Tuesday, March 17, 2009

Financial extortion?

Andrew Sorkin makes a case in favour of the AIG bonuses in today's New York Times. The article - I think unwittingly - provides a remarkable snapshot of all that is wrong with the financial industry today, and why, for the sake of efficiency if nothing else, it has to be radically reformed. I think it's worth reading in its entirety, but here are some excerpts with comments:
...more sobering thought: A.I.G. built this bomb, and it may be the only outfit that really knows how to defuse it. ... A.I.G. employees concocted complex derivatives that then wormed their way through the global financial system. If they leave — the buzz on Wall Street is that some have, and more are ready to — they might simply turn around and trade against A.I.G.’s book. Why not? They know how bad it is. They built it.

[CT here] First, isn't that illegal? If it isn't, shouldn't it be? Second, isn't this nothing less than extortion (not even by analogy, but literally)? It's the most explicit example of rent-seeking you could hope to find. The crucial thing here is this: it is now clear that these particular actors have never created any wealth (only destroyed it) but because they can do still more damage, we have to pay them whatever they want. If you think about it, this is even worse than the looting that takes place when financial systems are in chaos: it's the financial equivalent of a gun to the head (and really not so different from a demand from terrorists or kidnappers).
“We cannot attract and retain the best and brightest talent to lead and staff” the company “if employees believe that their compensation is subject to continued and arbitrary adjustment by the U.S. Treasury,” [Edward Liddy, AIG CEO] said.

[CT here] How about "arbitrary adjustment" by the market? Isn't that how markets work? These people are not schoolteachers, adding value far away from any explicit revenue stream, and therefore needing protection from market failure in the provision of their wages. Far from it: they're benficiaries of a market failure in the reverse direction - they've been overpaid for too long. At best, they're meant to be at the mercy of market forces, or at least that was the story they gave us in (what seemed like) good times, to justify their earnings.
Would you want to work at A.I.G.? Sure, maybe for $3 million. But not if you could go somewhere else for even more — or even much less.

[CT again] Sadly, this is probably true. Yet, you may ask, how can there possibly be a bidding war (and at wage levels that make the President look like an underpaid janitor) for "talent" between bankrupt firms? The answer is of course that on account of the "too big to fail" situation, these firms are now neither private firms nor publicly-operated utilities, but (and I'm being polite) but "zombies" (to continue the analogy you might say they are feasting on our national wealth).

Moreover, for the financial sector as a whole, the relationship between wages and marginal product has completely broken down. We're not talking about subtle issues, minor failures in labour markets, but a near complete breakdown of the link between what these people are paid and what they contribute to society.

This is glaringly obvious in the AIG case, but I would argue has been true for some years, for the financial sector as a whole. I'm not saying no net wealth creation took place, averaging across the entire sector and say a ten-year time window (although this may still turn out to be the case). What I am saying is that it is increasingly clear that the huge rewards flowing to this one sector (in recent years in the US and UK, ~30-40% of all corporate profits, net of a massive wage bill) bore little relation to the true value of the sector, under any reasonable definition.

What's going on right now is simply looting and in at least one case extortion. What happened until recently was legal, but a massive market failure of sorts which led to an extreme misallocation of wages.

One last quote form the Sorkin piece:
“The jobs are terrible,” said Robert M. Sedgwick, an executive compensation lawyer at Morrison Cohen who represents a number of employees of banks that have taken government money. “You have to read about yourself in the paper every day. These people are leaving as soon as they can.”

No comment.


Anonymous said...

Aren't a lot of the traders still there market makers that were encouraged to build too large of a book by their risk managers or risk mangers that were ignored by those above them?

Most failures like this seem to come down to a handfull of people above the traders that take on too much business and then find the position to large to sell because everyone else is selling too(LTCM).

That is not the fault of the traders. I'm as angry as the next guy about the whole situation but this can get worse if it turns AIG counterparties like Goldman, Morgan ect into AIG's as well.

Let's keep the traders and schedule a public hanging of their superiors.

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