Saturday’s discussion about the UBS report, including the post on banker’s compensation, led to some intriguing email from people who must remain nameless because of their professional affiliations.
Included amongst the feedback was the phrase "Creating Fake Alpha," which I had first read in John Cassidy’s Portfolio column earlier this month, titled The Banker’s Bailout:
"Then there is the central and controversial issue of how to pay people who work for financial firms. In blowup after blowup, compensation schemes based on short-term performance have encouraged traders, division heads, and C.E.O.’s to act recklessly.
In the typical case, a trader or executive places a bet that pays off immediately—or soon enough to increase the individual’s bonus or stock-options value—but exposes the firm to long-term dangers.
Examples include Merrill’s decision to step up its production of mortgage securities just as the outlook for the real estate market darkened and Bear’s refusal to keep an adequate reserve of cash on hand. Earlier this year, Raghuram Rajan, a former chief economist at the International Monetary Fund, referred to such behavior as “creating fake alpha—appearing to create excess returns but in fact taking on hidden risks.”
One possible solution to this is to "force traders and
senior executives to take a more long-term view." And the way you accomplish that is simple: Pay the traders and risk managers in stock or options that don’t vest for five or 10 years.
Perhaps when we look back at this era from a future vantage point, we will see that this was the last great era of finance (see today’s WSJ: Is Finance’s Economic Role Ebbing?).
I wonder if the bankers and financial engineers responsible for creating the subprime meltdown and the credit crunch may have finally killed the goose that laid the golden eggs . . .
~~~
What say ye?
>
Previously:
UBS $37B Write Down, Part II: Compensation
http://bigpicture.typepad.com/comments/2008/04/ubs-37b-write-d.html
Sources:
Analyzing Bear Stearns’ Bailout
John Cassidy
Portfolio, Apr 14 2008
http://www.portfolio.com/views/columns/economics/2008/04/14/Analyzing-Bear-Stearns-Bailout
Is Finance’s Economic Role Ebbing?
Sector May Make Up Smaller Part of GDP as Jobs Are Being Cut
JUSTIN LAHART
WSJ, April 28, 2008
http://online.wsj.com/article/SB120933096635747945.html
Related:
Switching boats in midstream to ride out credit storm
John Dizard
FT, August 14 2007 03:00
http://www.ft.com/cms/s/0/0739ecac-49fe-11dc-9ffe-0000779fd2ac.html
Bankers’ pay is deeply flawed
Raghuram Rajan
FT, January 8 2008 18:04
http://www.ft.com/cms/s/0/18895dea-be06-11dc-8bc9-0000779fd2ac.html
To be held responsible for one’s actions has become an arcane concept, especially in light of taking risks with other people’s money. Wouldn’t that fallacy create ‘moral hazard’ at the individual financial institution level?
I think there is a whole new generation of companies that are going to take leadership from the Goldmans and Morgans of the world.
Look a company like Citadel. They have a massive market making biz, control Etrade, own a hedge fund back office biz, in addition to hedge funds. They are poaching talent from the bulge banks left and right. They are slowly moving into all the traditional ibank businesses.
Or Blackstone with their M & A advisory business, real estate holdings and Chinese partners.
Fortress, MAN, GLG, Paulson, TPG, Och Ziff this is the future of finance. They won’t all make it but the next Goldman is a firm like these guys.
Out of sight (for the most part) in partnerships the way wall street used to be. Partners watch their capital, they keep an eye on the long tail risks. Then they go public and get leveraged compensation packages on top of a leveraged balance sheet and the cycle starts again.
The Bush Cartel house of cards is quietly
trembling IMO.
Feel that nausia in your tummy?
Get ready to puke violently after the November elections.
Cheers!
Peter
I don’t know. The Wall Street boys always manage to repeat the past by knowingly (or not) coming up with a new variation of an old scam, and fall again.
C’mon there’s too much money to be made. They boys will be back with a new game in a few years. Some will muddle thru, some will get taken over. Some will sink. Just like in the junk-bond mess.
What we have is classic: a bunch of folks with energy, intelligence, and motivation, but a dearth of ethics. Problem is, even from Flyover Country we can see that there’s an institutional bias to make a buck, damn the torpedoes. What sort of pinhead REALLY believes you can get 8.5% on AAA?
