Friday, December 19, 2008

Wall Street: Changing one incentive structure

I worked on Wall Street for 10 years and recently re-upped with a hedge fund with an eye to taking advantage of the current crisis to make a little money – at least for a while. So I know something about the perverse incentive structures on Wall Street. There are many of them, but today I want to discuss the bonus problem.

There are a number of problems with Wall Street bonuses, one of them being that they are disproportionate to other, in many cases more worthwhile, professions. This has caused Wall Street to drain off many very talented people from other parts of the economy where rather than shuffling bits of paper about making numerical profits, they could be curing disease or figuring out how to make a better solar panel. I do not joke: many of the main “quants” I worked with were chemists, physicists, mathematicians, statisticians etc whose talents could have been (and hopefully will be) employed better.

More importantly, the bonus cycle causes a number of other perverse behaviors. Since the base salary does not provide the lifestyle most employees live beyond their monthly means and rely on the bonus to bail them out at the end of the year. The problem here is that it has become impossible for bonuses to be paid only for exceptional work. Rather as it is the lion’s share of annual income it is expected. “No Bone” is hardly ever “No Bone” but rather some smaller amount. A true zero bonus has often been used as a sign that it is time for a person to move on.

What is to be done?

I think that the bonus culture is entrenched and could be reformed so that it works as it should. I would have the bonus carved into three equal tranches. The first would be the cash bonus as it is now. The second would be an all equity tranche that would vest one third after three years, and another third after four and a final one after five. The final equal tranche would be paid after three years.

This way not only would the worker have an interest in the health of the firm, he would also have an incentive to not get himself fired (fired with cause and you lose your outstanding payments) and also not to lose money. If your contribution were ever negative, the firm would be able to claw back any or all of your future payments.

This way that trader I worked with who, in advance of the Russian Crisis, loaded up on Russian risk and was paid handsomely would not only have lost his job when it all went pear-shaped, he would also have lost most of his income from taking risks others of us warned him about. Instead he made a ton of money and walked away laughing even as the firm almost went under.

Friday, December 5, 2008

May the Great Inflation Save Us

Many economists and other observers believe that we risk a new Great Depression. It certainly seems that way given how over leveraged the system is and how much of that will have to fall. The big-3 automakers will have to either shutter their doors or restructure (through bankruptcy) their operations to a production of less than half the current. There are too many retailers, too much stuff on the shelves not moving, too many houses, too much consumer debt, mortgage debt, and government debt.

Outstanding obligations come to some 200+% of GDP depending on how you measure these things.... And yes it is silly to calculate the Social Security, Medicare etc at $53,000,000,000,000 but that's what the handwringers tell us.

So there could be a collapse of economic activity, everyone buried under the pile of debt and standing in breadlines. That could happen.... but it won't.

It won't because we did learn a couple of things from the Great Depression among them the importance of battling deflation, of avoiding the collapse of the financial system, of the risks of a liquidity trap, etc. So the powers that be will stuff money everywhere until prices rise, they will do it through seniorage and monetization in the guise of fiscal deficits and Central Bank lending. They will allow inflation to clear out all of our obligations and get us back on track.

Inflation paid for The Great Society, the Vietnam War, and the imbalances incurred by the Gold Standard.

This inflation will make people right-side up on their mortgages, it will whittle down the costs if social programs. It will eat away a goodly portion of our national debt and burn off the value of the toxic paper the government will be forced to take onto its books.

It will hurt and those of us who do not have many debts now will be in worse shape on the other side. But it will bail out everyone who needs it.