Plus ça change, plus c'est la même chose

A investment banker with a very good take on the problems with the Wall Street bonus system. Note that it was written in 1988.Sounds familiar:

The headlines now are filled with stories of Wall Street's woes. Thousands are losing their jobs. Once powerful firms are being humbled by their own increasing debt and management problems. Many firms are turning to management consultants, a sure sign of widespread turmoil and desperation, for answers. How did an industry that could boast the highest returns, the brightest talent and the greatest compensation get to be in such trouble?

Part of the answer rests in the compensation system that fueled the explosive growth of investment banking. The bonus system — the annual ritual of money and merit. It is at bonus time that bankers, traders and salesmen look to getting their rewards. This is the time when the legendary endless hours, extraordinary creativity and plain hard work get the big payoff... for the year's work.

And, that is it. The bonus was simply for a year's work; but more importantly, the entire focus of the year's work was the bonus.

Does this short-term system serve the long-term best interests of clients and Wall Street firms themselves, particularly now? The bonus system has had an insidious effect on the economy, Wall Street's clients and ourselves as investment bankers. It directly skewed the structure of many Wall Street firms and, thereby, the national economy. It guided the energy of many of our society's best and brightest members, making their perspective short and their attitudes increasingly arrogant. It often undermined and diluted traditional standards of excellence.

But, the Wall Street bonus system reflects a larger societal problem, not simple greed as many believe, but the almost insatiable desire to have everything now. Bonuses are simple and logical. There is nothing wrong with the concept. But, the amounts involved on Wall Street, in practice, are enormous, almost unreal. And, now in the midst of extraordinary turmoil perhaps the way we pay ourselves must be challenged.

PSA on Banker Pay

Following up on a recent post by Tyler Cowen, Matt Yglesias says today that the empirical evidence that banker pay played a role in the crisis is "quite weak". He concludes:

All that said, what I think people really need to do is confront the fact that obscene banker compensation is really a social justice issue rather than a financial regulation issue. Which is to say the sky-high pay seems wrong just as such rather than because there’s a specific bad incentives issue that needs to be corrected.

But Ygelsias's comments miss a key point about the both the study and the structure of investment banks--the problem is not with the CEOs* (which the study measures). Rather, it's the traders swapping complex derivatives, bankers packaging shady mortgages, and salesman foisting these crappy products on customers we have to worry about. These people very clearly have incentives to think about the short-term gains rather than the long-term losses. The pay structure encourages bank employees to gamble with shareholders' money in a way that gives the bankers huge rewards if they win, while sticking them with little of the downside.

True, there probably aren't many, if any, studies that could empirically prove this. But that's because it's impossible to get actually get data on this to measure. CEO pay has to be reported to the SEC, but the numbers for non-top management employees are closely guarded. Banks are reluctant to turn them over to federal law enforcement agents when asked. Do you think they're going to hand them over to academics for research that will mostly be used to criticize their practices?

*Most of the CEOs of these banks were bond traders or salesman in a time when finance was much less complicated. I highly doubt the really understood what was going in many of the more complex areas of the bank, which is why the overly relied on measures like Value at Risk.

What Do They Get Paid For Again?

All the hubbub over the Freep's big Michigan story has inspired me to make my glorious (although likely short-lived) return to the blogosphere. I don't want to rehash many of the issues that have been discussed in detail (although I imagine I'm in the minority of Michigan fans on this one), but I did want to point something out I haven't seen anywhere else.

There has been a lot of discussion about how the Free Press failed to get both sides of the story. I'm not sure this is true.

The Freep DID seek out both sides of the story. Unfortunately, in typical fashion for a large entity (whether it be a school, company, etc.), the athletic department chose to give out a boiler plate response from all the parties involved. If it's true that the University isn't breaking any rules, shouldn't the PR department get some of the blame for not explaining to the journalists why Michigan's program falls within the established bounds? It's kind of tough to give both sides of the story equal treatment when one side refuses to talk you. Should the Free Press be required to make Michigan's argument for them if Michigan won't make that argument itself?

