March 24, 2009

Be Careful What You Wish For

Posted by JSpur at March 24, 2009 7:11 AM

Politicians have climbed over one another to express their outrage. Confiscatory tax legislation has been whooped through the House. One Senator has helpfully suggested that the offending executives make him happy by taking their own lives. Bus tours have been organized to deliver placard-toting protesters to the driveways of the guilty.

Now comes the news that AIG executives are coughing up their bonuses rather than endure further vilification. CNBC further reports this morning that a quarter of the senior executives at AIG's Financial Products unit have also tendered their resignations. More resignations are predicted.

And there was much rejoicing, right?

Well, let's think it through.

The Times article puts the value of AIG's derivative book at $1.6 trillion. Let's assume that this could have been fully recovered in time. If, because of the resignations of veteran staff and their replacement with less capable (but cheaper) traders, the company recovers 1% less of the value of those positions than it would have recovered had the bonuses been left intact and the senior executives who quit had remained, then the cost to the company of this uproar will have been a cool $16 billion, or 100 times the disputed bonus amount. If the recovery is 10% less than otherwise it would have been, the cost is $160 billion- 1000 times the bonuses.

Now the hapless taxpayer is on the hook to the tune of 80% of this at risk amount.

Meaning that by bending to the will of the mob and hounding the AIG traders into the wilderness our so-called leaders have risked hundreds of billions of losses in order to save hundreds of millions of dollars in bonus payments (half of which would have been taxed away under existing laws anyway, at least for those traders living in the New York area).

If he is to be held to his own standard of outrage concerning the waste of taxpayer money, perhaps Senator Grassley should be asking, in the words of Shakespeare: "Hath no man's dagger here a point for me?"

One hopes that the backpeddling from this madness that we saw over the weekend will continue, at least as respects the other institutions that have taken TARP funds (in some cases, at the point of an executive branch gun).

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Comments

Here's another line of thought. There aren't many other types of institutions that can pay them such a bonus anyway. I mean sure, they might try drug trafficking or gun running, but I'll wager that in general they are ill equipped to do much more than manipulate funds. That being the case these folks are going to either 1- call it good and retire (yeah, right "How much money is enough?... A little more than you have."), 2- work for another firm (which we probably own most of too at this point), or 3- found their own firm (good luck, seriously - read on). If they call it quits, we did actually lose an experienced player, et cetera. Either of the other two options amounts to something like trust busting, which probably should be done to anything "too big to fail" anyway. Better yet, in option 2 experienced people are dispersed and can guide a wider berth of assests. In option 3 they provide competition and diversification that might foster increased market confidence.

Posted by: Mylanda | March 24, 2009 6:09 PM

Thanks, Mylanda. That's an interesting point of view. My guess is that the most capable traders at AIG will opt for one of your three options, leaving the least smart/talented/capable/motivated traders- i.e., the ones who are probably overpaid at the reduced rates of comp anyway- behind to try to maximize the value of AIG's derivatives book. This is the phenomenon widely known as "adverse selection." The taxpayers, who are now the involuntary owners of 80% of this company, should be troubled by the implications of that. This is, however, the result to which all this "justified outrage" and policy-making fecklessness inevitably lead.

Posted by: JSpur | March 24, 2009 6:24 PM

Before I get too long-winded, I'd just note that Chad Orzel had an amusing post related to this.

There are two assumptions above which I find non-obvious. Why assume full recovery of this 1.6 trillion, and why assume any of these executives are competent, let alone more capable than their unspecified future replacements? Employees with any interest in the long-term viability of their employer wouldn't have signed off on heavily leveraged shenanigans with mortgage backed securities. So either they weren't very good, or they knew everything would fall off a cliff eventually but did it anyway to maximize personal gain (perhaps correctly assuming that the American tradition of privatizing profits and socializing losses would keep their company around anyway). Either way I don't see a great benefit from keeping these people. Not clear they'd be replaced, necessarily, either - one would expect fewer people entering the financial field now. AG, would you move to Wall Street if you were graduating this June?

On the recovery fraction, my understanding is that the toxic assets, Big Shitpile, whatever you want to call it, was all based on the premise of eternally rising real estate values. Now that real estate is heading back towards historical norms, isn't it a given that all the financial firms are guaranteed to take enormous losses (possibly offset by the gigabucks Paulson and Geithner keep throwing at them)? Assuming a recovery fraction of 1 really doesn't make sense to me... Are you talking about something different than I think you are? I'm not sure of the precise meaning of "derivative book" but a quick googling makes it look like it indeed refers to the leveraged mortgage backed shenanigans I thought it did.

