UNFORTUNATELY, WALL STREET STILL KNOWS BEST

Apart from being the type of financial reform that only the comics at Monty Python could appreciate, the new financial reform bill does almost nothing with regards to change the structural conditions that led to the 2008 market collapse. John R. Talbott, author of The Coming Crash in the Housing Market (2003) has a detailed master list of what makes the financial reform bill largely toothless.

But the real sin that I see in the financial reform legislation is not what it leaves out, but in it's premise. Fundamentally it's guided by a corrupted and failed ideology where the God's of Wall Street can say one thing ("When we're in trouble you need to bail us out") and then say another to Main Street ("When you're in trouble you can eat crack").

While our market ideology is supposed to be guided by the principle that if you work hard you will get ahead - which is the moral justification of capitalism - it's been turned on its head by Wall Street's new guiding lights of favorable legislation and unnecessary tax cuts. While the first corrupts the ideology, the latter deprives the state of the funds it needs to function.

Worse, after experiencing a catastrophic market collapse caused by 30 years of following Wall Street's "No tax, No Government" approach to public policy our political mandarins continue to believe that we need to appease the God's of Wall Street, as if they just did our nation a favor. What they don't understand is that the Wall Street's market players today are little more than rats on a sinking ship.

The failure to extend unemployment benefits, and the rather weak financial reform bill in front of Congress now, makes it clear that Congress is prepared to appease the Wall Street Gods. What they conveniently ignore is that unemployment benefits are needed because of what Wall Street did, and should not be determined by the sense that Wall Street will be offended by another $33 billion in debt (especially since we could pay for the benefits by retroactively taxing Wall Street's undeserved bonuses).

What our national leadership doesn't seem to understand is that as long as Wall Street is able to live by one set of rules, while Main Street is supposed to live by another, their concern over a few billion dollars in additional debt, and focusing on a set of weak "structural reforms" is akin to rearranging deck chairs on the Titanic. Want some evidence? Check out these two charts.

When compared to other economic downturns in the post-war era job losses have never been as steep as they are now.

Worse, the period of unemployment has almost doubled during this recession compared to other periods. It's one thing to be unemployed, but to be unemployed with no prospects on the horizon can be downright depressing.

The problem is that while Wall Street and their patrons have secured favorable legislation that's allowed them to change the rules of the game in their favor ("Bailouts & taxcuts for us, austerity & no job security for you ..."). This has created a situation where, as Les Lepold points out, there's "too much wealth in the hands of the few and too much power and wealth controlled by Wall Street".

While the new financial reform bill does little to limit this power and wealth, our too-big-to-fail banks, as Lepold points out, "are still with us--and cockier than ever." He adds:

Very few commentators or policy officials have the nerve to call for restoring taxes on the super-rich to the levels they paid from the 1930s through the 1970s. (Back then, their tax rate was up to 91%. Now they pay as little as 15% because they can claim their booty as "capital gains.") The 10 leading hedge fund managers each "earn" an average of $900,000 an hour (not a typo). Public officials and pundits should be calling such wildly excessive incomes a disgrace to democracy--especially given that without taxpayer bailouts the financial elites would have earned nothing at all. Instead we are told to admire the robbery as if it were a sign of entrepreneurial genius.

And, sure enough, we continue to admire the robbery. Think about it. How else could a group of people who caused our economic meltdown turn the tables and then be rewarded financially (bonuses & bailouts), legally (waivers), and with a politically opportunistic movement (Tea Party anyone?) that does their bidding? That Wall Street continues to have so much political influence after making a mess of things should be a national embarrassment.

At the end of the day, Wall Street and their political muscle in Congress continue to perpetuate the lie that we live in a free market economy. We don't (read The Myth of the Market). The reality is that Wall Street has become a voracious gambling den governed by favorable legislation and an irresponsible and clueless plutocracy.

Still, in the eyes of Congress, Wall Street continues to know best. Let's be blunt. As long as we continue to believe all we need to do is tinker on the margins of Wall Street's world, reform or no reform, we're in deep trouble.

- Mark

A PRIMER ON CEO PAY

If you want a primer on what's wrong with our nation's executive compensation system, this open letter from Yves Smith at nakedcapitalism.com is a good place to start. It focuses on the perverse incentives that encourage the Chief Executive Officers (CEOs) of America's largest financial firms to embark on reckless "heads I win, tails you lose" business strategies. 

