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Friday, January 15, 2010

I know more than the Financial Crisis Inquiry Commission

We had so much fun with the 9/11 Commission that the Obama administration offered a sequel entitled The Financial Crisis Inquiry Commission. Like a lot of sequels, it's looking disappointing compared to the original.

The mission statement of this Commission look promising:

The Financial Crisis Inquiry Commission is a bipartisan commission that has been given a critical non-partisan mission — to examine the causes of the financial crisis that has gripped the country and to report our findings to the Congress, the President, and the American people.

Hopefully, the Commission's work can help rebuild the American people's belief in a financial system that puts Americans to work, fulfills their goals and provides the foundation for a new era of broadly shared prosperity.

However, based on their line of questioning that I heard about on NPR, their performance is not promising.

The Financial Crisis Commission does not apparently know what hedges are. I'm not talking about gardening but rather "hedging your bets." In financial terms, this often entails buying a financial asset with the expectation that the price will increase while purchasing a short position or some kind of insurance in case it loses money. Or taking a long and a short position. It's about managing risk.

One of the Grand Inquisitors sputtered how a bank was selling securities and also taking short positions against that same securities was the equivalent of "selling a car with faulty breaks and then buying insurance."

I call that as fine an example of hedging that I have ever seen. If the securities do not sell well then the bank has protected itself from those losses. That's contrasted with an absolutely terrible analogy about the car with faulty breaks. What does he even mean by buying insurance? How about comparing it to placing a bet with 3:1 odds that the Yankees will win and a bet with 4:1 odds that the Red Sox will win? One could argue that only a soulless banker would not pick either the Red Sox or Yankees but bet on both just to make some money. Others would point out, it's a systematic way to gamble.

They don't understand hiring or compensation either: Another Grand Inquisitor suggestion was that banks pay risk management staff more in order to attract more talented individuals. Or in other words, they were asking if the banks ever studied compensation for this position and their own cost structure. Given that banks generally study the cost structure of every asset from Danish wind mills to Russian sky scrapers, they've probably figured out how much they need to pay their supporting staff. Given the support staff is a form of overhead, it's probably less than they pay revenue generators like traders.

With that question, the Grand Inquisitors ideas are right on par with what Human Resources was probably thinking in 1985.

They don't really understand bonuses: Lately, bonus has become a dirtier word than boner. Okay, I was going to call it a 4 letter word but bonus has 5 letters but it's kind of close to boner. Plus I want to see what kind of Google searches that I draw by saying boner.

Digressions aside, at least 50% of a bankers compensation comes from their bonus. Their base salaries are on par with industry positions. It's the compensation model that banks have chosen since they study this stuff (like how much they need to pay a competent risk manager) and have concluded that it results in behavior that they want to reward. The fact that bonuses are dramatically increased by financial engineering or providing services that don't really improve the value or efficiency of a company is not good. The fact that they reward creating asset bubbles that will later pop isn't good either.

However, nothing is inherently wrong with a compensation structure that is heavily weighted towards the bonus. Sales compensation is either heavily driven by commission or salaried depending on the results that the company wants to achieve. Focusing on the bonus is looking at the cart and ignoring the horse.

Personally, I think it would be kind of interesting if politician's salary and campaign contributions were tied to a bonus type level of performance. Suppose Congress had to reduce the unemployment rate by 1% in order to get half their salary or campaign contributions? Or pass 10 major pieces of legislation? That might result in a more bipartisan approach especially among Congressman who only own 1 house.

Summary: The 9/11 commission was probably viewed as successful since the members really understood the topic. The Pecora commission to the financial crash in the 1930's was very successful since it was both entertaining and produced lasting results. From what I have heard so far, I'm not impressed with the competency of the Financial Crisis Inquiry Commission nor their sense of humor (I still don't understand the car with the faulty brakes analogy). I don't think that Wall Street is so different from the rest of the economy to result in this level of misunderstanding. Wall Street bankers are not irrational and there is a logic behind their actions. The commission needs to understand that logic.

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