Regulating Systemic Risk and Banker Compensation Will Not Fix What Is Broken on Wall Street

Thirty years ago, Salomon Brothers and Goldman Sachs were two of the "bulge bracket" underwriting firms that dominated Wall Street. Both firms with partnerships with trading cultures that characterized their organizations. It was a time when Wall Street firms were looking far and wide for ways to increase their access to capital. Trading firms make money by making bets. More capital meant bigger bets. Bigger bets meant more money.

In 1980, in pursuit of a bigger balance sheet, Salomon CEO John Gutfreund negotiated the sale of his firm to Philipp Brothers, then the largest commodity trading firm in the world. The sale was not without controversy. Within Salomon, bond traders--led by Salomon family member William Salomon--opposed the sale. How, they asked, would traders be paid their due in the event the new firm lost money in other far-flung commodity businesses? As partners, they had a reason to be concerned by over-expansion into business lines that they neither understood nor controlled. They did not yet appreciate the benefits of trading with Other People's Money.

But the sale of Salomon went through--John Gutfreund pocketed his $30 million bonus--and over the next few years, the new firm, Phibro-Salomon was acquired by Travelers Insurance. Travelers, in turn, was acquired by Citibank, to create the financial supermarket that was supposed to give American banking a global dominance to match the well-capitalized Asian and European counterparts.

The Salomon story was part of the evolution of Wall Street over the past thirty years, as the storied Wall Street firms succumbed to the lure of capital to give up their partnership status and merge into commercial banks and to become publicly traded corporations. And while these firms did achieve their goals of increasing their access to capital--and ultimately won back their access to the massive pools of depositor money insured by the FDIC--the cost to the rest of us has been significant.

Where, after all, was William Salomon when Lehman Brothers decided to bet the ranch on collateralized mortgage securities that would ultimately bankrupt the firm. Where was William Salomon when Bear Stearns increased its leverage to thirty times, based on financial models that few in the firm really understood. And where was William Salomon when Joseph Cassano, the head of AIG Financial Products took the insurance giant headlong into the credit default swap business.

There was a moment when Cassano made his case to the AIG Board of Directors. The credit default swap contracts that AIGFP was providing to financial giants such as Goldman Sachs had no risk to AIGFP, argued Cassano, and therefore all of the annual receipts paid to AIGFP under those credit default swap contracts could be taken as current income--and used to pay very large bonuses--rather than held as reserves against future risk. CDS contracts are essentially insurance contracts provided to guarantee against defaults on corporate bonds, but Cassano argued that the bonds were so strong that there was no credit risk, and therefore the money paid to AIGFP was essentially free money.

But there was no William Salomon on the AIG Board of Directors. Unlike the old Wall Street partnerships, directors of corporations are largely insulated from the financial consequences of their decisions. Had AIG been a partnership like the old Salomon Brothers, a William Salomon would likely have asked the logical question of Joseph Cassano:

Goldman Sachs is paying us tens of millions of dollars a year, but you are telling us there is zero risk. One of us is wrong. This is a game of poker, and there is an idiot at the table. And you are telling me that Goldman Sachs is the idiot? I don't think so. I think we are the idiots at this table. If Goldman Sachs is paying us tens of millions of dollars a year, we are taking risk, and we sure better know what that risk is, because we are betting our future on it.

But, of course, AIG was not a partnership, and the rest is history.

But the Phibro-Salomon story had one chapter left. This summer, Citibank--the failed financial supermarket that is now a ward of the State--sought approval from the US Treasury to pay bonuses in order to keep a group of highly profitable traders from leaving the bank. The bonuses--the most famous being the $100 million for Andrew Hall--were to be for traders in its Phibro commodity trading subsidiary.

William Salomon saw the writing on the wall. The partnership trading culture that was critical to Salomon Brothers success--a culture that combined incentives and accountability--would not survive an evolution into a corporate model. What we have learned is that the incentives to make big bets and take big risks has survived, but without the accountability. Andrew Hall made $2 billion for Citigroup placing energy bets, and was due to be paid $100 million. But what of those whose bets lost Citigroup $2 billion? They have not even lost their jobs.

The trading firms gained the access to the capital that they sought in the 1980s, and they found the joy of playing with Other People's Money. And for twenty years, the game has gone on.

Heads I win, tails you lose. Or in David Einhorn's more elegant formulation, Private Profits, Socialized Risk.

Today, the US Treasury and the Fed are trying to hold the pieces together. AIG. Citi. Bank of America. GMAC. Fannie Mae. CIT Financial. But why? Where is the evidence that large financial corporations are more efficient at allocating capital than smaller banks? Surely, they have not been sound custodians of depositor funds or of the public trust. Neither have they proven they can deliver more predictable returns on shareholder equity than smaller, more nimble financial institutions, who themselves are increasingly disadvantaged by each bailout. Whose interest has conglomeration served but that of insiders seeking greater compensation with less risk?

One central question to all of this is whether the fundamental corporate model is not central to the problem. Today, absent prosecution for fraud, the CEOs and directors of all of these failed firms will walk away with much of their wealth intact, insulated from the consequences of the decisions they made. For years now, they have been playing with our money.