Somebody really need to explain to me what PR departments do. It seems like Michigan is working from the same playbook as the investment banks. Isn't their goal to head off stories like this one?

In The Hole

Following up on today's earlier post, I found this post on NJ's underfunded pensions from Harvard University's Kennedy School of Government lecturer and former assistant secretary in the U.S. Treasury Department Thomas J. Healey interesting:

New Jersey is on the cusp of a public pension crisis that could dwarf the $3.5 billion to $4 billion funding shortfall projected by Gov. Jon Corzine in October. Although the figures are obscured by current accounting rules, a detailed examination shows that New Jersey actually faces a potential $80 billion pension shortfall (not even counting the more than $20 billion in losses from the current stock market free-fall) and $50 billion in unfunded post-retirement medical and prescription drug benefits.

This total unfunded liability of $130 billion is more than four times the state's 2008 fiscal year budget, and represents a shortfall of around $44,000 for every household in the state. It's fair to conclude that sooner or later, someone -- almost certainly the taxpayer -- will be forced to shoulder this staggering fiscal burden.

This Explains A Lot

Barry Ritholtz posts today about a New Jersey firefighter stuck as the only tenant in a Florida high-rise condo. Although Ritholtz focused on the real estate aspect of the story, a few of the commenters on the story itself wondered how exactly a firefighter could afford the $430,000 vacation home. The answer is simple: he works in New Jersey.

According to a public salary database at the Asbury Park Press, the firefighter made $152,210 last year ($117,612 from the fire department plus $34,598 from the town). Even better, the firefighter, now 45 years old, plans to retire in four years. Assuming the standard 25 years of service, he'll pull down 65% of that salary -- or $98,936.5 per year -- in retirement, plus of cost-of-living adjustments (and likely full medical benefits, too).

Obviously, firefighters are putting their lives on the line, so I'm not complaining about them specifically. But when you expand these sort of salaries and benefits to policemen, teachers, and every other state and local employee, it adds up. It's no wonder that, according to the Tax Foundation, New Jersey ranks first out of all 50 states in terms of individual state and local tax burdens, while also having the worst tax climate for businesses in the country.

UPDATED: Included salary breakdown.

Economic Profits vs. Accounting Profits

I don't mean to pick on James Kwak over at Baseline Scenario because I do generally enjoy the blog, but a piece of a post he wrote today reminded me of an elementary mistake many people make that is worth pointing out.

Criticizing a piece in today's Washington Post written by a Yale Law professor, Kwak says:

In a competitive market, if one company is earning high profits, then other people will want to start new companies to compete with it. By entering the market, they increase competition, reducing profit margins for the original market leader; more companies and more competition also mean more innovation; both of these factors increase overall social welfare. In a true competitive market, one without barriers to entry or market power, companies should not earn any profits at all, because competition will drive price down to marginal cost.

But Kwak fails to draw the distinction that he is talking about a different type of profit than the professor is talking about.

The professor is referring to accounting profits. This is what a company reports to the public in the form of net income at the end of a quarter or year (corporate earnings, as the professor calls them). Quite simply, it is the company's total revenues, or sales, minus its expenses, which include the cost of labor, supplies, shipping, buildings, etc. It's what accountants get paid to figure out.

Kwak confuses things, though, because he is referring to economic profits. This is what an economic professor is talking about when he teaches you Econ 101. This includes "costs" an accountant would not consider when reporting net income, mainly opportunity costs. An opportunity cost, as Wikipedia nicely sums up, is the "value of the next best alternative forgone as the result of making a decision."* Economic profits -- not accounting profits -- go to 0 in a perfect economy because companies will continue to enter a market until the benefits of entering market B (in other words, the opportunity cost to entering market A) outweigh the benefits of entering market A. The cost of having to choose to enter market A instead of entering market B, though, is not an expense as an accountant would think of things, so you can easily have an accounting profit in a perfectly competitive market where economic profits are, in fact, equal to zero.