As a policy matter, I don't know what the right path is. Even if it costs extra money as you argue, JSpur, punitive measures to force these people out of their jobs could be reasonable. My interest, personally, is the hope that incentives will be rearranged to make a future crisis like this less likely. As I wrote earlier, it could very well be that capable people saw all this coming years ahead of time, but went ahead with bad bets anyway since they'd make so much money in those few years that their personal self-interest would be maximized that way. So I'd like to see everyone involved - traders, shareholders, executives - lose their shirts. If it were possible, reduced to grad student levels of wealth. Make sure that in the future, individual incentives are aligned with the long-term health of their company. If it costs taxpayers some extra gigabucks to (hopefully) fix a moral hazard problem in the future, that's not necessarily a bad tradeoff. Very hard to analyze that tradeoff quantitatively though (estimating changes in the probability of future crises based on various possible current actions, then valuing what percent change in probability on what timescale is worth a billion dollar extra loss -seems pretty intractible).

Note, my "let them all lose their shirts" position is not short-term AIG bonus outrage (I've reached the point of treating finance like Iraq - barely skimming stories anymore while thinking "are we still dealing with that mess?"). Had I been Paulson, I probably would have picked Bear Stearns (or one of the other early bailouts) for the "let's see what happens if we let them go bankrupt" experiment, rather than waiting until Lehman. Good thing I'll never come anywhere near the Treasury Department! :-)

Posted by: Justin | March 24, 2009 7:43 PM

I do not love that we (as a country) are in this mess nor that we gave money in a ill concived way to a companys that gave some questionalble bonuses. That said I have some serious issues with how our spineless politicians are handing it now.

1st the tax a bonus after the fact at 90% actually over 100% by the time local taxes are in play is a bad idea. First the way the house law is writen it will impact friend of mine at other firms that received money in group thast posted heathly profits for thoughs firms. So the broad stroke taxing will not only affect AIG but also may very compentent employees from other firms in not toxic asset related groups. Therefore this idea of taxing the bonuses may put this too big to fail companys at further risk as it drives talent from the company in groups that did not cuase the mess. Also the tax law is poorly written n thst it is based on total family income not jsut the income of the person with the bonus making it yet another marrige penealty.

2nd as a side note. I now have 2 horrible senators from CT Dodd may yet be a bigger mistake then Lieberman

Posted by: shellock | March 24, 2009 8:57 PM

Also being from wilton where there were idiots protesting and new article on it i foudn the groups bussing the protester dispictable. There we new interview we popel from bridgeport complaining I am lossing my house its all AIGs fualt i deserver there bonus not them. That just annoys me. This mess is not all AIG fualt it is a fialure of our cuontry as a whole in a systemic way across the system. Greed was rampant and we created loan we should not have then sold them off to investors who should probably have known better. unfortuanly we let it get so bad we need drastic measures to right the situation. They are not pretty and some popel who messed up and help sink the ship will get away with it. But for the good of the whole we all must suck it up and fix the system even if we dont get the satifaction of pinning blame on someone and making them pay.

sorry if this was rambling...

Posted by: shellock | March 24, 2009 9:02 PM

Justin, for a guy who generally skims this stuff, you seem to care a lot. Good for you.

And I was going to wait until tomorrow to answer, but what the hell. At the moment, I am in Washington DC, where everyone knows, tomorrow never comes.

As to the $1.6 trillion number- I am assuming only that the book value of these positions as reported in the media has been marked-to-market under FASB 157 and therefore the people who have studied the positions the most carefully believe that is what they are worth. (Their book is more credit default swaps than CMBS or other forms of securitized real estate, as I understand it, but that's beside the point for these purposes.)

But whatever the true value is- let's call it X- it presupposes that people expertised in these kinds of financial instruments- and all and sundry agree they are woefully complicated- can work them out on some basis that yields at least X to the company. Presumably, this means the people then on staff, who created the positions and understand them the best.

Now, what happens if we introduce taxation and compensation policies that cause these very people to up and leave?

New people, unversed in these admittedly complicated securities, must be brought in to work them out.

My point is simply this- as an owner of this enterprise, before I adopted policies that ran off the current staff, I would want someone to tell me what risk I am exposed to that, as a consequence of introducing new staff who know nothing about these positions, I will recover .99X, .98X, or .9X, instead of X.

No one has even begun to do this analysis. Nor will they. Because everyone is too intent on retribution to think like a rational owner of AIG.

Which is just plain dumb.

The good news for your point of view is this. Your wish that all concerned- traders, executives, shareholders- lose their shirts, has come to pass. AIG was a $45 stock a year ago; it is a penny stock today.

That is in the books, and it is not the issue.

The issue is, how do we structure the company going forward to minimize the hit us taxpayers, as shareholders, will end up taking when the dust settles. The answer is not to institute tax and compensation policies that are designed to attract no better talent than the guy who is selling hot dogs on the corner of 48th and Park.

If we do, then, with all due respect to Chad Orzel, the enemy is no longer those traders, who have long since fled to greener pastures.

