Opinion

Felix Salmon

Bonuses are Large Because They’re Unpredictable

Felix Salmon
Mar 30, 2009 03:36 UTC

Mike at Rortybomb explains that the whole reason why Wall Street bonuses are so big is that there’s a non-zero chance that they won’t be paid:

I’ve heard it from several people that the argument for the bonus is “we deserve our bonus because we don’t really get paid a big salary and expect to live on our large bonus.” I retort “Well it is so large because you need to be compensated for the employer counterparty risk; you run the risk your employer will be gone, and the next one, be it a new bank or the USA, won’t want to honor it.”

There are other risks, too, with the end-of-year bonus system: maybe your employer will fire you just before you’re due your bonus. Or maybe they’ll simply decide that you don’t deserve one this year, or that you deserve only a very small one.

The point is that there’s so much uncertainty built in to the bonus system that the expected bonus has to be enormous in order to make up for it. Suppose I give you a choice between a base salary of $75,000 a year and an expected bonus of $1 million, or a base salary of $350,000 a year. If you’re anything like me, you’d take the smaller amount with the higher predictability.

Now in the case of guaranteed bonuses, the calculus does change somewhat — in that case, you might well opt for the $1 million. But the guarantee doesn’t mean that you’re certain to get that seven-figure payday; it just means that the degree of uncertainty has fallen substantially. And as Mike points out, you’re still very much running the risk that your entire company goes bust, or that its new owners decide to abrogate those guarantees.

Not getting your bonus is a bit like those bad beats in poker. There’s no point railing against them, they’re bound to happen some of the time, and indeed if they never happened then the game wouldn’t be structured that way in the first place. So accept it and move on with equanimity. Otherwise you just come across like a petulant child.

Ben Stein Watch: March 29, 2009

Felix Salmon
Mar 30, 2009 03:17 UTC

Ben Stein counts Jim Cramer as a friend. And millions of people watched the showdown between Jon Stewart and Jim Cramer on The Daily Show. But judging by his column this week, Cramer’s friend Mr Stein wasn’t one of them:

As you may know, Mr. Cramer appeared earlier this month on “The Daily Show,” where Mr. Stewart yelled and cursed at him.

No, Ben, Jon Stewart does not yell at his guests. Cramer is the yeller, not Stewart. And in fact there was surprisingly little cursing, by Daily Show standards, on either side.

This was a substantive exchange — yet Stein still insists on characterizing Stewart as "a comedy guy from Comedy Central". And he also seems to think that Stewart’s only criticism of Cramer is that Cramer’s predictions were wrong. And so he launches into a long explanation of how "we as humans cannot tell the future"; in fact, in the space of four paragraphs, Stein manages to use the word "human" or "humans" no fewer than six times (and "mortals" once), each time making the same point about fallibility.

Defensive much? Well, yes:

I would be remiss if I did not add that I have succumbed to this temptation to speak as if I could tell what the future holds…
The most that economic seers can do is apply broad, generally acceptable principles to current situations and try to go from there. When I stray far from that, I hope that thoughtful readers will call me to account.

Ben, you’re a Hollywood hack, not an "economic seer". But in any case, if you’re genuinely interested in people calling you to account, feel free to browse through the archives here. You’re welcome.

And of course you don’t disappoint in this column when it comes to hackery:

Just two years ago, how many people would have confidently predicted that we would elect our first African-American president in 2008? Who would have imagined that Citigroup would trade for a time under $1 or that General Electric would trade for a time under $6 or that Bear Stearns and Lehman Brothers would virtually vanish, or that a graduating class of law students would be unable to get jobs or that high-end M.B.A.’s would be unemployable?
And who would have guessed that we would have a fall of more than 50 percent in the broad stock indexes or that oil would triple in price and then fall by more than $100 a barrel? Some people might have seen parts of this pattern, but all of it? Again, life is far too complex to be predicted with any consistency.

