Wednesday, October 22, 2008

STFU Barney Frank!

Barney Frank, today, called for a moratorium on all Wall Stret bonuses:

"There should be a moratorium on bonuses,'' Frank, a Massachusetts Democrat, told reporters yesterday in Washington. "They have a negative incentive effect because they are the ones that say if you take a risk and it pays off you get a big bonus,'' and if it causes losses "you don't lose anything.'' The halt on bonus payments should last "until they can get a better structure without that perverse incentive,'' he added. -

Seriously, Barney - shut the fuck up. Leave the asinine liberal populist pandering bullshit to ignoramuses like Pelosi - I thought you, sir, were smarter than this.
Let's start with the "perverse incentive" - is anyone suggesting that we should put a halt on Congressional pay, since Congress clearly has absolutely no clue what it is doing in its efforts to solve this financial crisis? Instead of acting in the best long term interests of our country, Congress is acting under the perverse incentive of pandering to constituents to get re-elected, by preaching things like "we must keep people in their homes," which is in stark contrast to the truth, which is "we should look for alternative housing options for people who cannot and never could afford their homes."
Barney - don't forget that if it weren't for all the perverse incentive risk taking on Wall Street over the last 5 years, America wouldn't have found the easy credit that allowed the constituents you tirelessly pander to to afford these homes they never could have afforded! They were allowed, thanks to the greedy bastards on Wall Street, to obtain mortgages they never should have obtained! Wall Street's ignorance of the actual risks allowed your poor ignorant constituents to bury themselves under mountains of debt - that's really the problem we have, don't forget - that people can't afford their homes. I still don't understand why your Populist Pandering Posse can't grasp this concept: that people who took out loans they couldn't afford bear (significant) responsibility as well!
This scenario has nothing to do with some risk-hungry Wall Street trader losing money. And on that note: this case is nothing like some cases in the past where individual traders lost billions of dollars by making wild bets doomed to fail - this is a case of street-wide failure to assess risk. Again, we don't need to go through the blame game - there are a number of parties at fault - to quote myself:

"The people who took out imprudent loans, the banks who made imprudent loans, the Government Sponsored Entities who guaranteed the imprudent loans, the conservative politicians who pushed for deregulation and figured the free markets would work on their own, the liberal politicians who pushed for the unreasonable goal of home ownership for everyone and exacerbated the debt problem (and who continue to suggest more debt as the solution), the ratings agencies who completely failed in their risk assessments, the people who bought the derivatives instruments and used extreme leverage to create a systematic risk to our country, and finally, the SEC - who first increased the maximum leverage allowed (At the behest of current Secretary of the Treasury Paulson, who was then at Goldman Sachs) and then failed miserably in its oversight roll and was probably most charged with preventing such abuses."

The point is - this meltdown was very much NOT caused by a handful of gung ho traders who threw all risk considerations out the window in search of big paydays - it was caused by a systematic mis-evaluation of risk and ease of credit.
Now, back to the issue - I no longer work on Wall Street, but I can shed a little bit of light on why Frank is off base here. First off, I spent many years on the sell side of a large bank. The sell side consists of multiple segments, like investment banking, sales & trading, research, etc. One reason people don't take absurd risks when they are trading on the sell side is that most sell side Wall Street trading desks get DISCRETIONARY bonuses, not QUANTITATIVE bonuses. That means that when my desk makes $500MM, I may make slightly more than if my desk makes $100MM, but no where near a multiple of 5, and probably much less than a multiple of two. Instead, the money gets spread around to pad the compensation of the other bank employees who may not have had such banner years.
After my time on the sell side, I also spent a few years on the buy side. This means I was working for a group whose job it was to take money (in my case, it was the bank's money), trade it, and make more money. I still didn't have a quantitative payout, but my group's net compensation was a quantitative pool based on how much money we made. Did we just throw caution to the wind and punt around massively risky trades? Of course not. Why? Because we wanted to be there for a while! It's absolutely true that we could have undertaken trading strategies which had higher risks: higher possibilities of large gains, and higher possibilities of large losses, and that if we had sustained the large losses we would NOT have had to repay them. We would have, however, lost our jobs, and our right to try to make annuity type income streams taking moderate, calculated risks. In addition, it would have been impossible for me to take risks which sunk my bank, let alone Wall Street and the U.S. financial system as a whole - because we, like all banks, had stringent risk controls in place. There are teams of people who looked at our positions on a daily basis, and questioned us if concentrations or risks appeared to be getting above their thresholds.
What really went wrong in the current collapse is not that one trader took a crazy bet that blew up the Street - it's that HUNDREDS of traders all had similar positions on, based on new innovation of products that capitalized on cheap money and underestimated risk assessment, and they all hit their six-sigma loss scenarios at the same time. A glut of new and innovative products where the risks could not be easily calculated in the distribution tail scenarios resulted in losses that people thought could only happen once every 1000 years. In reality, they seem to happen every ten years (LTCM, 1998). Maybe that's because the government bailout of LTCM didn't make the problem go away, it just buried it for a while! That's a discusssion for another day...
Also unfortunate for Barney Frank and the government is that in their infinite wisdom, they decided to try to prop up the stock market at the same time they were trying to help the financial system (and PLEASE - note that those two are very different things) - and instead of taking common equity voting stakes in the banks, they bought preferred equity with no votes (and a relatively crappy dividend to boot!) - so shut the fuck up! If you'd came in and given the banks the same kind of assistance you offered FNM, FRE, and AIG - which resulted in controlling interest in those firms, you'd have a big say in the compensation structures they employ. Instead, the government erroneously attempted to halt the stock slide and the credit slide at the same time - and resulted in cutting themselves a crappy deal.
Barney Frank - use your brain to educate your fellow congressmen, who, sadly, are much more ignorant than you in the ways of finance. Don't blame America's problems on the compensation of the Wall Street aristocrats - point out that the constituents you are pandering to are a huge part of the problem, and stop sugarcoating the issue that the root of the problem is their inability to pay - not Wall Street's excessive pay. The root of the problem is that people can't pay their mortgages - not that some idiot gave them mortgages. And please, whatever you do - don't subsidize the people who can't pay their mortgages by reducing their outstanding mortgage debt. If you don't allow home prices to come to a natural level, the problem won't go away. Restructure interest rates if you have to - take people out of their 5/1 ARMs and put them in 30 year 5.5% loans - but don't do something crazy like reducing the mortgages to 85% of the reduced mark to market home value. That's a horrible socialist solution that rewards imprudence and prolongs the house of cards.

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