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Compensation reflecting performance

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The latest economic news incudes administration complaints about the prospect of high bonuses at invesment banks. So why are these bonuses expected to be so high?

Well, as it turns out, the investment industry has done extremely well this year - as might be expected given the recovery of stock indices like the DJIA and S&P 500, which are up more than 50% since their lows near the beginning of the year. Good performance is reflected in high bonuses - exactly the kind of performance based pay the administration was advocating a few months ago.

It's more than just that, though. The investment industry is to a large extent what's driving the recovery; without their putting their money back into the market, the Dow would still be languishing at 6,000, instead of having recovered to 10,000. Without the recovery in the market, people who watch their retirement accounts would not have started spending again. We wouldn't have what little recovery we've seen, and the unemployment rate might be climbing towards 20% rather than stabilizing at 10%.

Now, it's certainly true that some investment banks were the beneficiaries of some government bailouts - especially indirectly, through the guarantee of AIG swaps that those banks had purchased. But you know what? If the government gives out money, whether in bailouts or other handouts, you have to expect that people's performance will including playing the government for as much of that money as possible. The answer here is to stop bailing people out, so their performance will be based on productivity, rather than on playing the game.

The administration can hardly complain when people are taking their advice, and compensating based on performance. And if they're unhappy with what that performance is based on, they should be learning instead of lecturing: in this case, learning that bailouts and handouts are counterproductive when trying to get people to be productive and to get the economy back on track.

Article on administration statements:
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On October 19th, 2009 05:15 pm (UTC), izmirian commented:
It does seem like a waste of time the way that the politicians are trying to limit the bonuses for firms that got government bailouts. Hopefully it will pass before long. I can see how the government was caught in a bind though: on one hand it might really rather have let the companies go out of business as a result of their poor decisions, but on the other hand that might have been worse overall for the economy, at least in the short term.

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On October 19th, 2009 05:38 pm (UTC), psychohist replied:
It should be noted that the investment banks such as Goldman Sachs who are giving out the current bonuses have mostly paid back their TARP funds, which as I've discussed previously weren't really bailouts in the first place for those banks. Those banks got bailed out more indirectly, as a result of government guarantees of AIG swaps - basically insurance policies guaranteeing the value of securitized mortgages. A failure of AIG would have put the risk back in the court of the investment banks and other institutions that held the swap insured mortgage debt.

Given that a significant proportion of those other institutions were foreign governments, I suspect the AIG bailout was based more on foreign policy considerations than on economic reasons.
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On October 20th, 2009 04:40 am (UTC), izmirian replied:
It should be noted that the investment banks such as Goldman Sachs who are giving out the current bonuses have mostly paid back their TARP funds

Sure, but there was still plenty of time for them to make a profit as the stock market recovered from its lows. It's hard to imagine a bank not wanting to borrow money at 5% when the Dow dropped below 7000 and then paying the money back six months later when the Dow went above 9000. Certainly I would take that deal.

which as I've discussed previously weren't really bailouts in the first place for those banks

Agreed that the term "bailout" has been used (or overused) for all different kinds of government intervention.

But ignoring the finer details of some of the terms, the banks were provided with cash at a point when it was really useful to have cash and I expect that they profited because of that.

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On October 20th, 2009 05:11 am (UTC), psychohist replied:
The TARP funds were handed out Oct 28, 2008. Google finance only gives me weekly closes that far back, but at the end of that week, the DJIA closed at 9325.

The investment banks applied to pay back the TARP funds between February and April, around the time the DJIA was at its low of 6626, much lower than when the TARP funds were handed out.

Those banks were finally allowed to pay back the funds effective July 22, 2009. The DJIA closed that week at 9093, still lower than when the TARP funds were handed out.

The data do not support the theory that the investment banks used the TARP funds to make money on the stock market; quite the opposite.

Also, we should be careful about drawing conclusions about "banks" in general when discussing investment banks. Investment banks are really closer to overgrown hedge funds than they are to real banks that take deposits and lend money.

Finally, note that the 5% interest on TARP funds is higher than banks' normal cost of capital, though that's more applicable to commercial banks than investment banks:


None of this means I approved or approve of TARP. However, it was problematic because it was the government squeezing money out of healthy banks, not because it was bailing those banks out.
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On October 20th, 2009 05:18 pm (UTC), izmirian replied:
The data do not support the theory that the investment banks used the TARP funds to make money on the stock market; quite the opposite.

I'm not claiming that they rushed out to invest the TARP money in the DJIA. Hopefully they have more clever thing to invest in. The point is that during a period when many assets are available at fire sale prices it's great to have cash to purchase assets. And we know that many of the banks (investment banks or overgrown hedge funds) did make quite a bit of money since we are now seeing their financial results. Presumably a portion of that was due to investing the TARP money.

