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?
UBS $37B Write Down, Part II: Compensation
Analyzing Bear Stearns’ Bailout
Portfolio, Apr 14 2008
Is Finance’s Economic Role Ebbing?
Sector May Make Up Smaller Part of GDP as Jobs Are Being Cut
WSJ, April 28, 2008
Switching boats in midstream to ride out credit storm
FT, August 14 2007 03:00
Bankers’ pay is deeply flawed
FT, January 8 2008 18:04