Revamping traders’ pay

By Felix Salmon
July 27, 2009

Roger Ehrenberg has a much-linked-to piece about how Wall Street banks might revamp the way they pay their traders: basically, he says, turn them into fund managers, with a large ownership stake in their virtual funds.

The main problem with this, that I see, is that a Wall Street investment bank has lots of very good traders, and they never all have big bets on at the same time. When one desk wants to put on a big trade, it generally needs to make a case for putting at risk a large amount of the bank’s capital. But the capital doesn’t then belong to that desk in perpetuity: it lasts only as long as the trade does. So capital is always flowing to where it can best be put to use. That’s how a bank’s prop traders, as a group, can often make much more money than any given trader or desk could on their own.

Under Ehrenberg’s scheme, I think, that flow of capital from desk to desk would be seriously diminished, since the whole point of his plan is that traders get to compound their profits after they’ve made them.

I’m also not a great fan of Ehrenberg’s “sanctity of contracts” argument in favor of Citigroup paying Andrew Hall $100 million this year. (For the reasons why it shouldn’t, see Yves Smith.) Hall’s contract would be worth bupkis if Citi had gone bankrupt; the only reason it didn’t was that the US government bailed it out. So if the US government wants to call some shots here, it can. Sure, Hall can sue if he wants, and he might even win. But depending on how the negotiations go between Hall and Citi, it’s probable that he won’t.


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Felix, this is a comment I penned in response to a friend who shares a view similar to yours on contracts:


[Name], i have written about this and agree with you, but you are mixing two important concepts: (1) bonuses that are existing contractual obligations of the rescued institutions; and (2) prospective bonus policy. the trader in question has a long-standing contract with the firm; the fact that the US Government chose to bail it out as a going concern means it made the conscious choice not to break contracts in the context of Chapter 11 bankruptcy. It could have done things differently, for which I argued strenuously over 9 months, but it didn’t. Therefore, it does not have the right as a matter of law to say “We’re unhappy with these deals, therefore we are declaring them null and void.” As noxious as some deals may seem, the necessity of following the rule of law overwhelms any financial implications, in my opinion.


Regarding the “fluidity of capital” argument, the same flexibility would apply in the fund structures. It just means that a trader whose strategies are not in vogue would be trading a proportionately larger amount of their personal capital than firm capital. Nothing wrong with this, is there? The fund mechanism is simply that, a mechanism. It doesn’t need to change governance.

If you don’t believe in the sanctity of contracts as it pertains to a bank and a trader, do you believe in the sanctity of the contractthat you’ve signed with, say, your landlord or mortgage company?

The conceit that contracts ought not be heeded because of political circumstance suggests that no contract ought to be treated as the word of its signatories.

I didn’t hear anyone posting screaming about the sanctity of contracts for the rework of GM and Chrysler union workers. Just the investment banks. If the government has to intervene to save the Titanic from going down, yes, contracts can be reworked.
That would seem obvious, but apparently not to the Rush-Goldman-Wall Street crowd. But we can go back and restore the GM/Chrysler crowd salaries and, hey, rework the California public worker furloughs if the posters here really want to get on their high horses.
Or the govt. can just fire this trader and a whole host of AIG management, as we should have done 8 months ago when we bailed them. What happens to his salary then?

I’m just laughing about the sanctity of contract meme here, at least for companies that suck of the teat of government backstops and, oh, 250 billion or more of direct aid. Sanctity of contract means that they go contact and their workers get, say zero dollars. That sounds pretty sacred to me, how about you?

Posted by RobJ | Report as abusive

The first comment rather hits on the head that we have a legal system set up to break contracts. It’s been decided, though, that the bankruptcy system isn’t well suited to large financial firms, and perhaps for some good reasons; it does seem, though, that we need something bankruptcy-like for financial firms. Zingales was pushing some good ideas last fall, when he was told there was no time to get them through Congress; maybe there’s time now.