Finally, note that the 5% interest on TARP funds is higher than banks' normal cost of capital, though that's more applicable to commercial banks than investment banks:

I think the key word here is normal because when you are in a significant market downturn and there is a liquidity crisis as well, it's very hard to raise capital. Remember that GE was raising capital from Warren Buffett last October and paying a 10% dividend on the money.

However, it was problematic because it was the government squeezing money out of healthy banks, not because it was bailing those banks out.

I can understand being annoyed about the mandatory nature of the TARP program and I'm sure there are some banks who were forced to take TARP money who really didn't need it. But there were banks going out of business and being sold on an emergency basis, so claiming that the banks were fine and the TARP program was just an additional government tax is a little hard to believe.
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On October 20th, 2009 06:47 pm (UTC), psychohist replied:
I strongly suspect that the investment banks ended up losing money on their TARP funds. Remember they also had to pay fees when they paid the money back; the government got returns in excess of a 20% annualized rate. That's considerably more than the 1-2% annual return that investment banks are making as a percentage of their assets.

While it's more difficult for nonbanks like GE to raise money during a recession, it's actually easier for retail banks. Consumers tend to save more and borrow less during a recession, both of which pump money into banks. TARP did likely help GMAC, another nonbank which got into trouble.

The selling of banks "on an emergency basis" was more an issue of panic on the part of the government regulators than actual need. This was best illustrated by the sale of Wachovia: the government initially agreed to a heavily subsidized fire sale deal to give it to Citicorp, but then when they finally decided they didn't need to close every bank sale over a weekend, Wells Fargo came in with a competitive offer that was better and didn't require any subsidies at all.

Now, as mentioned above, TARP did help some poorly managed and weak financial institutions like GMAC, and perhaps some poorly managed and weak smaller banks as well. It basically worked to penalize the well managed banks to subsidize poorly managed financial institutions. Does that sound like a good policy to you?
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On October 21st, 2009 03:31 am (UTC), izmirian replied:
Wow, 20% is quite a bit different from 5%. Is there a good website summarizing the amount loaned to each bank and the amount paid back? My quick search just found bits and pieces.

Does that sound like a good policy to you?

Well, no one is particularly happy about the policy, which is probably why the politicians feel obliged to complain about the bonuses. It's defenders will say that it was the best policy that could be implemented in a hurry. I'm certainly not enough of an expert to determine that. My guess is that it was a better policy than doing nothing. Were you in favor of letting the weaker banks fail or in some other rescue approach?
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On October 27th, 2009 05:40 pm (UTC), psychohist replied:
The difference in returns between 5% and 20% is due to the banks having to buy back warrants - essentially stock options - that were given to the government for free, separate from the preferred stock the government invested. The wikipedia article has a partial list with some information on which banks have bought their way out. Obviously it doesn't differentiate between sound banks who had the TARP money forced on them and institutions that needed the funds to avoid bankruptcy.

I think no intervention - beyond existing safety nets like FDIC insurance - would have been a far better policy, and I believe I even posted about it at the time. A bank failure is not a disaster for the economy. It's a disaster for the stockholders, who should have known they were in a risky investment, and the bondholders might lose an average of a few percent of their money, which is a risk they know about too. Depositors are not generally impacted. Wiping out some stockholders and making some bondholders take a haircut is much better than the mess we're in now.
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On October 19th, 2009 09:56 pm (UTC), sylvanstargazer commented:
Well, the main problem I see is that they got a bunch of cheap money in order to recapitalize, but because the government has failed to move on reforming the regulation they haven't had to, which means we could have exactly the same crisis we had last time tomorrow. Additionally, it doesn't seem like the "recovery" is much of a recovery outside of paper; unemployment has stayed high, wages have fallen and continue to, savings are unproductive due to the bargain-basement interest rates that have let these banks "drive" the recovery. Credit defaults continue to be high, as do mortgage defaults. Just because the Dow is back over 10,000 doesn't mean GDP growth has recovered, or is likely to. Innovation in finance can certainly help drive growth, but not in the absence of growth for it to finance.

From my melodramatic point of view, it's like the banks have successfully extorted America, and are now paying off their accomplices. The problem, of course, is that they really did, and still do, have the entire economy by the delicate bits. The government can't do anything, and especially can't allow market forces to "work" given the current political climate (I still think they should have just nationalized the banks and got it over with).

One thing all this has done is led to some fantastic innovations in economic thought, and constructive, cross-discipline conversations in the blogosphere. It's interesting to see traditional partisan lines collapsing as different people are swayed by different statistics and interpretations.
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On October 19th, 2009 10:15 pm (UTC), psychohist replied:
Please read this post before blaming things on the banks:


The truth is, most of the big banks didn't want the TARP money and pay it back as quickly as the government permits. Both major investment banks, JPMorgan and Goldman Sachs, paid back their TARP funds long ago, as soon as they were allowed.