Let me see: you’re pointing out that no one predicted, two years ago, that Obama would be elected president and where Citigroup would trade and where GE would trade, and that Bear would vanish and that Lehman would vanish and that law students would find job hunting difficult and that MBAs would too and that stocks would fall more than 50% and that oil would go up a lot and that oil would then go down a lot. And you conclude that since no one managed to get all of that right, then hey, that just shows that life is terribly complex.

If all of these things had a 50% chance of happening, the chances of them all happening would be less than one in a thousand. Stein might as well have thrown in a few real outliers too: who on earth would have predicted that Natasha Richardson would die after a skiing accident? No one’s asking for all predictions to be right. They’re just asking that people like Ben Stein quit with the brainless boosterism and pay attention to reality once in a while.

Alternatively, Ben, you could simply quit with the punditry: all those TV appearances and books and newspaper columns which are predicated on the idea that you do know what’s what. It’s much easier to simply keep quiet than it is to be wrong the whole time. And then you won’t have me or anybody else calling you to account any more.

Who’s Gaining from the AIG Unwinds?

Felix Salmon
Mar 30, 2009 01:36 UTC

Tyler Durden has a scary post up, connecting banks’ profitability in January and February to the fact that those were the months when AIG Financial Products was unwinding an enormous number of its contracts en masse. These trades, initiated by AIGFP, were allegedly enormously profitable for the biggest banks in the CDS market:

The size of these unwinds were enormous, the quotes I have heard were "we have never done as big or as profitable trades – ever"…
I can only guess/extrapolate what sort of PnL this put into the major global banks… I think for the big correlation players this could have easily been US$1-2bn per bank in this period."

If this is true, then (a) the banks still aren’t anywhere near sustainable profitability, and (b) those AIG retention bonuses — paid on the grounds that only the people who got AIG into this mess could get it out — are even more egregiously untenable than we had suspected.

The whole point of having the government take over AIG was that it wouldn’t need to enter into panicked unwinds. If it went ahead and did that anyway, the levels of competence and oversight at AIG are even lower than most of us had thought. Which is quite an achievement.

Newsweek’s Fearful Krugman Profile

Felix Salmon
Mar 30, 2009 01:23 UTC

Evan Thomas has a profile of Paul Krugman on the cover of Newsweek. The 2,825-word article has six on-the-record quotes about Krugman; none of them — not even the one from his mother — are particularly flattering. No one is quoted saying a single nice thing about Krugman’s economics or his opinions.

When it comes to the substance of what Krugman produces, rather than his personality, the only two quotes come from Daniel Klein of George Mason ("a lot of what he says is wrong") and Dan Okrent, the former NYT ombudsman with whom Krugman had a bruising encounter. ("When someone challenged Krugman on the facts, he tended to question the motivation and ignore the substance.")

The other on-the-record quotes in the article are hardly any nicer: Sean Wilentz says that Krugman "doesn’t like to be f–ked with"; Gene Grossman says that Krugman’s academic career is over. Meanwhile, Thomas himself speculates that Krugman is "a little wounded" by the fact that the White House isn’t showering him with attention; says that Krugman "sometimes gets his facts wrong" when he writes about subjects other than economics; and asserts that Krugman was so keen to win the Nobel Prize that he almost turned down his position at the NYT for fear of becoming "a mere popularizer".

All in all, the story is not exactly what you’d expect from a cover emblazoned with the words "Obama is Wrong" and the caption "The Loyal Opposition of Paul Krugman". Newsweek’s editor, Jon Meacham, has an interesting take on the article:

Is Krugman right? Is the Obama administration too beholden to Wall Street and to the status quo, trying to save a system that is beyond salvation? Does Obama have–despite the brayings of the right–too much faith in the markets at a time when prudence suggests that they cannot rescue themselves? We do not know yet, and will not for a while to come. But as Evan–hardly a rabble-rousing lefty–writes, a lot of people have a "creeping feeling" that the Cassandra from Princeton may just be right. After all, the original Cassandra was.

I suspect that the final product is the result of overcompensating for the fact that Thomas and Meacham have just such a feeling: they’re fearful that Krugman might be right, and have therefore come up with a list of reasons why it might be reasonable to ignore him.

