Tag Archives: compensation

Conventional Meaninglessness

By James Kwak

David Brooks may be a wonderful person, but I don’t like his columns (and I didn’t like Bobos in Paradise, either). It’s hard to put my finger on why, but he helped me out with yesterday’s column. For one thing, he has this annoying habit of trying to claim the reasonable center, often by making false equivalences between the two things he is trying to sound more reasonable than. So, for example:

“No place is hotter than Wisconsin. The leaders there have done everything possible to maximize conflict. Gov. Scott Walker, a Republican, demanded cuts only from people in the other party. The public sector unions and their allies immediately flew into a rage, comparing Walker to Hitler, Mussolini and Mubarak.”

Comparing the other side to Hitler is bad.* Pushing for legislation that hurts the other side is something else. In the abstract, that legislation may be justified; Walker did just win an election, after all. But it’s a completely different category from making stupid signs to hold at rallies, and it’s a classic David Brooks false equivalence.

But that’s just a minor peeve. It’s when Brooks adopts his pseudo-reasoned “everybody knows” tone that I get really mad.

“Everybody now seems to agree that Governor Walker was right to ask state workers to pay more for their benefits. Even if he gets everything he asks for, Wisconsin state workers would still be contributing less to their benefits than the average state worker nationwide and would be contributing far, far less than private sector workers.”

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Good for Goldman

Searching through my RSS feed*, I observer that not many people have commented on Goldman Sachs’s stunning compensation announcement (except for Felix Salmon), perhaps because it came out on the same day as the “Volcker Rule,” perhaps because bloggers are not wired to say nice things about Goldman. But I’m going to make the sure-to-be-unpopular statement that Goldman did the right thing here.

We all know that Goldman made a lot of money last year: $35.0 billion before compensation and taxes, on my reading of the income statement (that’s pre-tax earnings plus compensation and benefits). Many people think that it made that money because of government support, but that’s beside the point here; right now, this is purely a question of dividing the spoils between employees and shareholders.

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More from “The Lion”

In the short days between Christmas and New Year’s, BusinessWeek published an interview with Paul Volcker conducted by Charlie Rose headlined “The Lion Lets Loose.” Rose asked him why the U.S. economy has fallen behind in some areas, such as manufacturing. Here’s the segment:

“How did that happen?
“What happened is our best and brightest got attracted to Wall Street. You’ve read about those big bonuses. These are generalizations, but I do think that the pull of Wall Street on bright young people, ambitious young people, has been tremendous.”

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Bankers and Athletes

Bill George, a director of Goldman Sachs, defending the bank’s compensation practices, said this: “The shareholder value is made up in people and you need the people there to do the job. If you don’t pay them for their performance, you’ll lose them. It’s much like professional athletes and movie stars.”

The idea that the level of inborn talent, hard work, dedication, and intelligence you need to be a banker is even remotely comparable to that of, say, NBA basketball players is ridiculous. But leaving aside the scale, there are some similarities. Most obviously, athletes on the free market–those eligible for free agency–are overpaid. John Vrooman in “The Baseball Players’ Labor Market Reconsidered” (JSTOR access required) goes over the basic reasons, but they should be familiar to any sports fan. There is the lemons problem made famous by George Akerlof: if a team gives up a player to the free agent market, it probably has a reason for doing so. There is the winner’s curse common to all auctions: estimates of the value of players follow some distribution around the actual value, and the person who is willing to bid the most is probably making a mistake on the high side.

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Another Approach to Compensation

The problems with the traditional model of banker compensation are well known. To simplify, if a trader (or CEO) is paid a year-end cash bonus based on his performance that year (such as a percentage of profits generated), he will have an incentive to take excess risks because the payout structure is asymmetric; the bonus can’t be negative. That way the trader/CEO gets the upside and the downside is shifted onto shareholders, creditors, or the government.

I was talking to Simon this weekend and he said, “Why a year? Why is compensation based just on what you did the last year? That seems arbitrary.” When I asked him what he would use instead, he said, “A decade,” so I thought he was just being silly. But on reflection I think there’s something there.

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Paper of the Year

As bankers’ pay, at least for the fortunate ones at Goldman and JPMorgan, returns to pre-crisis heights, a paper by Thomas Philippon and Ariell Reshef is becoming everyone’s favorite citation. The paper, “Wages and Human Capital in the U.S. Financial Industry: 1909-2006,” got a first wave of attention from Paul Krugman, Martin Wolf, and Gillian Tett back in April (see Philippon’s web page for links). It’s also the subject of Justin Fox’s column in Time; see Fox’s blog for links to other discussions. (I also cited the paper in my ramblings provoked by Calvin Trillin.) The earlier references were mainly for Philippon and Reshef’s finding that pay in the financial sector correlated strongly and negatively with the degree of regulation — pay was higher in both the 1920 and in the post-1980 period, and lower under the stricter regulatory system created during the Great Depression. More recent references, including Fox’s column, have focused on the idea that people in finance are overpaid.

Since most articles have just focused on the headlines, I’m sure Philippon and Reshef are going to be misquoted all over the Internet. For example, at least two articles focus on a figure of “30% to 50% of financial-sector pay” in ways that are not quite correct. So I’ll try to lay out what they actually say.

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Where Else Are You Going to Go?

Yves Smith returned from book-writing land to catch up on the Andrew Hall story, which is one that I pretty much decided to ignore from the beginning. Hall is the Citigroup trader who, according to his compensation agreement, was due a $100 million bonus. The bonus was so big because Hall and his team were due 30% of the profits from their trades, which is even more than typical hedge fund fees. (This tradition of particular trading groups negotiating a share of their profits dates back at least to Salomon in its heyday; AIG Financial Products also had this type of deal.)

But Smith focused on one element that got me thinking. Hall’s division, Phibro, was bought by Occidental Petroleum. “Oxy paid $250 million, the current value of Phibro’s trading positions. There was NO premium, zero, zip, nada, for the earning potential of the business. Zero. Oxy bought the business for its liquidation value.” Smith infers that no one was willing to pay more because the success of Phibro depended on its being part of Citigroup and benefiting from Citi’s low cost of funding; in other words, the massive profitability of Phibro was in part due to an accounting error — not charging it an appropriate cost of capital given the risk it was taking.

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Financial Regulation, a Slightly Optimistic View

The big news on the regulatory front last week was the Wall Street Journal’s revelation that the Federal Reserve will give its regulators the ability to reject any pay package for any bank employee that encourages excessive risk-taking. The Fed is apparently claiming this authority on the grounds that as a safety-and-soundness regulator, it has the right to prohibit any bank practices that threaten the safety and soundness of the bank. Sounds good to me.

Now, there are certainly reasons to be skeptical, which Yves Smith abundantly outlines. This could be a ploy to gain some populist credentials and head off more Congressional oversight of the Fed. The Fed has been willing to trust banks to tell it what their risks are, so it is not equipped to identify compensation packages that create excessive risk. TheFed will be looking (according to the WSJ) for outliers among the group of the top 25 banks – so as long as all 25 banks are engaged in the same silly compensation practice, the Fed will let it go.

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