Robert Paterson's Weblog

Bonuses on Wall Street - The old myth - the New Reality

If we don't pay bonuses then our good people will walk to other firms - used to be true but now...

I deserve a bonus because I made so much money. Oh did you? No you used the leverage of your bank to make the money. You used the bank's capital to make the money. Now that capital belongs to the tax payer.

The bonus issue has to be addressed.

You can't pay based on the use of the firm's capital and leverage. That is not in the control of the trader or the banker. The gearing is the issue.

Using the gearing of what is in effect free capital is what has killed our financial system. No downside for the person = ultimate irresponsibility.

In the good old days - when I was young and a partner at Wood Gundy - we used our own money to make money. We risked the firm's money that was provided by us. Then you really did make the money. You argued your share of the firms capital and then you took the risk. If you lost, all would have to pay - you paid the most because you would have hurt your partners.

This is where the control can return. It is not about limiting the payout. It is is putting the risk back into the equation. To do that you have to take the firms' capital off the table. You have to put the bonus pool into the risk.

In the old days again at Goldman - it was assumed that you would leave the firm in your early fifties late forties. Your bonuses accumulated in the capital account of the firm until you sold at book in your last 5 years. Of course if the traders etc blew the pool, you left with nothing. That never happened but it could and it put the discipline into the deal.

The practice today is not based on risk - everyone expects a bonus. Put the risk back and put back the idea of being a partner.

The goal in the firm is to make partner. The big money comes from retiring or leaving the firm as partner where the pool of capital has been built by a successful enterprise over time

The Bailout

Thanks Gabe

Now I am really worried

Thanks JP

And you thought I was a pessimist!

The Financial Vortex is a cogent view of what is ahead. Here are 6 predictions for the years ahead

Doc Searls offers up his views here too

PEI Government Pensions - Guaranteed?

The provincial public service pension fund holds about $1 billion, and is the promise of financial security for about 10,000 people, counting retirees and civil servants currently paying into the fund: teachers, nurses, office workers, mechanics and MLAs.

But the total value of that fund has dropped significantly in the last two months. Sheridan told CBC News Monday it lost $110 million in September and another $50 million in October. But those losses are more a problem for the government than for pensioners, he said.

"Their pensions are guaranteed, no one has to worry about that," said Sheridan. (CBC)

In my youth I managed money. In the late 1970's I ran portfolios in excess of 2 billion. I was also responsible for benefits at CIBC in the 1990's. I say this to qualify what I am going to say about PEI's Public Pension.

There is no tougher job than this. Most pension owners are not experts and have to rely on their professional fund managers.

The conventional wisdom is that growth is only found in large equity positions. My bet is that PEI's fund went into the crash with a big bias to equities. That was the conventional thing to do. I am also sure that PEI's fund managers told PEI's officials that this was a blip and that they should remain calm.

PEI is trapped now and has to do more than hope that things will work out. PEI has to take a grip!

The fund is down 15% over the last 2 months. This is relatively a modest decline compared to what could have happened.

But while the current outlook is bleak, Sheridan said the money managers have positioned the fund to benefit when the stock markets finally turn around.

"We know the market's going to rebound, so once the markets come back up, we'll have purchased these stocks at very low prices," he said.

"That will bump up our overall pension fund and bring it back up to where we should be."

Sheridan said pension fund managers rarely concern themselves with short-term problems, instead focusing on the long term, 30 or even 40 years into the future.

This statement is what really worries me. "We know that the market is going to rebound" - Oh really. What makes you so sure? The market did not reach its starting price from 1929 until 1954 - 35 years! In 1974 it took 10 years. The Tokyo market has still not recovered from its fall in the 1980's.

Mr Sheridan - please don't take your fund managers at face value. They and nearly all the "experts" have got all of this wrong so far.

Are any of them discussing what the end of the auto industry, then end of traditional media etc may mean? Has any of them talked about what will happen when Citi goes down? Have any talked about what may happen if oil supplies are disrupted or a war breaks out with Iran on the bomb?

Has anyone talked about why this may not jiust be a correction?