And this, at heart, is why I think we haven’t yet seen the worst of this crisis, neither in terms of the financial markets nor of the broader economy. There’s still a sense of denial in the air — a feeling that if you’re going to devote an entire cover story to someone like Krugman, then the story should bend over backwards to showcase people saying that he’s wrong, while it need make no such effort to quote anybody saying that he’s right.

Or, to put it another way, the question posed by the article isn’t whether Krugman is right or wrong — it’s whether he’s worth listening to or not. And the answer posed by the article is "we fear he might be, but we hope he isn’t". The problem — which the article doesn’t mention — is that the history of this economic crisis to date is a history of fear being right and hope being wrong.

What they Used to Teach You at Stanford Business School

Felix Salmon
Mar 29, 2009 19:42 UTC

Chris Wyser-Pratte, who got his MBA from Stanford in 1972 and then spent the next 23 years as an investment banker, sent me the following note last night. I’m reprinting it here with his permission:

I learned exactly seven things at Stanford Graduate School of Business getting an MBA degree in 1972. I always used them and never wavered. They were principles that enabled me to put the cookbook formulas that everyone revered in context and in perspective. I think they served my clients (and perhaps me) rather well. Here are those seven principles, and who taught them to me:

  1. Don’t use many financial ratios or formulas, and when you’ve picked the few that will actually tell you what you want to know, don’t believe them very much (Prof. James T.S. Porterfield);
  2. Remember that any damn fool can compute an IRR or DCF. The trick is to find a business that can return 20% after tax, understand its critical indigenous and exogenous variables, and then run it so it meets its return target. (Prof. Alexander Robichek.)
  3. Always ask what can go wrong (Porterfield);
  4. Never extrapolate beyond the observed points of a distribution, you have absolutely no information outside the observed range (Prof. J. Michael Harrison);
  5. Remember that you can always break the bank at Monte Carlo by doubling your bet on red at the roulette table every time you lose. The problem is it will break you first; It’s called "the takeout." Therefore, always manage your financial structure so that takeout is not an issue. (Porterfield.)
  6. Big M (today Nassim Taleb’s Black Swan) is never a part of the optimal solution. If it shows up in the answer with any coefficient greater than zero, you have the wrong answer and have to continue to do program iterations. (Harrison.)
  7. There is never any excuse for looking through the substance of an economic transaction, whatever the accounting, and if the accounting permits you to do so, it’s wrong (Prof. Charles T. Horngren.)

Conspicuously absent from this list are Prof. Jack McDonald and his Efficient Market Theory and Random Walk, Prof. William Sharpe, Nobel Prize winning author of the Capital Asset Pricing Model (which he later acknowledged didn’t work because his data were wrong, but it’s still used everywhere and they didn’t take away his prize) and Prof. James Van Horne, who believed that the Fed actually controlled the economy through its monetary policy actions. Gene Webb — who at least tried to improve my people skills — and Ezra Solomon in International Finance deserve honorable mention.

The conclusion I derive from your interesting article is that the reason the economy was destroyed by Wall Street, which died in the fire it created, was that they violated, ignored and were probably ignorant of all seven principles listed above. They not only couldn’t do the math, they were mesmerized by its precision because they used a black box and believed in its oracular power even though they didn’t understand how it worked, believed what occurred before could be expected to occur again, hadn’t a clue about what risks were indigenous and exogenous to their own business (or which were which), how probable those risks were and what the consequences were of ignoring the takeout risk, in particular. They also thought financial sleight of hand had meaning. In short, they had their head stuck where the sun don’t shine and deserved what they got. We, the world, didn’t.

What Wyser-Pratt doesn’t mention is that in 1972, business school students largely expected to go into business, as opposed to finance. And insofar as banks hired MBAs, it was because they wanted employees who understood business. Over the following decades, MBAs, and the bankers they turned into, became increasingly expert in finance, while knowing less and less about business. Eventually we ended up living in a world where a major retail operation like Sears could be owned and run by a financial engineer who thought that the answer to any question was simply to spend yet more of the company’s precious cashflow on stock buybacks.

