Canadian Finance Blog

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When Greed Is Not Good Posted: 19 Feb 2011 02:00 AM PST The following excerpt on greed is from The Meltdown Years, written by Wolfgang Munchau and published by McGraw-Hill. Some people always get worked up when they hear that some banker earns dozens of millions of dollars a year. It is difficult to imagine that the endeavor of any human being, let alone a banker, could be so profound as to earn such compensation. I would agree with that proposition. My reaction has always been: let stupid shareholders pay however much they like to whomever. There is no way to justify such salaries. But then again, it is not my money. This was our ultimate consolation. That, as it turned out, was a misjudgment. When the big banks and insurance companies got bailed out by their governments in New York, and in London, the top executives nevertheless insisted on their bonus payments. AIG, probably the most incompetent financial company of all time, had to be bailed out to the tune of $160 billion, and yet its executives felt they were entitled to several hundred million dollars worth of bonus payments. Of course, these bonuses were small relative to the sums involved in the rescue of the bank, but they symbolized the unfairness better than anything else. Bankers were so incompetent that they had to be bailed out by the government, and then they rewarded themselves for their failure. It is no surprise that this outrageous behavior has greatly contributed to what I call regulatory revenge. It may or may not be a good idea to levy surcharge taxes on bonus payments, but the financial industry has no right to complain. They handled the situation with such incompetence and insensitivity that this result is inevitable. They have left behind an incredible space of torched earth. There is reason to suspect that the bonus system played an important role in this crisis. It created incentives for traders to take on excessive risks. If the risk resulted in failure, it was most likely to be a systemic failure. This means: Heads you win, tails you get bailed out. So this attitude was a clear example of privatizing gains and socializing losses. But how could traders and their superiors take on such risks? The reason was they were in a unique position to extract high rents, as they were sitting on the sources of funds to finance the economy. Money and finance are catalysts for economic activity that would otherwise not take place. If, in an old-fashioned banking system, you run the only bank in town, you would be in a position to charge monopoly prices. Everybody would have to come to you. The modern financial world was an oligopoly of a few large institutions. Most of the activity in the business for credit default swaps (CDSs)—a market with a notional value of some $62 billion at one time—was controlled by a group of ten banks. There was a handful of large investment banks, and a group of large global commercial banks that ran most of the business. Almost all the transactions in this transaction-oriented form of capitalism went through them. If you wanted an interest rate swap, chances were that the swap was organized by one of those large banks. Oligopolies can be fiercely competitive, but they generally do not produce ruinous price competition. This was certainly the case in the financial sector, where chairmen habitually spent millions installing open fireplaces in their fiftieth-floor office suites, where executives and traders expected to receive large bonuses, to be paid early and on time each year. Just think of how the bonus system worked in our credit bubble. Each year, the CDS market would more than double. Companies had no time to go bust, as one trader famously put it. The safest way to make money was to take on maximum risk The more of these toxic papers you created, the bigger your profit, and the bigger your bonus. There was virtually no immediate risk in such transactions, and the long-term risk was not apparent. For as long as the bubble continued, the CDS Ponzi game worked. The case for regulating bonus payments is therefore very clear. The system as it works at the moment produces the wrong incentives. It has what economists call negative externalities. The bonus payment may benefit the recipient, but it harms society by setting perverse incentives. The idea that bonus payments are needed to attract the best and the brightest is complete hogwash. These people were not bright, they were merely risk-loving. And taking on too much risk is never a smart idea. The bonus system was an important factor in this crisis, and it certainly deserves our regulatory attention, to put it mildly. There is a strong case to tax these bonuses out of existence, or at the very least to create bonus systems that are far less extravagant, more long-term oriented, and most importantly, not procyclical. But alas, the bonus system did not cause the financial crisis. It was in place long before this crisis erupted, long before the bubble. It was one of those many factors that contributed to the crisis. The current situation would have happened without it. As disgraceful as those bonuses may be, we should strike them off our list of fundamental causes. Related Posts: Low Interest Rates: The Good, the Bad and the Ugly Trading Psychology Insurance You Can Do Without – Credit Card Protection Insurance When Greed Is Not Good originally appeared on Canadian Finance Blog on February 19, 2011.

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