Now is not time for complacency. It is one thing to say you guarantee the fund - that means that you will cover the shortfall from income, as was done recently. But what if there is too much pressure from all the needy to make this impossible? This is entirely possible. What if your fund stayed fully invested and lost another 50% in the next 3 years? How likely might this be?

My humble advice to Mr Sheridan is that the Committee have to take a view and to take charge.

• Look out over 20 years and see what the pay out will be - you can be very clear and precise about this. You start here - not with the investments. You have to see what you have "guaranteed". This is the risk that you have to plan for
• The next 20 years is the risk hump that PEI has to cover both in time and in demography
• You will see that you have a gap now. Dealing with the gap is your work
• You have to have a view of where the economy is going. Start with no rosy forecasts - have a bad and a very bad scenario - you are taking out "fire insurance". Hope is not a plan.
• Every aspect has to go into the plan - views on the markets, views on what you can do now to add to contributions, your stance in the market, your risk weighting, and hardest of all the payout and the conditions of the payout. The future of the plan - can you even afford a defined contribution plan anymore?
• You have to do this work NOW

My own belief is that we are only at the beginning of a long term decline. I can see a bottom 4,000 points away from here. I don't have to be right, this is the "risk" that you have to plan for. It is the house fire that you have to insure.

You cannot give all of this work to your managers. You need to beef up your pension committee. Get members on it that are more that stakeholder reps. You have to have hard headed thinkers who are not overwhelmed by conventional wisdom and who are not intimidated by your managers.

There are some shrewd Islanders around. Also get onto the committee a person who really knows their way around Pensions - this is not a coded ask for me - I am talking about a real expert. If you don't know any - I do.

This person has to know all the actuarial moves that could be open to you and has to be able to evaluate and to contribute to the planning. This person must have nothing to do with the fund management.

No time to lose

How low will the Dow go and when will it come back?

To unwind the bubble that began in 1984 - we would end up at between 3,000 and 4,000

If we look at the 1930's as a model for the length of a depression the bottom was reached in 1937 and the 1929 high was not reached until 1954.

The 1974 high not reached until 1984.

What many miss is that this is not a "Normal" correction The bubble has been unprecedented. That in itself says that the down will be deep and long. But also we are seeing the end of a business model - the top down centralized model. Auto's, media, steel - this also means that all the pillars have to go too - that includes even how government is run and funded - all those who live in New York are starting to see this too.

So my predictions are 3,000 in 2009-2010 with at least 25 years or 2035 until we see 2008 levels

If you think I am too pessimistic - make case.

Michael Lewis - On the Death of Wall Street and why this is no blip

If you want to understand the mess that we are in - if you want to see that there is no quick fix - if you need to have a great story teller make it all clear for you - then please read Michael Lewis' brilliant article on what happened to Wall Street - "The End" - published in Portfolio.com.

Michael Lewis wrote a seminal book on Wall Street - Liars Poker. He could see back in the 1980's that the Street was a Potemkin Village.

To this day, the willingness of a Wall Street investment bank to pay me hundreds of thousands of dollars to dispense investment advice to grownups remains a mystery to me. I was 24 years old, with no experience of, or particular interest in, guessing which stocks and bonds would rise and which would fall. The essential function of Wall Street is to allocate capital—to decide who should get it and who should not. Believe me when I tell you that I hadn’t the first clue.

Lewis remains a great writer - his book on Baseball, Moneyball,  is a classic. I am not even a sports fan. Lewis can and does find a way to use story to explain complex things in a compelling way.

His new article The End, shows how it was possible for some to see while the majority just got caught up in the game.

It shows that no bailout will work so long as the culture of Wall Street allows people to play with OTHER PEOPLE'S MONEY. He is clear about the root cause - the corporatization of Wall Street.

This is what has to end. The only way to contain risk is to put the risk into play with the risk taker.

The piece ends with Lewis having lunch with John Gutfreund, the former CEO of Salomon Brothers, whose career had been ruined by Lewis's book - an irony in itself.

And he seized the day. He and the other partners not only made a quick killing; they transferred the ultimate financial risk from themselves to their shareholders. It didn’t, in the end, make a great deal of sense for the shareholders. (A share of Salomon Brothers purchased when I arrived on the trading floor, in 1986, at a then market price of $42, would be worth 2.26 shares of Citigroup today—market value: $27.) But it made fantastic sense for the investment bankers.