These reckless business models compel industry CEOs to focus on extracting rather than creating wealth. All of this is detrimental to both sound business decisions and the principles that surround market capitalism. Here's Yves' letter to Sheila Bair, Chairperson of the Federal Deposit Insurance Corporation. My synopsis and final comments are below.

Dear Chairman Bair,

America can no longer afford to have a banking system that serves the ends of its executives rather than those of taxpayers and communities who have been saddled with cost of reckless profit-seeking. The FDIC proposal to tie deposit insurance premiums to the incentives in executive compensation programs would be an important step forward towards making sure that bank managers operate in a way that reflects the value of the extensive government support and safety nets they enjoy. Bank officers should not be encouraged, as they are now, to take “heads I win, tails you lose” bets with deposits.

There is no question that the annual accounting/bonus cycle is badly out of line with the time horizon of many of the wagers that financial institutions take. Unfortunately, the belief that using stock options or restricted shares as an important part of compensation would lead to responsible behavior has proven wildly false. Both Bear Stearns and Lehman had substantial equity ownership at both the executive level and among the rank and file. By contrast, when Wall Street was dominated by private partnerships, so the management group was jointly and severally liable for losses, the sort of profligate risk-taking that took place in the run-up to the global financial crisis was virtually unheard of.

Unfortunately, all compensation arrangements at public companies are inherently, “heads I win, tails you lose.” No matter how badly a corporate team performs, its pay is immune from clawback, except in the case of fraudulent conveyance in bankruptcy, and even then, the “lookback” period is usually shortly before the failure of the firm. By contrast, it often takes years to reap the bitter harvest of bonus-flattering decisions.

It may be that the only way to cope with the agency problems inherent to risk-taking in a public firms is to make pay arrangements more symmetrical, as in to find ways to recover compensation from executives and senior business unit managers who managed and led programs and products that were ultimately destructive to their companies. The better the arrangements of the old private partnerships can be approximated (admittedly a tall order) the better.

In addition, I would encourage you to think hard about the perverse incentives posed by acquisitions. One of the striking developments in the US banking industry over the last 20 years is an increase in concentration, particularly among the largest players, which has played directly into our current “too big to fail” policy problem. The usual rationale given in greater efficiency, that is, that bigger banking is cheaper. Yet every academic study I am aware of has found the reverse: that once a minimum threshold is reached (there is some disagreement as to where that lies), banks in the US exhibit a slightly negative cost curve, which means the bigger the bank (measured in assets) the higher its cost ratios. Thus the dramatic expense cutting that occurs in the wake of acquisitions could have been done by each of the merged institutions, separately.

Another reason to be skeptical of bank acquisitions is the poor track record of mergers generally. Virtually every academic study ever done has found most mergers “fail” as in they deliver negative outcomes to stockholders.

So why do deals continue? First, there is a large constituency that promotes them because they are particularly lucrative, in particular, investments bankers (who collect M&A and financing fees) and management consultants. A host of other “helpers” such as lawyers and accountants also reaps fat fees from deals.

But the biggest incentive is again flawed executive compensation. Bank CEO pay is highly correlated with the size of the institution, measured by total assets. And the senior team of the acquired bank is effectively bought off via golden parachutes.

I strongly encourage the FDIC to remove the incentive for executives to bulk up their banks solely to pay themselves more. One way might be to require that executive bonuses be set in relationship to the pre-acquisition peer group for a substantial initial period (at least three years, better yet five) and be benchmarked against the new peer group of bigger banks only if the merged entity had met certain operational performance targets.

I also asked readers of my blog, Naked Capitalism, to offer their comments on the proposal that you, Vice Chairman Martin Gruenberg, and Thomas Curry are supporting. They are glad that the FDIC is serous about bank reform and are keen to see meaningful measures implemented to curb executive-serving, public-endangering compensation structures. I am attaching their remarks.

Sincerely,



Yves Smith

For those of you who aren't used to picking through the details, this is what Yves Smith is suggesting that Sheila Bair take a look at:

1. Excessive risk taking with short-term profit time horizons, and little to no liability for the CEO.

2. Paying CEOs with stock options that allow cash-outs with no loss price incentives, no matter how poorly the firm is doing.

3. No salary/bonus clawback provisions (like a retroactive tax) for executives who made short-term dumb decisions that collapsed firms after they left.