This doesn't necessarily mean Kwak's main argument is wrong, but it is a mistake worth mentioning (which is why I pointed it out in the comments of the post, too). Hopefully this post will keep you from making the same mistake in the future.


* For instance, let's say you take a job with company A for $50,000 over a job with company B for $45,000. The opportunity cost of taking the job is $45,000.

Why Financial Journalism Has Struck Out

The Atlantic’s Derek Thompson wrote an interesting post today critiquing the problems of financial journalism by comparing it to political journalism:

“Politics, I think, is fundamentally different than economics because...well, I don't want to say "because it's just just simpler," even if I suspect it might be the case. Instead I'll say this: Much of economics has its own language. For many Americans, it's a foreign language. Financial regulation reforms, like assessing risk in shadow banking markets, is still, I'm unembarrassed to say, a bit shadowy to me. And the right way to do stimulus spending in a crisis is still shadowy for the economic industry, even though they've been studying it for 60 years!

On the other hand, you don't need to exotically expand your civic vocabulary to understand that American politics is about votes, interests and values, and when you stir them together, you get a stew called strategy. Everybody gets politics, because it's all so much like life. If you were tasked with describing politics exclusively through sports metaphors, I think you could do it pretty effectively. The Democrats struggling to write a passable health care bill to get conservative Democratic support? Kinda like a coach designing a playbook for a quarterback with compromised skills. Obama pledging openness rather than clenched fists to troubling foreign leaders isn't so different from a team's strategy of dealing with troubled players (Artest, Owens, Sprewell) through inclusion rather than punishment. On the other hand, after 10 months, I still can't conjure baseball metaphors for the Public-Private Investment Partnership.”

So does financial journalism simply need more metaphors? Not necessarily. But if economics is going to be as approachable as politics, we're going to have to get creative. We can start by speaking in English, as Felix Salmon wrote, rather than Wall Street acronyms. We can start by imagining our audience, not as the author of the blog post we're responding to, but as the readers of the blog post we're writing, who don't know a CDS from an STD, because we haven't fully explained it since an entry we wrote in March. But we can do it. We can be readable!

I’m actually surprised Thompson considers journalists using sports metaphors to describe politics as an example of successful coverage. I think many people would argue that coverage like that is one of the biggest problems with political journalism. It doesn’t make it more “approachable”—it just fails to adequately discuss the real issues behind legislation. We don’t get to read about the various economic advantages and drawbacks of various health care plans floated by Congress, for instance, but only about which bills can get passed. I’d hate for finance journalism to be more like that.

The mainstream media already tries to shoehorn its business and finance coverage within that structure. Reporters write profiles glorifying (or villifying) CEOs — just like they might write about politicians. They report about company X’s decision to introduce a product to battle with company Y or combat broader trend Z—just like they might write about the fight over a bill. But it’s more difficult to write an explanatory piece about a complex financial instrument—just like it’s difficult to write about the substance of various bills. Journalists need elements like conflict, plot, and characters that that don't necessarily help explain those sorts of things.

The problem is not that readers can’t understand finance (or politics) if you aren’t able to easily compare it to life, sports, or some other thing the “common man” can grasp. The problem is that journalists can’t write about it within their traditional narratives without using those sorts of metaphors. It’s not just about finding the proper language to describe collateralized debt obligations of asset-backed securities, credit default swaps and other complex financial topics in terms readers can comprehend. It’s about finding organizations and structures of stories to convey that knowledge—and I’m not sure they exist in the traditional journalist’s toolbox.

This is why blogs have been so successful in explaining the financial crisis to us. They don’t need to use the inverted pyramid structure or write killer ledes and nutgrafs — they can simply explain collaterlized debt obligations of asset-backed securities to us. Or they can use cool graphics. It’s a bit easier to get something like that on a blog than it is to get it on the front page of the New York Times.