The financial companies that actually did need TARP money are not paying out any significant bonuses - they are companies like GMAC, which funds GM's auto loans and also makes mortgages, and kind of had to be bailed out for the GM bailout to have any chance of success, as well as some small regional banks that had mismanaged their mortgage portfolios. The only major bank that may have benefited from TARP is Citicorp, but they are also limited in the bonuses they can pay out, and in fact are being forced to sell off their most profitable operations by the government at fire sale prices. That's also an excellent example of how government control of banks hurts rather than helps, by forcing the banks to run inefficiently.

What do you think the banks could do to help the economy more - within the constraint that the current administration won't let them loan out more money?
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On October 20th, 2009 06:26 pm (UTC), sylvanstargazer replied:
Well, new information suggests that the idea that the capital infusions were to “healthy institutions” was a convenient fallacy, rather than an actual requirement of receiving funds. Goldman Sachs was among those recipients considered to be in trouble, their long term debt having been put on watch by Moody’s for possible downgrade. Not to mention that all of the institutions involved were being severely hit by the high cost of inter-bank loans and they agreed that there was a severe risk of systematic collapse.
(http://www.sigtarp.gov/reports/audit/2009/Emergency_Capital_Injections_Provided_to_Support_the_Viability_of_Bank_of_America..._100509.pdf) While they was the statement that regulators would require them to take the cash infusion if they weren't willing, the audit turned up only one executive who mentioned any concern with taking the money, and others who described it as “cheap money”. Given the additional help two of the other banks received, and the quote about a third bank “which has since paid off their tarp funds” being on the verge of going down, it does not appear it required strong-arming, despite the willingness of the government to provide such pressure.

The office responsible for transparency and accountability of TARP funds (http://www.sigtarp.gov) is my primary source of information. The most recent testimony points out that while some TARP funds have been repaid, not all the money involved was structured to yield returns, and that the stated goals of the program, including preventing homelessness due to foreclosure, promoting jobs and economic growth and increasing lending, have not been met, though lending has almost certainly declined less than it would have otherwise. 32% of the total cost of the Capital Purchase Program has so far been received, those loans with the stated goal of going to “healthy” institutions. Given the current health of Bank of America and Citigroup it is still doubtful that full repayment will ever happen.

Even if they *had* paid back their TARP funds, they are still enjoying implicit government guarantees. Goldman Saches, for example, lost money on consumer credit, on mortgages, and on investment banking. It made most of their profits from their trading activities in the rallying markets. At least they have paid back the explicit money the received; AIG’s bonuses are less justifiable.

What would I have the banks do? They could realize losses that exist in the toxic assets they continue to hold, unravel some of their exposure to real estate or raise participation in mortgage restructuring programs (an estimated 12% of eligible mortgages have participated so far). Any of these would avoid the bad publicity of having taken a large amount of government money and an even larger government cosign on their business and then handing it out as goodies to their employees. Even just holding cash reserves sounds better to me.

Part of me wishes the government had let the whole thing go down in the smoke it was set to, even though I know the cost when institutional costs go up and the danger of catastrophic collapse . What we have now is one huge economy of moral hazard.
On October 21st, 2009 03:31 am (UTC), treptoplax replied:
Of course, much of AIG's bonuses are paid to remaining employees in profitible lines of businesses where they have competitors; I'm not sure how kneecapping that business does anything about the guys who imploded the company years ago.
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On October 27th, 2009 05:06 pm (UTC), psychohist replied:
Did you mean AIG or Goldman? AIG is an insurance company rather than a bank and their case is a little different; I thought a lot of their bonuses were going to the only people in the world that had experience with the derivatives that they deal with, in order to unwind them. I won't defend those bonuses, except perhaps on pragmatic grounds.

Edit: good article on the AIG bailout and how it was managed - or rather mismanaged, in my opinion:


Edited at 2009-10-27 05:07 pm (UTC)
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On October 19th, 2009 11:29 pm (UTC), (Anonymous) commented:
Compensation (and interest rates) reflecting performance?
While it is good to see the economy coming back, and it is good to see financial firms paying their staffs based on attaining performance, it may have been possible for the government to have including some form of performance sweetener into getting our taxpayers paid back.

The ultra cheap money that was given out made sense when a collapse seemed imminent. Now that companies are performing well again, it seems inequitable that the companies propped up the government are getting all of the upside, while the taxpayers are being paid back at the, still, ultra low rates.

Since this will happen again sometime in the next 50 years it may good for people to remember the possiblity of recovery when planning for collapse.
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On October 19th, 2009 11:50 pm (UTC), psychohist replied:
Re: Compensation (and interest rates) reflecting performance?
That's certainly a good point. I might quibble about whether the bailouts and TARP ever actually made sense - better to take one's medicine rather than try to delay the blow, in my opinion - but the basic point is valid.

I would note that the government is getting above market interest on some of the TARP funds, and has made a return of over 50% in the case of Citicorp, where a substantial proportion of the money was converted at about $3 to stock that was valued above $4 both at the time of conversion and now. However, the government has also lost most of the funds used on the GM and Chrysler bailouts - unlike the last time Chrysler was bailed out.
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