As I’ve discussed before, the present financial crisis is not just a problem with liquidity, but one of insolvency. The money is not there. The assets have declined and will stay depressed, and the ponzi scheme that is the last ten years’ inflationary monetary policy is yielding its predictable result: mass liquidation of improvident investments, chiefly in housing.
The Democrats’ usual class warfare rhetoric has more resonance than usual in the light of Treasury Secretary Paulson’s proposed bailout. After all, the guys who got paid huge when this elevator was on the way up now want to be helped out by the general public as it goes down. It would be comforting if we could just take this money from the CEOs and well-paid executives of the institutions about to be bailed out, but that money, as much as it is compared to most Americans’ net worth, would only be a drop in the bucket. The problem is not that Wall Streeters want to make money, made money in the past, and likely will make lots of money in the future. They always want to make money. Everyone wants to make money. Investors have always made good money because they do something useful: they make other people even more money.
The problem with this bubble is that it was further enabled by the bonus-heavy compensation structure of Wall Street and the expansion of this structure to commercial banking. Salaries are typically a small part of the overall compensation structure in investment institutions; the lion’s share is a bonus, which is usually tied to the upside benefit of placing money on one or another position. Since a manager’s bonus is a fraction of a fraction of the investors’ upside, for every bonus dollar paid to money managers, the investors made many millions or billions more in profit. The problem is on the downside. If a huge position tanks, a fund manager does not typically book his own comparably-sized loss. He doesn’t have enough skin in the game. It might mean a zero bonus and termination. If his own money is on the line, bankruptcy sets a floor on his ultimate losses. (Similarly, mortgage originators get paid up front, but if the homeowner defaults down the road, none of that money is charged back against future commissions.)
Higher salaries and smaller bonuses for investment managers, however, would give bankers managing important institutions more sensibly aligned incentives where stability is just as important as big, money-making risks. This should be an especially important priority in FDIC-insured institutions, managers of AAA-rated paper and their underlying investments, and any institution which plays a substantial role in trading in government securities, such as Treasury Bills.
In other words, Wall Street compensation packages consisting of bigger salaries would be a good thing. A less bonus-heavy regime coupled with penalties for bad performance and larger salaries would create a more optimal risk incentives for institutions federally insured or that otherwise have a serious impact on the economy as a whole. The Democrats’ desire to punish CEO compensation simply on principle will lead to more backdoor compensation schemes that would reward excessive risk, such as larger equity stakes in investment projects. Smaller salaries would further promote heads-I-win-tails-I-go-to-a-competitor culture among investment managers that contributed mightily to the present crisis.