rope) to lose big, that they must have the stones (and the luck) to win big. It is simply the managerial manifestation of the asymmetrical risk/return faced by those employed by the corporation and the shareholders. Big losers get hired for big guarantees every day. Odd Wall Street logic at work.

Name · 5 months ago

Roger,

Another problem with investment bank prop trading is that because the firm already has the capital at hand, the trader never has to justify his investment strategy the way someone raising outside capital for his fund has to. Someone who raises outside capital is grilled endlessly on how he proposes to make better than market returns without excessive risks and in the vast majority of cases is turned down. This discipline forces the trader to create an investment thesis that is more than a leveraged momentum play.

infoarbitrage · 5 months ago

This is an excellent point. Honestly, the same applies to start-up founders. If someone just hands them the money, the likelihood that the money will be spent well (and that they are the best ones to build the company) is pretty low. Conversely, if they have to raise the money by pitching, pitching, pitching and pitching, then knowledge and discipline are built into the process. Thanks for chiming in.

Anal_yst · 5 months ago

That isn't entirely true. Traders work to get more and more bank with which to trade and are semi-consistently forced to justify their existence. This is of course a gross oversimplification, but the fact remains worth noting.

hmf284 · 5 months ago

I thoroughly agree with 99% of this post - & wish that you were directly involved in a policy-making / regulatory role. The one point of disagreement concerns employment contracts, which I feel need only be honored if the government isn't financially supporting the employer directly or indirectly (e.g., GS). Also, I think one could credibly argue that force majeure would apply. In any event, I strongly feel that the Obama administration should require anyone making over $x amount (say $500,000) as an employee of the financial sector, to be audited - & also publish annually their average effective income tax rate. I'm very glad that you're blogging again.

John · 5 months ago

"But what if Wall Street moved to a model where books were actually funded (but would still benefit from risk offsets with other books across the firm), returns to capital tracked and auditable track records created? "

Excellent point - although would be extremely difficult to implement.

I've audited banks and investment firms and worked in finance and middle office in both a big IB and a hedge fund. The way most desks are run at banks and how systems interact is a mess, at a fund though every asset is individually funded with real capital. So whilst in the former you only get (flawed) p&l and risk, the latter every relevant measure is almost instantly visible.

Rejigging compensation structure could be an opportunity to really beef up the middle ground between banks' front office systems and the back office and bring it properly into the 21st century. That way we could see better who the real star traders are, instead of lauding charlatans. Like people I've come across who in absolute terms were at a time pulling in $100mm a year, however were trading off a leveraged portfolio of $100bn, at least 10% funded, i.e. 1% return!

ohgod · 5 months ago

I think most of us have forgotten the real reason for this problem of overcompensation (to put it mildly), that of Reagan tax bracket compression. Let us bring back the progressive tax rates that we have had before (which I guess was something else 70% or more) and it will take care of most of the problems (It is stupid to argue that people will look for tax evasive schemes and hence the tax rates have to be lower. As a counter example, we have folks who over speed, use radar detectors etc., but we do not argue that we should hence abolish speed limits)

TonyF · 5 months ago

Roger - Good post. The points you bring up are valid and practical, and many of these point were debated vigourously in the post-Lehman days.

But, taking a step back:
1. Why do banks have to engage in such a level of prop trading (i.e what is the business logic of a principal risk-taking entity like PhiBro, w/in Citi)?
2) Why are the returns on human capital in banking so high?

Dov_H · 4 months ago

TonyF, great point brought up...

The returns on human capital are so high in finance because of:
1) Leverage, obviously allowing employees to scale their work many times over in ways that a different type of worker cannot, and
2) "Flipping" or the ease through which investment positions can be bought and sold many times over in a year. Although perhaps not with a profit each time, this allows much more cash to be made in any given period (sometimes due largely to luck). There is a physical limit to the number of software programs one can write, or the number of bikes a factory can make. Not so for the number of investment positions you can take each month (assuming you keep getting things right).