Some sort of financial moronathon seems to surface every decade — its as reliable as sunrise.
k
Nice idea, won’t fly. Carmen’s take is the probable outcome. PR, what on earth are you talking about?
One of my old shops , my Capital Commitment was 9-figures , and the CEO begged me to use it to facilitate trades … compensation was based on % of P/L … hard to change that attitude
Why just fake alpha? WE have:
– Fake M&A to churn out short-term profits and feed grand delusion to investors
– Fake buy-backs to prop-up stock prices
– Fake pro-forma earnings
– Fake agents stealing money from investors
– Fake corporate governance and fake boards who are with the agents and not investors
– Fake CEOs making 400 times company’s janitors who can probably barly pay for their gas tank on a trip to work!
– Fake Private equity guys levering up the society to prop up short-term profits for few and hurting the society
-Fake bankers robbing the bank
– Fake guardians/SEC who lets corporate criminals and CEOs get away with their scams
– Fake “progress” in war-against terrorism
–
– It’s all inside and I guess we human beings have a ‘fake-inside” — and we are bunch of sheeps and not alphas.
That’d be great.
Most of those people in the financial related world are beyond overpaid.
There are few and far in between that actually deserve their compensation.
Over the coming years we may or may not (if JPM tries to cover it up) find out how bad some of those BSC internal decisions were.
Let’s say there’s two choices for a trader:
1) Create fake alpha and get a $500K bonus immediately.
2) Invest for the long-term and get a $1M bonus after 5 years (assuming the positions are profitable, you don’t get laid off during that time frame, your supervisor doesn’t quit and the new supervisor interferes with the strategy, a recession doesn’t happen, etc, etc).
I know which one I’d take.
“…In the typical case, a trader or executive places a bet that pays off immediately—or soon enough to increase the individual’s bonus or stock-options value—but exposes the firm to long-term dangers…”
So start an EFT to take other side of these “bets.” Then buy it and hold it.
I think a ten year time span on deferred compensation that is contingent on the company’s circumstance a decade after the fact will never work. I wish it would, but I don’t give it a chance. The reason I’m so dour–investors’ greed. Investors will NEVER be able to stop chasing the hot returns. If a money manager gets hot, the money will follow. Think of what that causes. Imagine working at a firm that has a 10 year payout scheme. You call your hedge fund buddies and find out they’re getting rich because they had a good 4 or 6 quarters. If you had to wait 10 years, you’d look for a way to get in on that action, and quit the firm with the delayed compensation.
That said, if you make the compensation uniform for ALL financial services companies, including hedgies, and then set up restrictions so that capital couldn’t be invested in countries that would have a more lenient system, then you might make it workable because everyone is on equal footing. But that would never happen.
One unintended consequence to this is that some may fear that limiting compensation would cause Wall Street to lose access to the best and brightest. My question is, is that a bad thing? If you put the kinds of compensation restrictions in place Barry described, you might have a lot of bright people go into engineering or science instead of finance. Maybe a positive unintended consequence.
One thing I think is overlooked is that this isn’t just some big swinging dicks on Wall Street. Every corporation in America bases their bonuses on the short term. Everyone has to make the “end of the quarter”. There are crazy year end “sales” of consumer products by manufacturers to up their volume so that they get their bonuses that are based on volume, not profit.
If you expect this attitude to change, you are UnAmerican. By that I mean, this is how America is set up and to think it is going away because of a few bank failures ignores the fact that all public companies in this country work this way. Wall Street might make up funny names like “alpha” because they have a few more zeroes at the end of their checks but everyone else does it. Pay for short term performance. What have you done for me this quarter. I’ll leave the political nuts to hash out what that means for this country’s long term prospects.
one other thing, try not to act surprised when all the non financial companies get crushed in the coming down turn. You can only hide stuff for so long. But at least you got that bonus last year.
How about not giving stock options for exective performance, rather a percentage of the profits (only if positive in last quarter) based upon a moving 5-year average of profits for the company. If the company loses money short term- no bonus. If the company makes big money short term- mild bonus that averages over the last 5 years. The only way for execs to make big money is to make high average profits for 5 years in a row.
It would probably never work, but it would seem to make the economic incentives of the management more or less line up with those of the long term shareholders. A consistently high dividend would therefore result in a consistently high compensation.
LOL, and we wonder why the dollar is falling. Jesus Murphy…. rotten to the core.
