Wednesday, March 18, 2009

John Gapper plumbs AIG's heart of darkness

The Financial Times' John Gapper has perfect pitch on the AIG bonus firestorm. He has sympathy for where both Geithner and Liddy were coming from in this collision, but highlights the myopia of both. And he comes up with an extended metaphor that plumbs the moral depths of Wall Street's perverted pay incentives.

Here's Gapper on a distracted Geithner:

If there is one thing everyone should have learnt about Wall Street by now, it is that the financial contract a trader takes the most care to hedge properly – and to ensure is profitable in the long term as well as the short term – is his or her own employment contract.

Tim Geithner, the benighted Treasury secretary, forgot this point when he approved the doling out of $30bn more in US government support to AIG at the start of this month. Hence he is now struggling to survive the Washington maelstrom.

Mr Geithner has excuses for this oversight, since he was trying to save the rest of the financial system at the same time, and has few senior officials in place to help.

Still, as a Wall Street figure – I count him as such because he used to work within a stone’s throw of the Street of Shame at the New York Federal Reserve – he ought to have known better than to overlook $165m in “retention bonuses” AIG has paid to those who made it fail.

And on Liddy, trapped inside the AIG black hole:

My sympathies are with Mr Liddy, who is being paid only $1 a year and is not responsible for the debacle at AIG. He is doing his best to sort out all the mess, while public servants with megaphones bellow into his ear and Chuck Grassley, a Republican senator, suggests bone-headedly that AIG traders should atone by committing suicide.

That said, his reasons for paying the bonuses share the characteristic of being internally logical yet ludicrous when one takes a step back to consider the context.

And then, picking up his opening trope: the derivative from which only the individual trader derives benefit:

Mr Liddy’s second point is that AIG is better off retaining the traders who wrote the disastrous CDS contracts because only they know them well enough to keep them safely hedged while winding them down. Some are so complex and bespoke that an outsider could be stumped.

A lot of people, including politicians who do not care much one way or the other about the truth of the matter, dismiss this as more self-serving Wall Street claptrap. Personally, I think the appalling thing is that Mr Liddy could well be correct.

Consider the implications. We are by now familiar with the trader’s option – that an employee of an investment bank has an incentive to take big risks to make money. If his trading strategy works he gets a bonus but if it fails, the bank (and ultimately the taxpayer) pays.

In recent years, a lot of traders, including those at AIG, exploited this by coming up with derivatives that were very profitable in the short term but had expensive long-term risks embedded in them. That allowed the traders to enjoy several years of large bonuses before the bill for their recklessness fell due.

Now, the ever-ingenious AIG traders have come up with a derivative of the trader’s option. Call it the trader’s option squared.

They had an incentive not only to sell financial contracts that paid out a lot of money immediately in return for assuming a long-term liability, but also to make these contracts very complicated and opaque.

This allowed them to charge big fees (which brought big bonuses) and it also made them irreplaceable at the institution that employed them. If you are the only one who can understand your own handiwork, it puts you in an enviable bargaining position.

Wall Street banks used to believe it was in their financial interest to keep the credit derivatives market as an over-the-counter, high-margin, complex business. It turns out to have been a financial disaster for everyone involved except – surprise, surprise – derivatives traders.

And the final irony: the institutions composed of these self-aggrandizing geniuses are devoured by their children:

But for the financial institutions involved in credit derivatives, it is worse than that. To be taken for such a ride by their employees is a humiliation, one that has been in the making since the old Wall Street partnerships went public in the 1980s (in Goldman’s case 1998).

The denouement is practically a consensus theme among FT Comment writers: pay-for-performance as currently practiced is the root of all financial industry evil:

But for the financial institutions involved in credit derivatives, it is worse than that. To be taken for such a ride by their employees is a humiliation, one that has been in the making since the old Wall Street partnerships went public in the 1980s (in Goldman’s case 1998).

Robert Frost said that a good poem was like a piece of ice that runs on its own melting. The same is true of a good opinion column. The trader's contract as derivative is only partially a metaphor. But it's one that takes us into the heart of darkness.

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