New regulatory regimes will not be adequate to control this systemic risk. Controlling banker compensation might have a populist appeal, but no one should imagine it constitutes systemic reform. Regulatory bureaucracies cannot control systemic risk in massive financial corporations, because the systemic risk is the massive financial corporation.

Thirty years ago. William Salomon was suggesting a simple truth: Sound decision-making, incentives and accountability require that those who are making decisions and placing bets have their own capital at risk.

Comments

[Carl Caroli]

Where is the evidence that large financial corporations are more efficient at allocating capital than smaller banks? Surely, they have not been sound custodians of depositor funds or of the public trust.

The evidence suggests that large financial corporations spend more money to buy legislatures to do their bidding, not to be sound custodians of the public trust. Regulating risk and limiting compensation is a waste of time, Breaking up TBTF firms is the answer but that would require legislators willing to bite the hands that feed them.

[johnsopinion]

"Regulating Systemic Risk and Banker Compensation
Will Not Fix What Is Broken on Wall Street"

"When you try to change your convictions in order to
change your experience, you also have to first stop
the momentum that you have already built up."

Seth

[legalgirl]

"Regulatory bureaucracies cannot control systemic risk in massive financial corporations, because the systemic risk is the massive financial corporation."

Until we break them up, we're doomed. When employees became "costs" and not "assets," the Dickensonian result was inevitable. The use of the Sherman Antitrust Act to break up monopolies has long been out of favor, starting in Reagan's 1980's California. It is, however, the law of the land and was designed to address the issue of monopolies. Breaking up existing and disallowing the future formation of "massive financial corporations" is the correct solution and there is no reason to hesitate starting this process. There is no demonstrable evidence that corporate existence benefits the public interest; in fact, the opposite has been proven true again and again in the last year by the bailing out of the largest institutions, including GM, etc., with our money. Attempting to maintain the "status quo" with another economic bubble (as we're seeing now) is just kicking the can down the road. Hoping for a kick-start with the "next big thing" is more of the same bubble mentality.

I think we would be wise to ask ourselves what an economy is for. At a minimum, it must provide a measure of civilized stability to the daily lives of its users by providing real access to safety, food, shelter, medicine, etc. This is not the cluck we're getting for our buck today. Time for a change we can believe in.

[raskefing]

The idea that the economic problems in America and the West can be blamed on Wall Street and Bankers generally is very short sighted and even dangerous.
At the core is a financial system and philosophy that believes in power over what is right and fair, a belief
that the purpose of life is to accumulate material things and that the the weak deserves nothing but scorn and the strong has no responsibility to the weak.
average Americans believe in this philosophy hence health insurance and financial support for the poor is socialism , America is doomed to become a banana republic unless the average citizen begins to understand that when his neighbor is hungry soon he will also be hungry. and to become your brothers keeper is not weakness but a true measure of your development as a human being

[outnow]

I did a lot of work with Skinner boxes at UCLA in the Sixties as a behavioral psychologist. Reward and negative reinforcement, pair-associate learning, whatever. Extinction trials - when reinforcement was removed - demonstrated the resistence to changing patterns that were once rewarded and reinforced. We can call this relearning or just extinction. Now with the use of functional MRI brain scans, we can actually visualize the centers in the brain that are activated when there is a reward or a punishment via electrical shock.

It doesn't take genius to figure out that traders and their counterparts are essentially compulsive gamblers. Strangely, there is evidence of pleasure when the compulsive gamblers loses!!!!!! That's right. He takes a perverse pleasure in saying, "Now I'm really screwed." Look at the smug satisfaction on Madoff's face as people punched him on his way to court for sentencing.

The problem is in our genetics. I realized this problem as a child in Reno, Nevada. Watching people gamble away their paychecks. These peoploe will drag us all down if we let them. They need tight rein on all of their activities - punishment included.

[PlaceboStudman]

You really, truly and permanently want to fix what's wrong with wall street and you're going to have to change human nature. The only truly effective way to get rid of the people who are going to capitalize on and abuse people's greed is to remove people's greed. We're going to have to stop giving into our whims to invest in every new little scheme or plot that sounds too good to be true, like the real estate market or the tech market. You want to keep bubbles from bursting, stop creating the environment for a bubble to grow in the first place. Im not saying don't invest in these commodities, I'm saying invest wisely in these commodities. If something looks very popular, look for something else that isn't as popular. Basic risk/reward evaluation. It's really pretty simple. We are a corrupt and greedy society, and the only way to reduce the number of people who capitalize on that greed and corruption, as they do on wall street, is to resist the urges of greed and corruption and actually look out for long term goals rather than short term instant gratification, as we seem to run into every 15-20 years, leading to predictable 15-20 year economic cycles

[NeoconGal]

After what has happened it seems obvious that if any business is too big to fail then it should be broken up. We did this in the past, why can't we do it now?

[PlaceboStudman]

My point is that we should have never let this happen in the first place, and never let a company or an entity become too big to fail from the outset.

This the result of life after Reagan. The idea that any company smaller than Warren Buffett or Bill Gates or the Sultan of Brunai is considered a "small business"