Essentially, we moved from a world where banks were run by businessmen, to a world where businesses were run by financiers. Let’s hope that the pendulum will now swing back (only with more women in charge this time around), and that business schools will start de-emphasizing finance in their curricula. But that might be too much to hope for. Even in 1972 students were being taught CAPM. And the vast majority of them failed to ignore it.

Whining Executive of the Day, AIG Financial Products Edition

Felix Salmon
Mar 29, 2009 18:08 UTC

Executives at AIG Financial Products are not happy bunnies these days, and they’re starting to make their views public. Jake DeSantis, for instance, published his resignation letter as a NYT op-ed. But Paul Harriman and his wife, Jan Ellen Harriman, clearly don’t have that kind of access. So they’re blogging at Livejournal instead.

John Carney at Clusterstock found Jan Ellen’s blog on Friday and her husband’s on Saturday. Today he reprints Paul’s latest blog entry, since Paul has now put it behind a firewall. It echoes his wife’s in all its main points: he worked very hard, and London is very expensive (he’s paying rent of $10,000 a month and school fees of $30,000 a year) and he needs that bonus to cover his annual expenses.

There’s also this:

We’ve been forbidden to speak to the press, by a company that obviously hates us and spreads false and misleading "information" about us, when they can be arsed to respond at all.

I think it’s fair to say that morale at AIG Financial Products is low — but not quite as low as the self-awareness of an executive who genuinely thinks that if you live in London you need to pay $10,000 a month in rent, and who also seems to think that joining his wife in ranting on Livejournal is in any sense a good idea.

So a word of advice for any other AIGFP executive who’s tempted to go public bemoaning the loss of his bonus and his livelihood: don’t. You are hated already, and this kind of display, with ten parts self-pity to zero parts contrition, doesn’t help you out in the slightest.

Long-Term Stock Market Volatility Datapoint of the Day

Felix Salmon
Mar 29, 2009 16:44 UTC

Warren Buffett, take note:

Although mean reversion makes a strong negative contribution to long-horizon variance, it is more than offset by the other components. Using a predictive system, we estimate annualized 30-year variance to be nearly 1.5 times the 1-year variance.

The subject is the stock market, and the paper in question, which Mark Hulbert writes about in the NYT today, could well give the Sage of Omaha some sleepless nights, since Buffett famously accepted a $4.5 billion bet, very near the top of the market, that stocks would go up in the long run and not down.

There’s been a lot of debate surrounding the bset way to mark Buffett’s losses on that bet: while the base case is to use Black-Scholes, a vocal contingent of Buffett supporters has said that it’s silly to use today’s elevated volatility to price long-dated European-style options which can only be exercised on one specific date. Over the long term, they say, stock-market volatility is much lower than we’re seeing right now.

Well, it has been in the past. But how much reason do we really have to believe that the future of the US stock market is going to resemble the past of the US stock market, rather than simply wending its way, in a necessarily volatile fashion, towards zero? Empires do fall, after all, and one of the co-authors of the paper, Robert Stambaugh, points out that the probability of global warming proving catastrophic for the stock market, while it can’t be calculated with any specificity, is surely non-zero. Stambaugh’s co-author, Lubos Pastor, generalizes:

Professor Pastor emphasized that the last two centuries could easily have been less hospitable to the United States, most likely lowering the stock market’s returns. An investor couldn’t have known in advance that the United States would win two world wars, for example, or emerge victorious from the cold war. In any case, he said, there is no guarantee that the next two centuries will be as kind to the domestic equity market as the last two.

This is exactly why an unknown set of counterparties paid Warren Buffett $4.5 billion: for his triple-A-rated guarantee that over a very long time horizon, something catastrophic and unexpected wouldn’t happen to US equities. If you couple that guarantee with some credit protection written on Berkshire Hathaway, you come close to having a very powerful insurance policy against black swans. You can’t clip tails outright. But clearly there are some people trying their hardest to minimize their tail risk. Maybe they put more stock in Bayesian analysis than Buffett does.

