Make Wall Street Risk It All
By WILLIAM D. COHAN
Two years after the near collapse of capitalism, we certainly have our fill of financial reforms. The 2,200-page Dodd-Frank Act, which President Obama signed this summer, creates an Orwellian alphabet soup of new agencies, oversight boards and offices intended to protect us from ourselves.
The problem is that since the incentives on Wall Street have not been changed one iota by the new laws
— nor are they likely to be changed by any of the soon-to-be-written regulations of federal agencies — we’re no better protected from bankers’ potentially reckless behavior than we were before the latest round of reforms.
It’s not that Dodd-Frank ignored Wall Street’s past excesses. The law will ensure that some, but not all, derivatives will have to be traded on exchanges and that some, but not all, of the banks’ proprietary trading will be curbed and that some, but not all, of their private-equity and hedge funds will be shuttered or spun off. Dodd-Frank is also supposed to curtail Wall Street’s penchant for creating conflicts of interest, although how the law is going to do that is far from clear.
“In the end, our financial system only works — our market is only free — when there are clear rules and basic safeguards that prevent abuse, that check excess, that ensure that it is more profitable to play by the rules than to game the system,” President Obama said when he signed the bill into law. That rhetoric is fine, but unfortunately Dodd-Frank will do nothing to change the rules on Wall Street.
Nor, frankly, will the expected coming into force, in a couple of years, of the new Basel III capital rules, which will likely require banks to have common equity equal to 7 percent of the value of their assets.
Bankers and traders still have the same irresponsible, accountability-free incentives they have had for the past 40 years to generate as much revenue as they possibly can each year, regardless of the consequences.
The change occurred when Wall Street firms stopped being partnerships, in which every partner put his full wealth on the line every day, and became corporations, which put the risks on their shareholders and creditors.
Dodd-Frank and Basel III both missed plum opportunities to change Wall Street’s incentive structure. Which is a shame, since it would not have been difficult. Human behavior is pretty simple actually. We do what we are rewarded to do.
On Wall Street, people are hugely overcompensated for generating revenue, which they do by selling products (stocks, bonds, advice on mergers or investing) and by using their vast balance sheets to facilitate trades for clients and to take the risks others don’t want to take.
What’s made all this possible is the vast amounts of capital that Wall Street firms have amassed. Fifty years ago, Goldman Sachs had around $10 million of capital, which came from its partners; today Goldman has upward of $74 billion of capital, derived mostly from the generosity of its shareholders and the creditors who have bought Goldman’s public and private securities.
Over the past generation, this business model has worked well for one group in particular: the bankers, traders and honchos who work on Wall Street. These days on Wall Street, around 50 percent of every dollar of revenue generated is paid out to its employees in the form of compensation.
What other business on earth does this? None.
And how would Dodd-Frank change this dynamic? It would give shareholders a nonbinding “say on pay” regarding the compensation of executives of public corporations. And even if a majority of shareholders expressed their displeasure, the companies would be free to ignore them. Yawn.
Regulators at the Securities and Exchange Commission will also have the mandate to explore whether a Wall Street firm’s compensation practices are contributing to excessive risk-taking and, if so, to try to do something about that, like making it easier for shareholders to oust directors. But that directive is an afterthought, too.
We already have definitive proof that Wall Street’s compensation practices lead to excessive risk-taking: witness the way Wall Street’s armies kept selling mortgage-backed securities filled with defaulting home mortgages long after the securities made any sense as an investment.
Wall Street did the same thing in the 1980s with junk bonds, the same thing in the 1990s with Internet initial public offerings, and the same thing in the early 2000s with the debt of emerging telecommunications companies.
This sort of thing will happen again soon enough unless Wall Street’s senior executives have the clear economic incentive to closely monitor the risks their firms are taking and make it their business to ensure that the risks are prudent.
IN June 1987, Deputy Secretary of State John Whitehead, who had previously been Goldman’s co-senior partner, reflected on the insider trading scandals that were roiling one Wall Street firm after another.
“Anybody who alleges that Wall Street is rotten I just don’t think understands Wall Street,” Mr. Whitehead told Institutional Investor magazine. “I think it’s a remarkable system that still works effectively at the heart of our free-enterprise system. But if we are going to avoid sweeping government controls and regulations, then it is incumbent on the system to clean up its act.”
Of course, Wall Street did not follow his advice about cleaning up its own act. Rather, Wall Street went to the other extreme, pushing its friends in Washington for less and less regulation all through the 1990s and early 2000s. Let the market regulate Wall Street, we were told repeatedly. Now we face the “sweeping government controls and regulations” that Mr. Whitehead feared.
This did not have to happen. For example, Goldman Sachs seems to understand the power of creating internal incentives to monitor and to regulate the risks the firm is taking. When Goldman went public in 1999, unlike other firms it decided that a group of its 400 or so top executives would get paid not out of the firm’s revenues, but instead from the firm’s pretax profits. If the firm has no pretax profits in any given year, these executives get (only) their six-figure salaries, not the tens of millions in bonuses they count on.