4. Unwarranted and inefficient mergers that benefit only a select few professionals at the top.

5. Volume-based compensation schemes which insure that the bigger the institution, the bigger the CEO pay schedule (which helps to drive mergers).

As one of the commentators added in the thread, it doesn't help that we have "zombie boards" made up of CEO friends and market sycophants, who also want the CEO to vote them big salaries on the boards they oversee. There's more to the story, but all of this is a good beginner's handbook for understanding what's wrong with Wall Street, and it's executive pay packages.

- Mark

WHY I SUPPORT TAX CLAWBACKS

The following has become a standard move for failing businesses ...

As we saw in the financial sector during the market meltdown large companies that get into financial trouble often pay their executives a lot of money, regardless of performance ... When companies (like Bethlehem Steel and U.S. Air) actually go bankrupt company executives will drop their underfunded pension programs in the laps of the the federal government ... The federal government, in turn, is charged with stabilizing and fulfilling "private" retirement obligations. The following helps explain how this works.

In January Nortel Networks filed for bankruptcy protection in the U.S. and Canada. Because Nortel had underfunded their retirement program their workers were left with roughly 58 cents on the dollar for their pensions. As a result of Nortel's bankruptcy the federal Pension Benefit Guaranty Corporation (PBGC) - which receives no money from general tax revenues - stepped in and took over Nortel's underfunded pension plan in July, and became its trustee on September 8.

Now for the fun part.

At the same time the company was going bankrupt Nortel was also cleared by bankruptcy judges to pay it's top executives and managers about $45 million in bonuses. The rationale was a simple and, by now, a standard industry meme: They had to compensate these talented people for their "high level of expertise." If you're wondering, since 2005 these talented experts helped the company lose over $7 billion.

Today, while Nortel Networks Retirement Income Plan has assets of $716 million, it has liabilities of $1.23 billion. Still, the PBGC believes that they will be able to cover the entire $514 million pension shortfall through other investments and insurance premiums (although this is far from a sure thing).

If you're keeping score at home, this is what we have.

* GOVERNMENT SAFETY NET: Private companies that go belly up while paying their executives big bonuses have found they don't have much to worry about. When it comes to funding pensions they are learning that the federal government will eventually pick up the tab, and their mess.

* ARTIFICIAL PROFITS/INFLATED COMPENSATION: Company board members and other executives who see the PBGC as a safety net are then able to shift money that should have gone into pension funds into other areas. This artificially inflates profits and, no doubt, increases bonuses.

* LOST STATE REVENUE/CORPORATE SUBSIDY: When money that the PBGC earns is siphoned off to pay for underfunded corporate pension funds - instead of being looped back as "profits" into the general fund - the process acts as yet another corporate subsidy.

I don't know about anyone else, but these developments tell me that we need tax clawbacks applied to the salaries and bonuses of executives who run their companies into the ground, and then dump their underfunded pensions on the federal government.

- Mark

THIS IS WHAT I'M TALKING ABOUT ...

A week ago I posted the following: Let's RETROACTIVELY tax bonuses of executives who ran their companies into the ground and then asked for and received TARP aid. I was thinking we could tax the more than $18 billion in bonuses at a 90% rate, or something like that. Even my liberal colleagues here at the university thought I was nuts.

Then we got Sen. Claire McCaskill's call to limit CEO compensation. I became a happy camper. Now that I've (finally) read the specifics of Senate Bill 360 I'm an even happier camper.

Specifically, these are the parts I like:

(a) ... no person who is an officer, director, executive ... may receive annual compensation in excess of the amount of compensation paid to the President of the United States.

(b) Duration- The limitation [of CEO pay & bonuses] in subsection (a) shall be a condition of the receipt of assistance under the TARP, and of any modification to such assistance that was received on or before the date of enactment of this Act ...

In plain English, this says that the executives who received big bucks after TARP was enacted can keep $400,000 (what we pay the president) but will have to pay the rest of it back.

And I thought my 90% clawback tax proposal was far fetched. Go get 'em Claire McCaskill.

Maybe we'll finally bring some semblance of market reward back to the system, and save America in the process. And no, I'm not being overly dramatic with my last comment. Our system of compensation and reward is so out of whack that the moral justification of capitalism is in peril.

Like I said, SB 360 makes me a happy camper.


- Mark