Have you no sense of decency, sir?

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Expert Perspective by Grahall’s Robert Cirkiel & Garry Rogers

expert perspective telescopeLast January just a week after his inauguration, President Obama lashed out at Wall Street in reaction to a report that by the New York State comptroller that found financial executives had received an estimated $18.4 billion in bonuses for 2008, less than for the previous several years but the same level of bonuses as they received in 2004, when times were flush.  President Obama said: “That is the height of irresponsibility.  It is shameful.  And part of what we’re going to need is for the folks on Wall Street who are asking for help to show some restraint and show some discipline and show some sense of responsibility.”  (“Obama Calls Wall Street Bonuses ‘Shameful’ ”, New York Times, January 30, 2009.

With the announcements this past week by Goldman and Morgan Stanley of dramatic increases in the reserves for compensation it seems that the President’s comments have had little, if any, impact on Wall Street’s pay paradigm.

On July 21, 2009 Business Spectator reported that Obama once again rebuked the Wall Street banks in an interview with PBS television saying: “The problem that I’ve seen, at least, is you don’t get a sense that folks on Wall Street feel any remorse for taking all these risks. You don’t get a sense that there’s been a change of culture and behavior as a consequence of what has happened. And that’s why the financial regulatory reform proposals that we put forward are so important.”  (“Obama Says Wall St Has Not Shown Enough RemorseBusiness Spectator July 21, 2009).

Even if Wall Street doesn’t care, Grahall’s consultants do, and have strong points and counter points of view.  Grahall’s Robert Cirkiel (robert.cirkiel@grahall.com) and Garry Rogers (garry.rogers@grahall.com) share their thoughts.

Robert Cirkiel: “I’m still having trouble picturing this huge Wall Street conspiracy to steal from the world. As we suggested in our blog Woodstock for Capitalists Revisited, Wall Street created derivative products that the market said it needed and only a supply-sider can claim that their creation was the sole cause of the problem. Surely wrongdoing should be punished, but there is plenty of blame to go around for the real estate meltdown including the government, Wall Street, realtors, builders, lenders and borrowers. Regulations that ensure fair and open trading are good. Regulations that impose and restrict free and open trading are bad.”  I just think that “blaming Wall Street” is a too simplistic and convenient way to explain away a complex issue caused by a chain of events and a number of players.

At the end of the day if the government wants to promote home ownership as a social good then the government should provide the insurance or the loans because the capitalization requirements are too enormous to immunize all the risks.

Maybe Wall Street actually thought it could cover the risk but the losses were too great. For example, insurers were able to cover the losses for Katrina, but a second such hurricane that season could have put many of them out of business and unable to cover the claims. Likewise, no insurer will be able to cover its life insurance claims if, for example, the Swine Flu pandemic becomes too widespread and lethal. That does not make the insurers evil.  They can only price and reserve insurance based on expected losses and a reasonable margin for error.

I did have a big problem with the fact that the Wall Street products were sold as “insurance” when they were anything but. 

Garry Rogers:  There is always going to be some jealousy and consternation regarding Wall Street’s pay levels among the general population, that’s just human nature. But what is really is different now is the “moral hazard” – that Wall Street firms took very aggressive positions and when those positions blew up, the taxpayers ended up having to cover the risk and absorb the losses.   Going forward, this has enormous implications, as “too big to fail” institutions now realize they have a safety net in Uncle Sam. 

Any financial “instrument” whether a derivative, stock option, etc. can be useful when utilized properly, but the abuse or overuse of this same “good” instrument can distort incentives that can then badly distort behavior.  The recent Goldman and Morgan Stanley compensation announcements are a stark illustration of the current “heads we win, tails the taxpayers lose” scenario, and surely points out that the executives at these companies have very little regard for what the President or anyone else thinks, if it interferes with their getting paid handsomely.  Goldman for example is particularly bothersome, because it had billions of exposure to AIG, and those losses ended up on the taxpayers’ backs after the bailout. Now Goldman is reserving a like amount for executive bonuses – and it seems that there’s only one degree of separation between it being a direct transfer payment from the government/taxpayer to Goldman’s executive’s pockets.

Now, some may argue that the government was complicit as well, first because of the role of the Community Reinvestment Act in increasing demand for housing and for making credit widely available to high-risk borrowers and also because of the general lack of regulation.  I think there’s some validity to those claims, in fact it’s surprising to me that President Clinton hasn’t received more criticism from the media regarding the CRA.

[SIDE BAR:  The Act, originally introduced in 1977 was intended to address the deteriorating conditions of American cities—particularly lower-income and minority neighborhoods – and was strengthened during the Clinton administration by changes to further reduce “red-lining” which was the practice by private and public entities to withhold mortgage capital from neighborhoods that were deemed "unsafe".]

But my impression is that blaming the CRA may also be too simplistic, because the credit bubble seems to have occurred globally – as part of an overall loosening of credit standards – rather than occurring solely or even primarily in the United States as one would expect if the CRA was the  principal cause. 

In any event, the interplay between the major forces of capitalism –financial markets, government, and taxpayers –needs to be rethought in light of what’s recently occurred.  Clearly, Wall Street isn’t going to regulate itself or moderate its pay practices. But most importantly, risk cannot be allowed to be transferred onto the taxpayer.

Again from Robert Cirkiel: We fear that redress will only treat the symptom: (1) blame Wall Street, (2) send a few people to jail, (3) agree that the problem is solved.  These steps will not address the basic problems: greed coupled with a failure to comprehensively manage risk.  If these issues are not addressed, then history will likely repeat itself.  Risk hedging is not insurance. Risk transfer is. If the market requires the latter then the products should be priced, marketed, reserved, and regulated as insurance.

Final thoughts from Grahall’s OmniMedia Editorial Board:

The ‘need’ that existed for derivative products was simply that investment firms, banks, etc. ‘need’ high return, low risk vehicles. (Don’t we all?) In the “brick and mortar” world of widgets and other tangible items, it’s fraudulent to knowingly pass off junk as something wonderful.  That activity generates lawsuits.  Wall Street banks and other “co-conspirators” knowingly packaged junk into derivative products, got a AAA rating from a heavily conflicted ratings agency and then were able to sell their product as safe, high-return low risk investments. 

But, because of the complexity of the products, the banks could make a general case for having disclosed the applicable terms (even though the terms are nearly impossible to understand or value without a Ph.D. in math) and “buyer beware” applied. Even with all the disclosures there have been many lawsuits over the last couple of years relating to deceptive, unethical and even outright illegal practices by brokers, Wall Street banks and bond insurers.  With that in mind, it’s hard to believe that Wall Street was benignly providing supply to meets its clients’ demand.

To sum up our comments about Wall Street bankers, we will borrow from a classic quote by Mr. Welch to Senator McCarthy at the Army-McCarthy hearings: “Until this moment…[we] never gauged your cruelty or recklessness…. You’ve done enough. Have you no sense of decency, sir[s], at long last? Have you left no sense of decency?”

Edie Kingston
Editorial Director
edie.kingston@grahall.com

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