CDS: The No-Natural-Seller Meme

Felix Salmon
Mar 27, 2009 22:52 UTC

I was on a panel last night with Simon Constable of Dow Jones Newswires, and I’m sure that to our lay audience a peculiar exchange in the middle of the conversation must have sounded a bit like dolphin squeaks. He was trying to demonize credit default swaps, and said with great finality and self-assuredness that if you wanted proof positive that they were the spawn of the devil, all you needed to do was examine them objectively, as he had done, and you’d see that they had no natural seller.

I then interjected that of course credit default swaps have natural sellers: any bond investor is a natural seller of CDS protection. We started going around in ever-decreasing circles of mutual incomprehension, until the moderator happily put an end to that particular discussion and moved us on to the next topic. But now Arnold Kling has resuscitated the meme:

There is no institution which, in the ordinary course of its business, takes a position for which selling credit default swaps is a natural hedge…
Credit default swaps allow companies to trade the default risk on, say, a mortgage-backed security. The holders of that security have a natural interest in buying protection. But nobody has a natural interest in selling protection.

I thought I’d dealt with this back in December, but evidently not, so let me try again, this time quoting a little of my Wired article on the Gaussian copula function:

If you’re an investor, you have a choice these days: You can either lend directly to borrowers or sell investors credit default swaps, insurance against those same borrowers defaulting. Either way, you get a regular income stream–interest payments or insurance payments–and either way, if the borrower defaults, you lose a lot of money. The returns on both strategies are nearly identical, but because an unlimited number of credit default swaps can be sold against each borrower, the supply of swaps isn’t constrained the way the supply of bonds is, so the CDS market managed to grow extremely rapidly.

The point is that there are a lot of very sophisticated bond investors out there, and much of the time they could replicate the risk and return of buying a bond by putting together certain trades in the CDS market — and get much better liquidity that way. It’s not easy to find bonds from certain issuers, but you can always find a broker willing to buy credit protection on any given name.

A bond investor isn’t really hedging anything, so it’s true that if and when a bond investor starts selling default protection, then he isn’t offsetting some opposing risk. But it’s simply not true that in order to make a derivatives market work, both sides have to be hedging something. In the CDS market, you can simply have one person, who doesn’t want risk, selling that risk to another person, who does want it.

Generally speaking, it’s a good thing for banks to sell down their risk, even as it’s also a good thing for institutional fixed-income investors to buy risk: that is, after all, their job. Part of the problem in this financial crisis, as I was talking about earlier, is that banks started persuading themselves that they’d sold so much risk that there wasn’t any left, even as the amount of risk they had on their balance sheets continued to balloon. That was a serious failure of risk management: they didn’t sell enough risk, largely because they couldn’t find any buyers (except for AIG, sometimes) for the super-senior risk tranches that they were prone to keeping on their books.

But those buyers weren’t absent because there were no natural sellers of CDS; they were absent because the yields on offer on those super-senior tranches were so ridiculously low that no one in their right mind wanted to buy them. So long as there are bond buyers, there are natural sellers of default protection. They might not be hedging anything, in a narrow sense, but they are large, and numerous, and extremely useful when it comes to providing liquidity and price discovery. By all means regulate the CDS market; by all means move CDS trading onto an exchange. (Although that might not make as much of a difference as many people hope.) But let’s not kid ourselves into believing that there was no reason for the CDS market to exist in the first place.

Miami Beach Datapoint of the Day

Reuters Staff
Mar 27, 2009 12:19 UTC

Josh Giersch finds a Zillow map of the SoFi district of Miami Beach – a five-by-five block are south of Fifth Street which has 317 properties for sale, including 21 in just one building.

The problem is that with that kind of oversupply, prices are sure to continue to fall, which means that no one’s going to buy at these levels, which means the oversupply will only get bigger, and so on and so forth. I have no idea what can turn this around, but for the time being, always remember: things will get worse before they get worse.

Reprinted from Portfolio.com

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