Creating Fake Alpha
One of my favourite economist blogs, The Big Picture, has a post titled Creating Fake Alpha, that highlights once again a malady that western business just doesn’t seem to be able to rid itself of. Namely, the inability to…
In many instances Banks executives have to live with shareholders profits pressure, board members have little knowledge of the banking business; Banks CEO’s design their pay and compensation package in accordance with their peers in the same league (asinus asinum fricat oblige their strategies will be the same)
The whole downstream pressure will be leveraged on the capital markets dealing room as they are the one bringing and making the alpha other business alleys are often contributing on a recurrent mode to profits.
Many measures have to come with prevention of payments bonus derived from risks assets, those should be rewarded with stock options
Capital markets operations should be mechanically downsized through BIS ratios.
Board members should be changed more often
CEO’s should not have cash payment as they are responsible for the risk assets and strategies, the capital market profits in part belong to the traders when cashed and realised.
Since banks are willing to engage in more, business in the fields of the probability of numbers CEO’s should be conversant with maths and probability and they should be more often questioned on their knowledge of their books in derivatives.
It really is possible to be too cynical. Just sayin’
If we consider production capital to be the ‘Golden Goose’, then we must also consider the expansion of claims upon that ‘goose’ and whether it has been up to the task or whether shortfall has been offset via a progressive substituting of fictitious values making claim to one another and the slumping, overloaded, goose.
If we think that finance as such is the goose, we must discover how it is able to survive in the airless sphere of circulation.
Heres the thing; the bank that takes the most conservative approach to compensation is just taking on the big selection bias risk of knowing that they are not going to be getting the top people.
And if you are not interested in the best people, why bother.
A civilization can misallocate assets for only so long before the mistakes demand their own correction.
Looks like we’ve done it again. Credit creation always bumps up against the limits of repayment. Its not a credit crisis, per se, in that it isn’t a liquidity problem. Its a confidence problem caused by a solvency problem.
When excess risk taking is undertaken, primarily when measured by unrecognized costs or deferred/off book liabilities, it always ends in collapse.
Demanding restitution from the fortunate financial engineers who drank deeply at the head-waters of credit creation have much to draw upon. We’ll see how up in arms the populace grows at the magnitude of the incompetence, fraud and corruption.
We are talking about the preference for short term benefit even if it means long term detriment.
Yes, it has been a strong tendency in human beings throughout history, and I’m afraid that there is no ‘solution’ to it, other a preponderance of humans becoming more aware, and shifting their preference towards the longer-term.
That is: no matter what system or regulations you put in place, those regulations must, ultimately, be enforced by a sizable portion of the population of stake-holders. And if the stake-holders don’t care, then ain’t nothin going to be done man.
The preference for the short-term is not necessarily an illogical stance to have: at the most fundamental level, a human does not have much visibility into the future: he knows that he could die tomorrow, therefore there is a tendency to get what he can today.
I see this tendency all over the place, not just in business.
It is the same reason that politicians and public figures cannot speak the truth about major impending shit-storms — they are, or fear they would be, angrily rejected. Work today for something that wont benefit me for 10 years? No way. (Little did he realize… 10 years isn’t really a very long time….)
I must say, though, I think that we are, as a species, slowly… arthritically slowly and unevenly… expanding our awareness, and gradually usurping control from the fear-based parts of our minds. We’ll see, huh.
I think the rise of financial news television mirrors the rise (or bubble) of finance. For years it has been brewing into a national obsession, with people following its course on TV for entertainment. The launch of FBN marked the top of the bubble, but going forward mass interest in finance will wane. It will exit the national consciousness it just as interest in house fix-up TV has declined with the crumbling real estate market.
From my time at UBS, the old school traders, the ones who were not considered “the best and the brightest” (remember, Halberstam used that title ironically re Vietnam), the ones without the engineering degrees, the ones who got pushed out in favor of the quant jocks, they understood, intuitively, these risks much better than the young hotshots.
It doesn’t take a genius to wonder how a bank makes money by pricing some exotic option expiring ten years out, using all kinds of dubious inputs that are impossible to forecast, pricing it at X, selling it for X + 100, then booking that “profit” and making the numbers. The old school guys had to trade the old school way, generating actual P&L that could be easily understood, because they weren’t “smart” enough to do anything else.
Nihilism;
Sir. Wouldn’t you like a fake rating agency to go along with your fake alpha….?
And, may I supersize that for you sir….?
