My Contribution on Zero Intelligence

Discussion in 'Wall St. News' started by PragmaticIdeals, Jul 26, 2009.


    Any comments?


    The past few weeks have seen a spate of announcements detailing upward surges in U.S. investment banking compensation expenditures. Goldman Sachs began by boosting compensation and benefits by 33%, Morgan Stanley recently set aside 72% of second quarter revenues for compensation, Citibank and UBS have each increased pay by 50%, and two days ago JPMorgan followed shrewdly by announcing increased salaries to be implemented in 2010. These announcements generally follow on the heels of initial decisions to boost base salary and benefits in exchange for bonus refinement.

    Of course, some of these pay raises are predicated on a more concentrated industry and Fed measures to prop up the financial sector (i.e., Fed discount window, AIG ATM mechanism, etc). The rest of the pay raises are, as loyal Zero Intelligence readers know, due to notorious high frequency trading platforms (scamming retail/institutional investors). Unfortunately, in a de-leveraging economy supported precariously by government/Fed handouts to opining Wall Street professionals, all of these factors are transitory and short-lived.

    High Frequency Trading will soon yield 0 economic profit when it becomes illegal, destroys the stock market or sufficient players enter the game to arbitrage all profit away. Being in a concentrated industry won’t help when a long and drawn out economic recovery ensues and puts a damper on investment banking and underwriting/lending/securitization profits. Soon enough, the Fed and Government’s kleptomaniac hands will become politically tied down and the free money train will stop.

    And since the only Fed strategy is to re-inflate prior bubbles, we can assume such earnings streams will violently come crashing down in the short or mid-term.

    So why is the bailed out financial industry able to brazenly raise pay in the faces of tax payers who indirectly funded it and even as the real economy suffers dramatically and will suffer for many years to come?

    Well, suffice it to say, this is not the first time in history shareholders have been left holding the short end of the stick as an entire market collapses. The CEO’s of the 70’s were widely regarded as ‘empire-builders.’ Under the guise of ‘diversification,’ managers would gobble up useless company after useless company, enlarging their balance sheet and then boosting their salaries accordingly even as they failed to properly run the behemoth conglomerates they had created. Needless to say, shareholders had been duped by managers.

    In a landmark study, Jenson argued that there was a cost to wasted free cash flows for any firm and that firms pursuing ‘diversification’ strategies were needlessly fritting away shareholder value. The solution was corporate restructuring and the 80’s saw the rise of the LBO. Poorly performing firms were taken over, leveraged and thoroughly controlled to make sure managers didn’t do anything stupid.

    Of course, as investors approached ‘irrationally exuberance,’ too many firms were taken over and over-leveraged leading into the 90’s and shareholder value was destroyed due to ‘too much of a good thing,’ and the decline of cheap credit markets led to the fall from grace of the LBO.

    Again, the solution was corporate restructuring. Instead of debt and interest payments representing control, we saw the rise of the executive stock option grant, share grant and compensation/bonus packages more closely aligned to share price performance. Everything looked good for a while.

    But then management realized they could game the system by boosting short term earnings through accounting massage, low transparency and over-leveraging. The Kings of Wall Street realized that the creation of bubbles (tech, real estate, commodities) allowed them to reap disproportional benefits in the good times as stock prices surged irrationally, and then profit even more during the bad times when their ‘bubblicious’ (Krugman) policies forced the Fed and Feds to hand over further power and opportunity to them.

    And now, even though their game has been unmasked and the economy lies in ruins, Wall Street titans have the cahonas to double-down, pat themselves on the back and grudgingly raise their compensation to unprecedented levels.

    Lest there be any lone voice arguing that these levels of compensation are required to produce shareholder value, let’s all take a look at this graph depicting Lehman Brothers compensation versus employee compensation. And this is before we knew we were in deep recession.

    Clearly, such behaviour is far from shareholder profit maximizing.

    But luckily, there is a solution. A timely and well thought out proposition and simulation done by Bhagat & Romano suggests that the optimal corporate restructuring and incentivizing involves largely a mix of restricted stock and stock options (to be released some years hence, when the extent of their policies should be more wholly reflected in the stock price).

    Of course, there is the risk that policies following the executives’ termination result in unfair stock price depression. But, as recent history has shown, the risk that executive policy culminates in disastrous effects years later is far too prevalent and systematically compromising to ignore.

    Although it would be best for shareholders to enforce and stimulate the creation of such policy, the government should not stand idly by and wait forever for shareholders to act. The systemic risks posed by high-flying High Frequency Traders, sleazy lending and securitization, corrupt hedge funds and ratings agencies must not be ignored by bodies politic charged with safeguarding the public interest.

    If the Fed is going to keep the bailout money a-flowin’, we must at least pressure politicians and engage in shareholder activism to restrict the compensation of executives (which enforces dependence on future stock price/events). Such a modus operandi would at least be more politically palatable and easier to handle than wrestling power away from Voldemort (the Fed).

    ‘Too-Big-To-Fail?’ Okay… Aside from staging a coup on the Powers-That-Be, we are stuck with this label for now...

    ‘Too-Big-To-Restrict-Bloated-Compensation?’ Hopefully not.
  2. Aww no comments =[

    It just got put on the front page too (top left):
  3. 1)'re bearish?
    2) If you want more response, limit your prose to no more than 4 sentences and get rid of the goofy-looking "greek" lettering. :cool: