Saturday, January 31, 2009

Time to Bring Financial Wizards Back to Earth

When you read today's Wall Street Journal about the outrage over Wall Street bonuses, there's a telling quote at the end:

"From 2002 to 2008, the five biggest Wall Street securities firms paid an estimated $190 billion in bonuses. Those companies churned out $76 billion in combined profits during the same period. Last year, the companies had a combined net loss of $25.3 billion, yet paid bonuses of roughly $26 billion."

That means securities firms would have broken even had they done what most responsible firms would do - rein in controllable expenses. When you are burning investor cash, you need to find a way to make a profit, not overpay people who are losing money for you. However, Wall Street doesn't work that way, they think they actually deserve multi-million dollar bonuses for their work. They say they work a tremendous amount of work and have specialized knowledge. Well, given the unbelievable damage they have caused the world economy, that specialized knowledge was not so valuable after all.

I know I'm going to get in trouble here as a number of my friends have made fortunes on Wall Street. I have a lot of respect for those in the investment banking and financial field, but it's about time the field gets called out for its abuses.

In one of his famous letters to shareholders, Warren Buffett discussed how financial executives were not creating value with derivatives and hedge funds as much as they were simply moving money around and taking more for themselves. First came the financial advisor, then the mutual fund manager, then the hedge fund manager. At at stage, the financial manager, would move around the same investments, continually taking more for himself. Derivatives were extreme forms of this practice as they were highly leveraged to supercharged returns with little clarity of the underlying risk.

I will acknowledge that efficiency reduces interest rates by providing greater transparency and assessment of risk. However, as an electrical engineer who used to take electives like multidimensional calculus of imaginary number for fun, even I had a hard time understanding the models. I have a feeling that these folks used complex spreadsheets that spit a decision without knowing what they were doing.

There was so much money to be made that instead of going into electrical engineering, our top minds went into financial engineering. When I heard that 1st year Harvard MBA's were going paid $350k to go into hedge funds, you knew there was a problem. Real engineers create new products and technologies that transform our lives. Financial engineers move money around - valuable - but its not like creating the next generation solar array or the Dreamliner. For a while there, people thought that becoming the financial and retail center of the world was the way to go. The last year has shown us how dangerous that is.

Financial supermarkets like Citibank and Bank of America have been widely discredited. Lehman Brothers, Merrill Lynch, and Bear Stern has shown the disaster of overleverage. AIG - that's $150 billion of taxpayer money - and still going.

Obama labelled executive bonuses as, "Outrageous!" It is my hope that this is the beginning of a new era. We will reconsider our devotion to these financial gods who create exotic ways of manufacturing money out of whole cloth.

My message to you: No, you do not deserve extraordinary compensation when you need a taxpayer bailout. You failed and must be held accountable. Saying that, "Nobody saw this coming," is a lame excuse. For years, you've been claiming millions of dollars in wealth for working for brand names while shifting money around. You've demanded accountability from the companies you invest in. It's time to take some of your own message. You too, Robert Rubin. I love your service for the Clinton administration, but you sat by at Citibank allowing the firm to use diversification to create even greater risk.

I love Sen McCaskill's new bill limiting bailout executive compensation to beneath Pres Obama's pay. That's no more than $400k in overall comp. As mentioned in my previous blog, it should be lower - like $200k. These corporations are riskless. They have the US government as a backstop. It's hard to argue that the CEO of Bank of America is worth more than the Defense Secretary. Robert Gates is responsible for America's security. Kenneth Lewis runs one of many big banks. It's a bank that needs to be broken up. One bad decision and we all pay. Maybe we should use the bailout money to seed fund the start-up of new banks. Maybe they will actually lend with reasonable underwriting standards.

John Thain is a true fraud. Earlier, he saved the NYSE, but decided to cash in at Merrill. He attempted to ensure traders and execs got bonuses while Merrill lost $15 bil in a quarter. Let's not even talk about the $1 million in furnishing his office. And who is backstopping these losses - not Bank of America - it's the United States of America.

Since Obama did not take money from corporations and PACs, he can truly lead a change of culture. Move away from crony capitalism where the richer can lobby and pay their way to get richer. Move to a culture where real innovation is rewarded and excessive pay is diminished. Rather than putting limit on compensation, bring back high marginal tax rates. For income over $1 mil/year bring back the 50% marginal tax rate. You made that money because the US system gave you an advantage. There are soldiers around the world protecting your ability to make wealth. Your access to government officials enable you to get special tax and business breaks. You have a legal framework to ensure that contracts are actually enforced. It's your responsibility to pay for the system that provides you that benefit. I'm not talking about capital gains on a startup - those investors and management create real value without government officials bailing them out. I'm talking about the proponents of the supposed death tax.

The free ride is over - it's time to change.

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