David_Merkel · 5 months ago

This would work. Good post.

jturner · 4 months ago

As someone who used to trade at one of these firms and still follows the markets closely, I'm still somewhat surprised by the relationship between the dollar and the Gold Price since I would think both would increase during bad economic times.

MutantDog · 4 months ago

I think the problem in implementing this idea would be taxation. I'm inclined to doubt our government would be willing to defer taxing the trader's winnings; and inasmuch as each individual has a different tax situation, the implementation of the scheme becomes problematic.

It also seems like the proposal is to re-implement a partnership-like structure; the eventual cash-outs of which have proved to be problematic in the past.

Still a thought-provoking proposal. Thanks !

JeremyG · 4 months ago

Really glad to see you are blogging again - I've learned so much more about the economics, incentives, and behaviors of the financial services industry (and Washington) from you posts this past year. Please keep it up.

Guest · 4 months ago

This is a very good post. The failure to risk-adjust the unliquidated end-of-year position while paying comp on a current-year basis is the heart of the problem.

I would think that the tax issue could be addressed by escrowing the money subject to vesting later, although I am not a tax expert. But that creates issues for the firm which are the loss of funds for that time and when does it get the tax deduction.

S J · 4 months ago

what are the receivers of bonus money saying to their employees request for their bonuses the employee making the money for the corporation to stay afloat?
If your not happy with what your pay and bonus is "go find a another job.
I also do not buy the fact the excutive is worth 2 million a year are how ever the amount is the truth is they just do not have any concern of how this is draining the economy and no one has the skill are knowlegde to stop this train from another collision. Increase other employees pay so the man want lose his house. The one who has worked for the corporation doing the shipping and receiving for 30 years and can not retire because he lost more than half his retirement this past year.
Is it still not a wake up call that this country has people living in tent cities and the corporate world has no grace what so ever to just accept pay for the performance they have not produced. In fact getting pay for nothing sound syco at it's best.
I have read a 1977 congressional report discusing tax cuts for corporation to keep labor rate down to control inflation but it does not work this way. Goverment spending controls inflation. So the money corporations did not pay in labor went towards large bonuses and they got a tax cut to keep labor down but increased their net income by 10 times and up since 1977. This took a while for the outcome to surface they kept on ignoring this scam that took thousands $ from their own employees making less than a living labor rate and their retirement fund has been bilked. This country has no mshame what so ever when other countries have people in tent cities US tax dollars goes out for humantarin aid but nothing for US citizens living in a tent with their children. How much do the executives deserve in bonuses not one red cent. They have done nothing but brought pilfering and disgrace to our country's reputation over the years. Send them to afgan. mountains to capture osama and then pay a bonus to the one who completes this quest that is the only one who has earned a bonus the one who can save our soldiers lives. What cowards are in the corporate world more than likely they are laughing at all of the jobless and homeless US citizens and this comment w/sp. infractions.

ericshirschberg · 4 months ago

I have put out 2 papers on the topic
A Framework for Risk Based Fund Manager Compensation
and The Four Agreements of Terms and Conditions
both are available at kapitalmarks.blogspot.com
and will hopefully be published thru the Journal for Alternative Investments this fall

Jean Gateau · 4 months ago

The larger issue I believe that people have with the $100M payday, is that the "rule of law" was already broken to save the employer of said trader. Once you have decided to dishonor one side of the rule (bankruptcy), it only follows logic that the other side stands to be dishonored as well. Instead the taxpayer is forced to buy the golden scissors for his own haircut.

Not to sound like one of the one hundred fatalists out here on the internets, but hasn't the entire foundation of free and fair commerce already been jeopardized?

rfreeborn · 4 months ago

There is one additional item you didn't really dive into that I think deserves discussion - simply tying the traders income to investment term.

Quant traders who's books are "closed" by the end of the day have 100% certainty that the trades they made were profitable or not.

Buying and selling MBS that have a somewhat longer term...well....if that's the business you want to be in then you're going to want to stick around a little longer. That's not to say that there is some amount of fee income every year that can be recognized but it's unfathomable to me with Enron fresh in our rearview mirrors that we're allowing this!