We have met the enemy, and he is us.

I will leave it to AG to say whether he would take another shot at Wall Street were he graduating now instead of then.

Posted by: JSpur | March 24, 2009 9:04 PM

To answer Justin's question, it is true that Wall Street jobs in general would look a lot less attractive if I were graduating now instead of last year. (Also a lot less numerous: some of the places I interviewed at or applied to don't exist anymore, and others are smaller than they used to be.) On the other hand, if I had been offered my current job this year instead of last year, I think I still would have accepted. All the reasons it felt like (and turned out to be) a good fit for me still apply today, and I'm not just saying that because some of my coworkers read this. :)

I am content to let others make the general case against the bonus tax; I do think it's a bad idea, but this view is obviously colored by the fact that I work for one of the firms that is subject to it. I am inclined to comment on some of the narrower points in this thread, but since I also need to catch up on sleep tonight I'm going to have to postpone.

Posted by: Arcane Gazebo | March 24, 2009 11:34 PM

So the 1.6 trillion is *after* all the loss in value in the past year?! What did AIG think it was all worth back in '06, 50-100 trillion? I do vaguely remember reading someone (a few months ago) pointing out that the total losses in this crash work out to a few years of planetwide economic output. I didn't think individual companies could be in the multi-trillion loss range, though...

Care a lot - maybe; it is the pressing issue of the year after all. I tend to write a lot when I write at all, though, so that's probably also part of it.

Seems like the US has an odd kind of ownership of AIG (and other bailout companies). To me, "ownership" implies the ability to just call 'em up and say "Hey, no bonuses for you guys! Give that money back." and have them do it, without the need for ad hoc kludges to the tax code, written perhaps overly broadly (Shellock's friend, for example) to pass constitutional muster as not being a bill of attainder. Apparently the US can't bend company policy to its will in that way, so we have this controversial bill (which looks like it'll die in the Senate, like so much else does now that a filibuster is the default for any bill).

I don't think everyone has lost their shirt - shareholders, apparently, but these guys getting the bonus money that pissed everyone off are doing great.

I've seen the retention argument before, now that I think about it. IIRC, 11 of the AIG "retention bonus" recipients left anyway (before this mess hit the press). And as a general point, do we really think the people who created the mess are the best ones to clean it up? Are "the people who created the mess" the same as "the people best versed in the current value" of the company's positions? Not sure there's a straightforward way to answer these questions. People who saw the crash coming and managed their funds accordingly would be a selection for good judgment and overall market knowledge, but as you say these things are absurdly complicated and those qualities might well not help much if brought in to fix a particular company like AIG. But given that AIG has screwed up so badly that it needed to be bailed out (and the stock drop you mentioned), relying on the same people to fix their company seems really dubious. Maybe if their compensation was actually tied to performance (bonus only for actually doing well for the taxpayer-owners, penalties or reduced future base salary or whatever for additional losses), but I gather that's not how Wall Street does things...

Has there been systematic turnover at these companies, firing guys who lost the company tons of money while retaining the ones who did well? My default assumption is "no", but I wouldn't necessarily have noticed if the answer is yes (if this has even been reported at all).

Posted by: Justin | March 25, 2009 2:09 AM

Justin -

Two things about ownership of AIG and the bonuses. First, when you buy a company (or anything, really) you are also buying that company's agreements. This is good and bad - if the company has an agreement that it will be given millions of dollars a month, you want that agreement kept. Of course, it goes the other way as well - if you have an agreement that you will pay millions of dollars a month, you can't just back out of that agreement because you own the company. Particularly with an insurance company, which lives and dies by its ability to meet its contracts, you can't just go in and say "I own this company, and I don't wanna do that."

Second, remember that these were retention bonuses, which you noted. However, to my understanding, the people who wrote all of these CDOs had actually left the company by the time these bonuses were agreed to and these were the folks who were being counted upon to clean up the mess that those other guys had made.

Posted by: ChrisLS | March 25, 2009 7:12 PM

Chris, I was wondering where you were... :-)

Point #1 - Had a paragraph written, but I think I answered my own question as I did so (I don't buy the contract argument for employees). Helpful analogy: the state of California "owns" the UCs, yet I don't think the legislature could directly dictate tuition, faculty or grad student pay, or stuff like that. So I'd best think of US:AIG as CA:UC... I had been thinking in terms of the government having an "ownership" role analogous to a University President and/or Board of Trustees. Expressing it in terms of the academic analogy makes clear that that's incorrect.

Point #2 - good to know, thanks. I still think the amount financial folks get paid is ridiculously high (much like pro athletes - more in a year than I'll make in a lifetime), but that's life. Large sums of money to (hopefully) competent, responsible people to clean things up is quite a difference from the idea of those sums going to a bunch of screw-ups who bankrupted their company.

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