When I first started working as a “Senior Specialist” at Merrill Lynch, processing Credit Default Swap transactions, I was not sure whether I just didn’t understand how the market functioned, or whether it didn’t really function that well at all. Newly minted with my BA in Economics from Tufts University, I was not confident in my abilities to grasp the complex underpinning of the high world of structured finance. It seemed no one in my department really understood how the big machine worked and when, in 2007, there was talk of a “credit event” (a default on debt, filing for bankruptcy, etc.) at General Motors, many people joked that the event would also coincide with their resignations.
It’s easy to have 20/20 hindsight, but after observing what is happening today, I realize now that I new a lot more than I thought I did, and I also knew it before I had ever heard of a Credit Default Swap. In high school, my friend Devin and I spent so much time talking about how the combination of Capitalism and Democracy in the US has some horrendous effects. We (like most everyone else who shares this view) were aware that all was not well, but did not have much of an alternative to suggest. Even so, I feel compelled to add myself to the list of people who can’t control themselves and must blurt it out hoping for the satisfaction of a dialog with someone who can add something new.
Why did all the big financial companies continue to originate the swaps? Well, for one thing, there was no model to properly price them because their wasn’t any data on the correlation of credit events in the modern world of structured finance. On a more basic level though, banks kept extending themselves because they were making so much money. The guys on the sales floor were making $25,000 every time one of their clients made a trade! Millions a year without even taking risk! Who held the risk? The client and The Firm.
Who is The Firm? The Firm is the shareholders and that’s about it. Its the small-time common shareholders and The Board of directors. The Board is made up of people who usually hold large percentages of the stock, and usually includes many of the firm’s top executives. The CEO and the Executives make a very large salary, and also get a lot of stock. Its like the icing on the multi-million dollar cake. While the stock value can go to 20 cents, the cash they are paid is real. Thus comes Capitalism’s greatest strength and its greatest weakness: The more money you make, the better for you, what happens after that is The Firm’s problem.
Who is at fault when a CEO makes $10 million a year for 10 years, and the company becomes a ticking time-bomb under his watch? He’s still got $100 million and worst of all, he probably made that kind of money taking the risks that put the company’s future in the ground. I’d do it too, and so would you.
You have a stunning record of making money and exercising sound judgment in the middle to upper ranks of a company. You get promoted to CEO. Would you rather $100 million with an unknown chance of destroying a company and being partly to blame, or $20 million, with the possibility of being right in the end?
Like everything in the world, its not that simple, but I hope you see my point. Since the incentives push people to make the money now and not worry about the future, they are rationally making risky decisions. What this says to me, is that the people who are in control, need to be paid differently. Notice I didn’t say more or less. If they are given the same overall compensation, but with a higher percentage of it in stock, it will make them care more.
Government cannot be counted on to solve this problem through regulating new markets. New markets must be left to self-adjust and correct. Through time and experience, prices will include more information about the real risk of the market. It takes time for shifts in the market to occur, and each one makes market participants smarter about the future. Markets are a beneficial force for everyone, but they cannot grow and evolve while being restricted. Instead, we must constantly strive to reinforce positive behavior with positive compensation. Instead of “Panel this, regulation that,” I wish Obama and McCain could really think about the root of the problem. Maybe they would realize that it lies within the flawed relationship between the individual and corporation. Cash compensation for executives should go the way of Lehman Brothers and maybe in the future, Wall Street’s smartest bankers will end up focusing on what’s good for The Firm, rather than how much cash they will pull in for the end-of-year bonus.