From that moment, though, the Wall Street firm became a black box. The shareholders who financed the risks had no real understanding of what the risk takers were doing, and as the risk-taking grew ever more complex, their understanding diminished. The moment Salomon Brothers demonstrated the potential gains to be had by the investment bank as public corporation, the psychological foundations of Wall Street shifted from trust to blind faith.

No investment bank owned by its employees would have levered itself 35 to 1 or bought and held $50 billion in mezzanine C.D.O.’s. I doubt any partnership would have sought to game the rating agencies or leap into bed with loan sharks or even allow mezzanine C.D.O.’s to be sold to its customers. The hoped-for short-term gain would not have justified the long-term hit.

No partnership, for that matter, would have hired me or anyone remotely like me. Was there ever any correlation between the ability to get in and out of Princeton and a talent for taking financial risk?

Now I asked Gutfreund about his biggest decision. “Yes,” he said. “They—the heads of the other Wall Street firms—all said what an awful thing it was to go public and how could you do such a thing. But when the temptation arose, they all gave in to it.” He agreed that the main effect of turning a partnership into a corporation was to transfer the financial risk to the shareholders. “When things go wrong, it’s their problem,” he said—and obviously not theirs alone. When a Wall Street investment bank screwed up badly enough, its risks became the problem of the U.S. government. “It’s laissez-faire until you get in deep shit,” he said, with a half chuckle. He was out of the game.

So my take on what must happen is this: no regulation can make the risk taking work until the risk takers take the risk.

So long as the risk takers take the risks with our money and take the profits themselves, we are in shit.

The proper balance has to be restored. Until then - we are still in systemic trouble. There is evidence available right now - AIG

The Crisis - How will we get out of this mess? Use a better context!

The smartest folks in the world missed this crisis. What does this say about what "smart" may be?

Alan Greenspan - the hero of his age - has admitted that he did not see this coming. But some people who did, such as Nassim Taleb, were laughed at as madmen.

What is going on? Why could the smart people see what was clear to a few of us? Why does their inability to see why this happened make their efforts to fix the mess so risky?

The answer to these questions is "paradigm", mental model, mindset. They could not see because they could not see. Their mental model "blinded" them. They laughed at people like Taleb and dismissed him as a crackpot because he inhabits a different paradigm or mental model.

Economics, the last bastion of Newtonian thinking is being overthrown by Quantum and Chaos theory that more accurately model natural systems in complex environments.

For modern economics is based on a deterministic and grossly simplistic view of the world. That price will drive everything correctly.

In America, the risks are greater because this idea that one simple element, price and hence the market will govern our society best. By the way I am not saying that the state can or should do this either.

The current opposing view that the state can or should control directly via policy levers is just as wrong.

For both idea are really the same idea - that the man on top can control society with direct levers. The wrong idea is that we can be deterministic while living in a complex system.

We are out of touch with science here. At least in science, determinism has been on the run for 100 years. In physics this idea of a neat universe with fixed relationships was severely challenged by Einstein in 1905!

No one in physics questions now that most relationships in the universe are relative and effect each other in complex ways.

In 1927 what was left of determinism was demolished by the Quantum boys.   The best you can do in a Quantum world is to use probabilities - there are no certainties.

But large centralized organizations like banks and governments want there to be certainties. So they ignored all the the rest of science and clung to the idea that money and prices were the key factors. People are poor - give them money. Economy is slow, drop interest rates.

I don't blame them. For many years, when the world was less connected and hence less complex, deterministic principles did work.

It seems that since the 1980's, the advent of the web,  the world has become so connected as to increase its social complexity beyond our comprehension. Human Society has gone through a phase shift.

Fortunately for us, at exactly the same time, a new form of math, itself only possible with a PC, has emerged that can help us to understand complex environments better.

Those of us that have been influenced by this new way of understanding our world, could and did see what was coming. One of the people who did see what was coming was Nassim Taleb - author of The Black Swan. Taleb has been deeply influenced by the Einstein of our time - Benoit Mandlebrot - the discoverer of this new form of math - fractals - that can model natural systems.

