Too much risk, too much reward

For those who may be too young to have been around in his heyday, Henry Kaufman, aka Dr. Doom, was one of the preeminent economists during the early to mid 1980s, when his firm, Salomon Brothers, ruled the bond markets. Kaufman had a particularly well honed ability to read interest rate trends, no mean skill when that was where the action was (during the Volcker-induced recession of 1980-1982, equities were seen as a has-been). He is also a particularly articulate speaker and writer.

Kaufman is still highly regarded. For example, after Bernanke's October presentation at the Economics Club of New York, Kaufman asked him a question from the floor. Mere mortals don't get to do that.

Today (3/1/08), in the Wall Street Journal, Kaufman criticises the Fed on its policies towards transparency. He argues that the current mix, transparent monetary policy and opacity in financial markets, has not only helped fuel asset bubbles, but will also impede the return of stability.

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Kaufman avoids polemics of any kind and goes to some length to be factual and dispassionate. Nevertheless, his article sets forth how a short-term focus took innovations that could have been salutary and instead rendered them toxic. In large measure, this happened because the inmates are running the asylum. Senior managers are hostage to mid-level producers, who could take their business to another firm or form a hedge fund.

And these internal entrepreneurs have every incentive to take huge risks. If they win, they'd get a handsome payout. And if they lost, even if they lost their job, Wall Street is remarkably forgiving. Many number traders who have been responsible for noteworthy meltdowns (the poster child being former Salomon star and head of Long Term Capital Management John Meriwether) go on to successful second and third acts.

This is nevertheless a fundamental indictment of the incentive structures of the financial services industry. And it results primarily from the fact that these firms are now public.

In the old days of private partnerships, it wasn't just senior management, but also the leaders of the revenue producing units, which were often quite narrow, who were owners. Profits were retained largely within the firm, creating long-term incentives. And while talented young performers were well paid, the big prize was joining the partnership, which enabled the partners to rein in current compensation.

Now with public shareholders, everyone is paid on a current basis (even executive option plans tend to operate in addition to rather than in lieu of bonuses) and there is no particular reason to be careful with the house's money. Even though Morgan Stanley CEO John Mack decided to forego a year-end bonus, the firm's bonus pool was $10 billion. Note that it has also secured an agreement from China Investment Corp, to invest $5 billion, ostensively to shore up Morgan Stanley's capital base after a fourth-quarter loss of $3.6 billion.

Looks like Morgan Stanley sold equity so it could pay out bonuses, a move that would have been unthinkable 20 years ago.

Back to Kaufman. He discusses in detail how the Fed's move towards greater transparency has in fact backfired in terms of helping it achieve its institutional goals. And he point out how the libertarian/free market ideology so dear to Greenspan and widely accepted in the American culture cannot readily be reconciled with the cold fact that there are institutions too big to fail, and the number that falls into that category has increased over time. More disclosure of their risk-taking is a minimum requirement, and although Kaufman does not say it here, more regulation is likely necessary as well.

Posted by Yves Smith on Naked Capitalism, Thursday 3rd January