Best regards,
Econolicious
I think observer’s idea could work if fleshed out.
The weird thing about the paragraph Barry quoted is how reminiscent it is of LTCM. They showed these amazing returns, but it was only due to the massive amount of leverage. Their returns on individual trades were minimal, but the leverage made the return look big. Nothing was learned then, so I doubt anything will be learned this time around.
“It really is possible to be too cynical.”
Disagree.
Vermont Trader – good post and I agree. we actually just bought some BX and added to GS, avoiding the big retail banks most likely in perpetuity. what I like about the pools of capital that come from a private equity mentality is that their foundation is premised on real underwriting (i.e. underwriting that focuses on the ultimate exit versus just getting the deal done). to be sure, i imagine that will get corrupted along the way but it will take time. i like that BX is actively closing distressed funds and those fees alone, support the business.
How are you claiming that 10 year options–which will depend more on the economic climate at t+10, not the long-term viability of the traders’/bankers’ actions–any more aligned to outside stakeholders than the current system? This 10yr delay may work best with the C-class managers, but not the hired guns in the rest of the bank. Furthermore, if you tie a bonus to the product’s viability how do you determine whther the products/deals were faulty (especially since the bankers take most of their model’s inputs from the companies) or there were exogenistic issues?
If you regulate this into existence then the best will just continue to leave the big banks for the Citadell’s of the world.
I don’t disagree that something has to be done about these principal-agent problems; i just haven’t heard any good suggestions.
The Epicurean Dealmaker has a great series on this on his site and he and I went after the FT on this exact topic. Check it out.
Fred I own some BX too. I also have FIG, OZM, BLK, AINV, CIM, and FRH. I like FIG the best at the moment. I bought them all over the last couple months, they are 20% of my portfoliom and I intend to hold them through the cycle .
Would also like to buy ETFC because I think this could be a future vehicle for Citadel but Home equity portfolio scares me. Think they may have to buy the whole company and re- IPO down the line.
The vast majority of plans vesting 5 or 10 years out for compensation would never work, and more so, might well punish good performance.
You would have the same problems we have now in different ways; for instance, take the example of the moving five year average for profits. Should my bonus get tanked because we hit a recession in year three? Very long term bonuses, often, would simply mean rather than redistributing based on short-term performance, we are redistributing based solely on luck.
This is ignoring the fact that the average tenure of an employee in finance is much shorter than the vesting period. Why should my bonus (which I don’t even get until I’ve left, apparently) be primarily based on how stupid my successors are, or how unlucky a firm or the general economy is after I’ve left?
I agree that people should have skin in the game, but the methods being proposed here are wildly impractical. Perhaps the best structure remains something like a partnership – the people at the top, in that case, have a very strong incentive to keep things under control. In that case, both their short term and long term profit depend on it.
I also agree with the commentator above that the Epicurean Dealmaker had some good commentary on this. Worth a read.
Yeah, sure, it’s different this time. Until the next cycle.
Reward risky behavior – get risky behavior.
Reward “good” behavior…
Bring back tar & feathering and the public stocks.
amazing how every down turn is followed by assessing blame to short term thinking executives,
should follow the jap thinking the last time around.
news flash to Bar-since last time, there is no place on earth that has innovated to advance the human race like the USA.
instead of offering management advice,
how abt focusing on the morally bankrupt individuals?
these problems-none of them are systemic. They are the result of the unaccountable, irresposiible do it cause it feels good generation wreaking havoc by laying down when the rubber meets the road.
That be your generation Bar.
I do not think I was clear.
Explicitly-
your generation has ZERO accountability,
you made such institutions as marriage and banruptcy laughable jokes.
Now you people are wandering away fr your houses and by so doing are indirectly starving the world.
The suppply siders gave everyone a chance to realize the net present value of their life now, all you needed was a signature.
Not my fault that these people’s lives aren’t worth the paper they signed.
Not my fault these people used home equity to finance new lifestyles and thanks to your generation’s no winners and losers philosophy-no one pays.
It is incredible-money is freedom
in our world, the current administration’s policies have enabled every man woman and child to borrow to advance themselves,
and for it they
are being perptually demonized.
It would be nice to have bonus structures based on a rolling 3 year performance indice, but in as much as investors look at things on a quarterly basis (dividend wise), unless dividends are paid out on a similar rolling performance basis, its all tilling at windmills.