Of course most mathematicians thought at first that Mandlebrot was merely creating nice looking pictures.
 
But what he has done is to find the geometry of complexity - which is how the natural world works.

Why did we miss this? Why did so few see what was coming and so many dismiss the warnings. Because for most of our lives determinism worked  and worked well.

I suspect that the root of our wrong thinking was the 2 world wars of the 20th century. Our lesson was that machine thinking - that has to be deterministic - was the winning way.

But our world now is so interconnected since 1980 that it has become "Complex". We can see how complex it is as all struggle with the crisis. No single government can cope. We are all in this and it seems too much.

Our only chance is to put away the dogma of determinism and to investigate how nature itself governs complex systems. For govern them it does.

This is the point that David Brooks made so well earlier this week:

Perceiving a situation seems, at first glimpse, like a remarkably simple operation. You just look and see what’s around. But the operation that seems most simple is actually the most complex, it’s just that most of the action takes place below the level of awareness. Looking at and perceiving the world is an active process of meaning-making that shapes and biases the rest of the decision-making chain. 

This is why we will be using Boyd's thinking as the basis of our conference in December on how to create more resiliency into our local systems. Here is Chuck Spinney talking about how Boyd sees the mental model as the key to winning:

Each of us bases our decisions and actions on observations of the outside world that are filtered through mental models that orient us to the opportunities and threats posed by these observations. As Konrad Lonrenz and others have shown, these mental models, which the philosopher of science Thomas Kuhn called paradigms, shape and are shaped by the evolving relationship between the individual organism and its external environment.

I think that our job now is to show the value of the new. Over the next few days I will try my best to share with you some work by friends who are using the principles of systems to create a better world. But first, I will talk about organization - for it is the organizing principles of systems that are so different from the ones we know that are all based on determinism.

Some of you know where I will be going - but here is a recap anyway.

In a deterministic approach, you seek to find and to use direct levers. You seek control.

In complex systems, you acknowledge that the system has a life and a trajectory of its own and that you can only influence it. You can go a long way to getting the result you want by working to create the surrounding environment that is required to enable a part of the system to achieve its ideal lift off trajectory.

If you want to send a rocket to the moon, you have to set it off on its ideal trajectory. Too slow, it will fall back to earth. To fast and it will go into the universe. You can determine the ideal.

This is not as hard as you think. Nor is it a random unknowable process. The math and the trajectory for all things are all known and have been for millenia. We just "forgot"

 

All the potential for this acorn to become a mature forest, is contained in this one seed. A forest is a complex system. What it needs is the best possible starting environment. It does not need this environment to be ideal for all of its life - just for the lift off phase. This is the wonderful economy of nature. If you get the initial conditions right, the "seed" will have a good chance of making it. Plant the tomato plant after June 8th on PEI and chances are you will get fruit in September.

Give your baby the right kind of family experience until two and it will be set for life - or not if you have not been able to do this.

 

If you can provide the ideal environment to the figure 8 in this Fibonacci curve - the natural development trajectory for all systems living and not - it is highly probable that the acorn, the baby, the planetary system, the human organization, the galaxy - will reach its design potential.

This is a lot less work and effort that trying to manage a system - impossible anyway. Such a process also uses far fewer resources.

Tomorrow I will start to talk about the concrete proofs of this new world

Credit explained - how to get out from under - the Historical Truth

Part 1 here - Getting into trouble - major penalty in store

Part 2 here - first attempts at getting out of debt - failed!

Part 3 here - getting even worse trouble - stumped at the end

Part 4 here - saved by a cunning plan

History - our best teacher! :)

Another view of the credit squeeze - oooh!

It looks from this that Americans (I bet Canadians and Brits too) just could not cope by about 98. They made up the balance with debt.

So as lenders pull in - what does this mean?

I think it means that the structural issue trumps the market worries. Most Americans are broke. This reality will have a long term effect.

For me - it will be about work and jobs. We have exported both to cut the costs of what we buy. We then borrowed the money to buy the stuff now made abroad.

I think that we have to help people find good work.

This won't mean going back to work for GM but new work. Local energy? Local Food?

Not just subsistence but large networks of people working for each other.