Sunday, February 8, 2009

The Disconnect Between The Media, Banks And The Public

The media coverage of the financial crises has been horrible with its penchant for painting a broad brush that all bankers are evil. This poppycock is dispensed by clueless politicians -- President Obama included -- and spread to consumers whose confidence in the system is the lowest in more than a quarter century.

As Jacob Weisberg points out in the Feb. 16 issue of Newsweek Magazine:

One obvious point is being lost in the rush to flagellate Wall Street: the vast majority of toilers in the financial vineyards had nothing to do with the meltdown. Most are themselves victims of poor judgments they didn't make, didn't know about—and would not have understood if they had known about them. The current crisis came about through a toxic cocktail of reckless lending into a government-subsidized real-estate bubble and misjudgments about the risk of complex financial instruments. There were other factors, too. But only a small fraction of people employed on Wall Street worked in areas connected to the big failures. Even within the units that helped to blow up big firms, the damage was done by a minority within the minority.

Weisberg cites as an example AIG, which was saved from extinction by an $85 billion government credit line and is now effectively nationalized.

You'd be justified in directing your anger at Joseph Cassano, who ran the London-based AIG Financial Products subsidiary. This 377-employee unit issued $500 billion in credit default swaps. Losses on these once wildly profitable instruments undermined AIG's credit rating and thereby threatened the global financial system so seriously that the Fed had to step in. But even if you assume that every one of those 377 employees in that London office—the receptionists, the HR specialists, the IT guys—share Cassano's responsibility for downing AIG (and throw in the firm's top management and board of directors to boot), you're talking about less than 1 percent of the firm's 116,000 employees spread among 130 countries.

A week after the bailout, Congress caught wind of AIG's spending $440,000 on a retreat for top insurance agents and reacted as if Bernie Madoff were throwing a ball for Charles Ponzi at Versailles. But as AIG executives not unreasonably pointed out, their ordinary insurance business was profitable, and the people who were making the money for them had no connection to the derivatives madness in London. If the company is going to return to profitability, it's going to have to carry on with its normal business. Like it or not, that business rewards successful salespeople in ways that most jobs do not.

The same point goes for bonuses and salaries. On the larger point, that the gap between executive pay and the pay of working people is a moral scandal, President Obama is surely correct. Financial firms have failed in part because they rewarded people in ways that encouraged them to serve their own interests at the expense of shareholders. Moreover, grotesque rewards for banking jobs are themselves an illustration of how the market can misallocate resources, sending too many intelligent people away from more economically productive (and stimulating and fulfilling) pursuits. But even under a different system, we will need an energetic and creative financial class. Shooting the wounded now won't help us get one back.

Government-mandated salary caps risk institutionalizing failure; creating new, perverse incentives; and deterring talent when it is most needed. A CEO who can turn around Citigroup—which could save tens of billions in taxpayer funds—is worth a lot more than $500,000. If punishing all for the sins of a few is unfair, it is also likely to prove counter-productive. The economy will grow again only with a revival of what Keynes called the "animal spirits" of financiers and capitalists. Bankers have to be willing to lend money and take risks again.

While Weisberg pontificates a broad clemency for bankers, only Wells Fargo of the eight major banks receiving $350 billion in bailout funds has ratchet up its consumer loans and began quarterly dividend repayments to Treasury.

The national credit crunch remains as seen in the dismal consumer borrowing rate in December.
The Federal Reserve said Friday that consumer borrowing dropped at an annual rate of 3.1 percent in December. It declined $6.6 billion. It followed an $11 billion drop in November that was the biggest monthly plunge on records going back to 1943.

The weakness in December reflected a big 7.8 percent decline in the category that includes credit card debt, and a 0.2 percent drop in the category that includes auto loans. The cutback in consumer spending, which accounts for about 70 percent of economic activity, is the major reason the overall economy, as measured by the gross domestic product, contracted at an annual rate of 3.8 percent in the final three months of last year. That was the biggest drop in the GDP since 1982.

While Wells Fargo may offer a beacon of light, small subsidiary banks are ruining homeowners. Aurora Bank refused to renegotiate causing my son to file bankruptcy even though he has a well-paying job and his wife works. His attitude is sour on government, bailing out banks that won't lend and refusing to help homeowners in foreclosure.

The thousands of community banks which are on solid economic footing share that same criticism of the federal government. Why, they ask, is the government rewarding failure to their chief competitors.

Now, about Obama's proposed $500,000 salary cap on new loans to banks and investment houses receiving TARP funds.

Unfortunately, while this move rightfully punishes yesterday's fools, it may inadvertently create tomorrow's culprits. The Treasury Department stated that the pay cap is meant to "ensure that the compensation of top executives in the financial community is closely aligned not only with the interests of shareholders ... but with the taxpayers providing assistance to those companies."

From Sunday's Wall Street Journal web site:

"The search for ways to get around this," says one expert on Wall Street compensation, "started within minutes of the announcement." For starters, the limits seem to apply only to "senior executives" -- the chief executive, chief financial officer and the like -- and not to many of the people who can earn the really big bucks on Wall Street, like traders, hedge-fund managers and the mad scientists who cooked up all those derivatives that almost destroyed the world financial system.

Leaving the compensation of these hot shots intact, while reducing the pay of the people who are supposed to boss them around, isn't going to make the investing world any safer.

Outsourcing is another way to get around a pay cap. In 2003 and 2004, managers at Harvard University's giant endowment came under withering fire from the ivory tower for earning upward of $35 million apiece. They soon left to start their own firms, which were promptly hired by the endowment and got paid a percentage of assets under management rather than a cash salary and bonus. That new form of payment stopped the criticism cold -- even though it isn't likely the managers earned any less. Nor did it reduce risk-taking: One spinoff from Harvard Management Co., Jeff Larson's Sowood Capital, blew up in 2007, dealing Harvard a $350 million loss.

And, they used to say crime doesn't pay.

No comments: