GOP wants to repeal Dodd-Frank: instead they should listen to Nassim Taleb
by Linda Beale
GOP wants to repeal Dodd-Frank: instead they should listen to Nassim Taleb
Nassim Taleb, the author of the book on long-tail events, suggests in a Nov. 6, 2011 op-ed in the New York Times that “it is only a matter of time before private risktaking leads to another giant bailout like the ones the United States was forced to provide in 2008.”
That’s pretty strong language, and should be cause for worry among those GOP debaters who have been in a pissing contest over how much legislation they can suggest for repeal, like Dodd-Frank, health care reform, and environmental protection. Instead of defending big banks, the GOP should start thinking about how to break them up. Instead of suggesting that we need to repeal Dodd-Frank and end regulation of banks, Taleb says we do need regulation but can’t depend on it alone: “Supervision, regulation, and other forms of monitoring are necessary, but insufficient.”
And instead of defending risk-taking bankers as innovators and entrepreneurs, Congress should be considering measures to undo the incentives for risk taking. Taleb says–End Bonuses for Bankers.
[I]t’s time for a fundamental reform: Any person who works for a company that, regardless of its current financial health, would require a taxpayer-financed bailout if it failed, should not get a bonus, ever. In fact, all pay at systemically important financial institutions–big banks, but also some insurance companies and even huge hedge funds–should be strictly regulated.
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Bonuses are particularly dangerous because they invite bankers to game the system by hiding the risks of rare and hard-to-predict but consequential blow-ups, which I have called ‘black swan’ events.
Seems like sound advice. Bonuses encourage risktaking, and risktaking encourages breakdowns of TBTF banks. Breakdowns lead to taxpayer bailouts. To break the chain, deny the bonuses.
The asymmetric nature of the bonus (an incentive for success without a corresponding disincentive for failure) causes hidden risks to accmumlate in the financial system and become a catalyst for disaster. This violates the fundamental rules of capitalism: Adam Smith himself was wary of the effect of limiting liability, a bedrock principle of the modern corporation.
Here Taleb touches on a factor in the expanding risk of our economy–and the expanding immunity of the manager class from the risk they cause. Corporations provide limited liability to their owners. And innovations over the last few decades have expanded limited liability to almost all investors even in pass-through entities that pay no entity-level tax, through the limited liability company and the limited liability partnerships. That is one of the reasons I have argued for Congress to enact legislation to restrain the availability of tax-free mergers and reorganizations. The combination of easily attained limited liability plus easily attained consolidation of entities has been a factor in the growth of the corporatist state.
Taleb has a good point about the incidence of bonuses in the US market system as well.
We trust military and homeland secrutiy personnel with our lives, yet we don’t give them lavish bonuses. They get promotions and the honor of a job well done if they succeed, and the severe disincentive of shame if they fail. For bankers, it is the opposite: a bonus if they make short-term profits and a bailout if they go bust.
Eliminating bonuses would make banking boring again, like it was before the repeal of the Glass-Steagall Act. Boring, in this case, is good. Congress should consider what kind of legislation could be designed to make bonuses in banking less likely, through tax disincentives or other means.
Dodd-Frank will ultimately fail because it is too complicated to implement – the same reason Obamacare will fail.
If memory serves me correctly D-F requires more than 400 different sets of administrative rules.
Complexity is the enemy of successful implementation. Every major bill written by Democrats is ultimately a welfare program for lawyers and bureaucrats.
Somebody (can’t quite recall the pundit) pointed out in a recent op-ed that the reason regulatory law is complicated and arcane is because of the lobbyist friendly exceptions to regulation. It would probably be possible to write simple clear declaratory regulatory law if you didn’t have to get it past the shadow congress of lobbying and trade organizations that insist on volumes of exceptions and special cases.
The US tax code is a great case in point. The basic framework of “If you make more than X, pay Y% of X” is simple enough to explain and legislate. But then the lobbyists for the mortgage/housing industry get their carveouts, the oil boys get their exemptions etc and it all goes to hell.
You can use the last year’s legislative priorities as another object lesson. We began the year with massive easily documented evidence of securities fraud, fraudulent foreclosure processes, influence buying scandals by huge organizations of all kinds and what does the US Congress decide to focus their legislative energy on? Swipe Fees. The one easily identifiable regulatory issue that reliably motivated lobbyists on both sides to write fat checks.
If you want simpler and more effective regulation of any industry (or for that matter labor union), help get a constitutional amendment passed that undoes Citizens United.
Bonuses were put in as a mechanism for a business with a comparatively highly volatile revenue stream. For most of the 90’s and up until the crisis, total compensation as a % of revenues was fairly stable. In high revenue years it would be a little lower and in low revenue years it would be a little higher. From a management of expectations for employees, it’s much easier to to tell them at year end that their bonus is going to be reduced by 30% than it is to tell them their salary in the next year is going to be cut by 25%.
Also STR – if you have an example of successful simple uncomplicated regualtion passed by the GOP in the last 40 years I could use a cite. This is not a partisan problem. It’s a dysfunctional political “system” problem. Your attempt to blame D-team politicians is naive at best.
From a bigger picture perspective, once revenues are generated there’s a limited number of places for that money to go: government through taxes, charity through donations, employees through compensation, counterparties/suppliers, or shareholders through any combination of retained earnings, dividends, or accretion through share repurchase.
And Glass-Steagall repeal was not a proximate cause of the crisis. Lehman and Bear Stearns were not deposit taking institutions (nor Goldman, nor Morgan Stanley). IndyMac and Washington Mutual were not investment banks. AIG, Countrywide, Fannie, Freddie weren’t banks in any sense of the word. Citi was the only post-Glass-Steagall bank that had an issue. Bank of America had/has issues, but that was because they acquired Countrywide, which wouldn’t have been prevented under Glass-Steagall, and Merrill, which they tried to back out of using the MAC clause, but were allegedly forced into closing by Treasury and the Fed.
Gee it was super nice of the taxpayers to solve that little volatile revenue thingy. Now that the financial industry is explicitly subsidized by the US treasury the bonuses are no longer justifiable. If they ever were – I have long held the view that bonuses as reward for performance aren’t much more effective than tipping. If investment bankers don’t think their paychecks are big enough let them try putting tip jars on their desks.
Perhaps Glass-Steagall wasn’t but you’d be hard pressed to argue that the successful attempt to limit regulation of CDS didn’t fan the flames. The full court press to marginalize Brooksley Born’s efforts in the late 90s are well documented from multiple contemporaneous sources.
I’m pressing. Do you really think the meldown of 2008 would have been as huge without the unregulated side bets at AIG et al?
And of course if the poor bankers are generating so much revenue that they can’t help giving themselves big licks off the cone every year they could also try providing their “services” cheaper. You know, that great old american invention of competition.
There exists something like 7,000 banks in the U.S. There are very limited barriers to starting a new investment bank. On any equity issuance I’ve looked at over the past five years, at least five underwriters are on the cover. There’s also competition from foreign banks – Deutsche, UBS, Credit Suisse, Nomura, Credit Agricole, Barclays, and hundreds of boutiques. Can you provide some evidence, e.g., market share of top 10 investment banks relative to other industries suggesting there’s a lack of competition?
All of the big banks and investment banks paid back TARP in full. Outside of covenants, lenders typically don’t have a say in how businesses are run. When Buffet invested in preferred equity in Goldman in the fall of 2008 or in Bank of America earlier this summer, I don’t recall him asking for restrictions on employee compensation.
And there’s a great misunderstanding of “bonuses” at financial services firms. They’re shaded among individuals for performance, and are dependent upon revenue performance of the firm, but they’re seen by industry participants more as variable compensation than the way non-financial firms view performance bonuses.
Help me out here Jed. Are you trying to argue that since the banks pretended to pay back TARP with other money the UST and Fed provided to buy up their incompetent clusterfucks they are no longer subsidized by the taxpayer? Really?
Did GS pay back the money the treasury gave AIG to cover their incompetence? GS’s and AIGs? I must have missed that development somehow you’d think it would have made bloomberg.
Correction. Simple rules for complex systems will always fail. Attempts to oversimplify when faced with a complex system just make it easier for the rules to be avoided via technicalities.
Do you think Citi, Wells Fargo, BAC, would keep their doors open another week without the Fed’s ongoing policy of paying interest on their reserves?
If you do I’m willing to try and see. Ok either way.
I don’t think we disagree per se. Simple schemes with tons of exceptions and special cases are by definition complex. We can have a separate debate of whether or not that additional complexity is worthwhile but I acknowledge the political difficulty of limiting that complexity.
And full disclosure – I’m not actually advocating limiting it. We ought to be making a lot more exceptions in regluatory finance for honest reliable entities that serve the public interest. I think it’s great that we have credit unions, I haven’t had a regular bank account since Reagan was in his first term. But why can’t the credit union model be expanded to provide other critical services like medicine, housing, telecommunications, energy etc…? One of my favorite brewpubs in Austin is a co-operative owned by the employees and customers. Why can’t I buy my internet service, electricity, prescriptions, etc from a coop?
Jed:
Not AIG and we are still into an ownership society with them. And since GS and the other investment firms have paid back their portions, it is time to revoke their bank status and put them on their own again. No more cheap loans financed by taxpayers to invest.
Jed:
I beg to differ. BofA as well as other banks were heavily into CDOs which as you know were tranched in favor of riskier mortgages, financed heavily by offshore money looking for a safe haven hoping it was in mortgages as TBs were low interest, insured by CDs, and falsely rated by Moodys and S&P. Did they buy derivatives? No, but they damn well used them and were over leveraged. Of course, we will never know what were the true causes of the Fed pumping trillions into TBTF and Wall Street as they would not tell us plebians.
Glass Steagall erosion started with the appointment of Greenspan and the demise of Section 20 which allowed an increasing percentage of banking gross profits to be invested in Walls Street and their less than conservative investments. Glass Steagall was already dead when it was repealled and the National Bank act changed to allow Citi Bank (Weil) to buy Travellers with Summers, Geithner, Rubin, Levitt’s, etc. help.
Interesting how Merril has transferred its derivatives to BofA the depository part of the bank. We are all set to bail BofA “again.”
AIG was not originally part of TARP, and they would have been able to pay off what ended up becoming TARP had Treasury not converted their Senior Preferred position into common equity – a political scheme done by Obama and the Democrats for 2010 election cycle. GS would love to revoke their bank status, but the Fed won’t let them.
As for the payment made to GS on AIG’s behalf – GS had purchased CDS protection if AIG defaulted. Treasury asked GS for concessions and they rightfully told Treasury to go jump in a lake – GS gets paid in full if AIG defaults and Treasury had just demonstrated they were reluctant/unwilling to let AIG so why would they have settled at less than par.
What do you mean pretended with other money? Most companies raised half of their TARP receipts in common equity issuance and/or conversion of existing preferred equity and paid the rest through retained earnings – where do you think the money came from?
Jed:
A minor technically of course that AIG was not a part of the originally bail out. It seems Geithner, Summers, and Hanke hatched the plot of converting the investment firms including AE into banks to make them eligible for TARP. GS has ~$20 billion covered by AIG CDS and it was a forgone conclusion that AIG was going to be rescued unless one considered the godfather to Summers, Levitt, and Geithner was going to fail. Now was GS failing even a consideration???
Obama had nothing to do with the conversion of Preferred to Common. Geithner and his mentor Summers with the Fed certainly made that decision. It is in the keeping of rescue of Wall Street. What money was used to rescue Wall Street and TBTF? Main Street . . . Yeah righ GS does not want access to cheap loans . . .
“Nassim Taleb, the author of the book on long-tail events, suggests in a Nov. 6, 2011 op-ed in the New York Times that “it is only a matter of time before private risktaking leads to another giant bailout like the ones the United States was forced to provide in 2008.”
“That’s pretty strong language, and should be cause for worry among those GOP debaters who have been in a pissing contest over how much legislation they can suggest for repeal, like Dodd-Frank, health care reform, and environmental protection. Instead of defending big banks, the GOP should start thinking about how to break them up.”
Excuse me? Who do you think are the beneficiaries of GOP policies? Hello? Too Big To Fail is a feature for them, not a bug.
That’s a lovely dance Jed. But you still haven’t explained why GS was owed that money by the taxpayers or why they shouldn’t be expected to repay it. Or why their failure to repay doesn’t amount to a direct subsidy.
Run – AIG was never converted to a bank, nor was GM, nor Chrysler. Hartford and Lincoln both purchased banks, but never converted to banks. The conversion was clearly political – it was announced in late September 2010, with much fanfare about AIG repaying TARP at break-even, even though the conversion took place at a discount to the price, the press releases were drafted as if the conversion was made at a premium.
What is the purpose of rescuing AIG if not for it to be able to pay it’s lenders and counterparties? Let’s assume for a second that instead of a financial crisis, AIG was on the verge of failure after Hurricane Katrina because of it”s homeowners insurance exposure. Once AIG is rescued, doesn’t it have the obligation to pay it’s debts in full – in other words, if I were an insured of AIG, why would I settle for less than I was contractually owed, or tear up my contract early at a discount? GS was owed that money by AIG, and AIG has always remained a publicly traded company.
FWIW, the original TARP was a simple legislation – 3 pages if memory serves.
So did the geniuses at GS deserve their bonus checks because they made huge bets with an insolvent gambler? Or because they had the fix in place once the bet paid off?
Just remember the morons making the rules in both houses are exempt from things like insider trading. People like Dodd got special favors from Countrywide, and Braney Frank is a proven liar.
Decent piece on 60 minutes tonight on insider traiding by legislators. Speaker Pelosi really didn’t cover herself in glory though. “I’m sorry I don’t understand the question…” What?
If by “fix” you mean they exercised prudent risk management and hedged against an insolvent counterparty, then yes.
And if AIG ends up paying back TARP, (I don’t think they will thx to the conversion to common) again even though they weren’t subject to the original, I assume we’ll be hearing a full retraction from you on this matter.
So where should the 2011 bonus pool at GS be redirected?
More complex than the CDO/CDS’s including synthetic CDO’s?
If complexity is the issue then the number of folks bailed out by the fed and treasury is far too small.
Mark to market is not so complex………………………
The folk who could not stand mark to market are too complexity challenged to exist.
What’s the market value of your house if you have to sell it in the next 2 days?
Relative to the size of their balance sheet at the time and given how large a mortgage originator they were (prior to Countrywide), BofA was a minor player in CDOs. The lookbacks that show them number one from 2005-2007 are because they include Merrill, which was one of, if not the largest issuer of CDOs.
Jed:
Where did I say AIG was converted to a bank? And GM and Chrysler were not a part of TARP’s original plans? They came as an after thought because the Senator from Toyota and the Senator from Nissan did not want to allocate more money to save Main Street companies.
Lets assume that the CDS sold by AIG were little more than a scam perpetuated on Wall Street to little more than insure fraudulent CDOs tranched with less than secure mortgages so they could be falsely rated by Moody’s, S&P, etc. Lets also assume the buyer of the CDS knew of the volatility of the tranched CDOs and bought the CDS from AIG to insure against their failure and then bough naked CDS to insure for their failure, why would anyone compensate the buyers of either CDS to the extent that “we-main street” did? This was fraud all the way around. There was no transparency in any of these transactions and it was purposely meant to be that way. Originally, Wall Street was supposed to set up a clearing house for these transactions . . . it never did.
At the least, the holders of both sets of CDS should have been given pennies on the dollar and not rescued. There was no way one could have determined who held what, the same as the FED could not determine who held what in the LTCM failure for which Summers and others played a part in also. Throttling a thriving market as Summers implied in front of Congress in the late nineties in describing what Brooksley Borne was doing in demanding transparency was little more than a lie to keep the shell game going. Regulating the shell game would have saved this country $trillions of ill spent money on gambling debts. TARP were not the only funds spent to rescue Wall Street and too big to fail.
Lastly, while AIG was an insurance firm, comparing CDS and naked CDS to insurance is not relevant. Insurance companies are forced to carry reserves by law and when profits are down, they raise their premiums the same as they did for the entire nation after Katrina for homeowners insurance. The reserves for a CDS and a naked CDS were non-existent and their was little or no law or regulation to track them. It was a shell game, a Ponzi scheme, meant to take profits up front leaving little behind except a piece of paper and a false promise in case of downturn. GS pulled the string and the Popper popped taking down AIG. We had this insurance discussion before.
Comparing CDS to insurance is perfectly relevant. AIG had underwritten these to a 0% loss ratio, which is why they didn’t hold reserves against them. When Joe Cassano testified in front of Congress in the summer of 2010 he said that other than one deal, which Blackrock unwound early, nonel of the CDS written on CDOs had experienced a loss.
There’s a difference between illiquid and insolvent. State Farm doesn’t hold reserves against the possibility that every single car they insure gets totaled tomorrow. AIG’s CDS contracts were written such that they didn’t have to post collateral as long as they were AAA-rated by the rating agencies. When Spitzer ousted Hank Greenberg and the rating agencies downgraded the company, they slowed their CDS machine materially, but the cake was already baked. When Goldman and other counterparties started ramping up collateral requests because of mark-to-market, AIG was illiquid. But Cassano’s testimony demonstrated they were by nowhere near insolvent.
And the volatility of tranched CDOs came not because of the volatility of the underlying assets, but because of the volatility of the trading vehicles to which they were compared and marked – the ABX – which was a derivative designed to be shorted for hedging and risk management purposes. Again – what’s the value of your house if you have to sell it in the next 2 days. It’s much different than if you have as much time as you’d like to sell the asset. But if we marked someone’s personal balance sheet to an asset value of a home that needs to be sold in the next 2 days, they look insolvent.