As a result, the senior brass at Goldman is hyperfocused on making sure the firm is always profitable, and it always has been. This may very well be the precise reason that Goldman alone saw the brewing mortgage meltdown and did something about it.
When other firms were losing billions of dollars in 2007 as the mortgage market exploded, Goldman made $17.6 billion in pretax profits, one of its most profitable years ever, and its top three executives split around $200 million. You would think the rest of Wall Street would emulate Goldman’s approach to compensating its top executives. But it hasn’t.
SINCE neither Goldman’s example nor Dodd-Frank and Basel III will change Wall Street’s behavior, we have to find a new mechanism. To my mind, its central feature should be that each of the top 100 executives at Wall Street’s remaining “systemically important” firms be personally liable for the risks they take. Not just their unexercised stock options or restricted stock, but every asset they have in their possession: from their cars to their fancy homes to their bulging bank accounts.
The days of privatizing the profits for Wall Street and socializing the risks must end.
As radical as this sounds, in truth it would be no different from when — before 1970 — Wall Street was a series of private partnerships.
We can’t turn back the clock: Wall Street’s big firms will never again be private partnerships. Instead, I propose that each large Wall Street firm create a new security that represents — and is secured by — the entire net worth of its 100 top executives. This security would be subordinated to all other creditors as well as to all preferred and common shareholders; in other words, if a firm goes bankrupt, this security is the first to be wiped out.
Had such a security existed at the time of the collapse of Lehman Brothers, the net worth of the top 100 Lehman executives — no doubt totaling several billion dollars — would have been collected after liquidating everything they owned and paid to Lehman creditors, who under the current system will be lucky if they get back 10 cents on the dollar.
Wall Street’s first reaction to this idea — aside from profanities — will be that it cannot possibly be done. Or that it would somehow threaten the sanctity of our capital markets.
But, in fact, it can and should be done. Indeed, Wall Street has all the intellectual capital it needs in its own archives to construct such a security: in the old partnership days every partner signed an agreement requiring him (and rarely her) to put his net worth on the line every day. Surely, clever Wall Street lawyers can draft a 21st-century version of the old partnership agreement.
What’s more, Wall Street should take the initiative to do this unprompted. As John Whitehead warned, the banks’ failure to show responsibility will only invite more government intervention.
If, however, the firms balk, the S.E.C. should require this sort of accountability from the senior managements as part of its new regulations governing Wall Street compensation. Or Congress should take advantage of the still-brewing outrage against Wall Street to force the creation of such a security.
Pretty harsh, right? Maybe, but Wall Street deserves no sympathy. Had this security, or something like it, been in place at every Wall Street firm five years ago, there would have been no mortgage bubble, no financial crisis, no deep and unsettling economic recession with nearly 10 percent unemployment, no need for the Troubled Asset Relief Program, and no need for Dodd-Frank or Basel III.
Why? Because human beings do what they are rewarded to do
— especially on Wall Street — and if they are rewarded for taking prudent and sensible risks, that’s exactly what they will do.
This column appeared in print on October 8, 2010.
(Back before 1970 America had the strongest economy in the world which was based on manufacturing and innovation. Back then the role of Wall Street banks was to provide capital for companies and finance was not the dominate sector of the economy. Before the 70’s companies and investors had a long term view of R&D and good employees were the most valuable commodity a company had.
Since the 70’s the economy has been hijacked by the financial sector. Manufacturing and all the innovation that went with it has been off shored. The short term view rules all and Wall Street is nothing more than a casino where the Wall Street plutocrats make insanely risky bets knowing that their losses will be covered by the middle class.
Unless Wall Street is brought to heel nothing else matters. All the stupid social issues, or which party is in power, or where some mosque is built, is just noise. Either this gets fixed and Wall Street is brought to heel, or an America with a strong middle class will cease to exist.
There will still be something called America but it will be a land of a few fabulously wealthy individuals, a ever shrinking middle class, and with many many poor. What we need is a president in the mold of Teddy Roosevelt, Trust Buster, who can represent the middle class and break the power of Wall Street.
I see little hope of that happening since almost all of the Republicans and most of the Democrats have been bought by Wall Street though campaign contributions. The tea party is no solution since the only power strong enough to stand up to the Wall Street plutocrats is the government. The Tea Parties anti tax, anti government stand plays perfectly into the hands of Wall Street plutocrats who will continue to off shore jobs and import cheap foreign labor to generate short term profits at the expense of the middle class workers.
We will have more booms and busts and the only ones who will profit will be Wall Street tycoons As is happening now the middle class will be forced to pay for the excesses of Wall Street and the country will grow steadily weaker. As the middle class is slowly destroyed freedom will die as the justice system, just as the political system is now, will be for sale to the highest bidder. At this turning point in history the country I grew up in is now unrecognizable.
Well now I know how the citizens of Rome felt when King Alaric and his Visigoths marched over the hills in 410 AD. I fear we will "meanly lose the last best hope on this earth". – mesa, Note the quote is from Lincoln.)