March 17, 2010


By William Gruver

Is Washington becoming the new Wall Street? The answer to this oft-asked question is unequivocally "yes," but not for the obvious financial reasons. True, the federal government in the past two years has put as much capital into the financial system as Wall Street has raised for its clients — $3 trillion.

It is also true that the most profitable organization in the history of American business is no longer Exxon-Mobil, which earned $45 billion in 2008, but the Federal Reserve that recently reported a 2009 profit of $46 billion.

The real reason, however, that Washington is the new Wall Street is that it is no longer trusted. Historically, Americans natural distrust of Wall Street has been tempered by a trust that government will insure that our financial system remains fair. In his recent state of the union address, President Obama referred to one of our deficits as the root problem in America today. The deficit, to which he referred, however, was not our federal budget deficit or our current account deficit, either of which most economists predict are now or will be huge problems for us in the future. The deficit the President accurately identified as our root problem is a deficit of trust.

Trust is essential
Trust is essential for any financial system to function properly and all advanced economies need a healthy financial system. Our economic problem originally was and in many ways still is a credit crisis. The Latin word from which the English word "credit" originated is credere, which in turn means trust.

If an economy is looked at as a building, the financial system is its plumbing. You cannot have a functioning house without proper plumbing; you cannot have a viable economy without a financial system; you cannot have an effective financial system without trust — trust that starts with faith that the government is properly overseeing the system.

Sadly, Washington has become Wall Street when it comes to distrust. In a recent national poll, 33 percent of the respondents said they had no faith in Wall Street. That's bad, even by Wall Street's normally high level of distrust, but in the same poll 47 percent of the respondents said they had no trust in our federal government. Before we can fully recover from the financial crisis it will be necessary for Americans to begin to trust the system again, and before they will trust Wall Street, they must first trust their government to insure that the system is fair.

The Opium Effect
Wall Street, Main Street and Washington all were playing with more and more of "other peoples' money" (OPM). The narcotic effects of this other form of opium were equally as dangerous as and eventually more lethal to our economy than that which comes from poppies. The path to restoring trust in our credit markets lies in dampening the incentives for greed in our system by addressing the underlying causes of the crisis.

This is the second in a three-part series on how regulatory reform should address the underlying issues that caused the financial crisis.

The double bubbles of tech and real estate were fed by a classic agency/principal conflict of interest. The shareholders bear the principal risk while management (the agents) lacks sufficient downside potential to temper their risk taking. As I suggested in a February 2009 article in The New Republic, trust in Wall Street will only be restored when the American people see a change in the rules of the game from the current socialization of risk and privatization of profit. In the days when Wall Street was a collection of private partnerships (in which the principals were the agents with the unlimited liability associated with that form of business organization) there was a natural aversion to excessive risk taking since the OPM temptation was not present. In recent years, however, the major Wall Street firms are all public corporations in which the executives have landed in the utopia of unlimited reward, but only limited liability. It has become a "heads I win, tails you lose" relationship with their shareholders and, in the "too big to fail" dilemma of 2007/8, with taxpayers.

The OPM temptation to lever excessively must be addressed in any regulatory reform. A return to a Wall Street composed of private partnerships would probably accomplish the task, but is probably impractical in the global financial market of the 21st century. Nevertheless, there are other means to address the OPM temptation and bring executive compensation into better alignment with the risks borne by the shareholders.

Elevator Equity
Prof. Edward Kane of Boston College has called for a new class of stock — one in which the recipients (senior executives of Wall Street banks) have extended liability, i.e., risk beyond their stock going to zero in a failure of their institution. My term for this new class of stock is "elevator equity," which unlike traditional common stock ("escalator equity"), is not limited to one direction. In the current system of stock bonuses, the executive is rewarded with some value as long as the firm remains solvent. Much like riding an upward escalator, the executive has no risk of going down. Elevators, on the other hand, go in either direction — up or down. Elevator equity, which presents the executive with clawback risk extending to their personal assets (outside of the firm's stock) reduces the OPM temptation in Wall Street senior executives — much as it would be reduced in a private partnership. The systemic risk resulting from excessive leverage would be lessened.

The compensation committees of Wall Street firms are moving in the right direction by paying bonuses, as in the case of Mr. Blankfein and Goldman Sachs, all in the form of the company's stock. Their shareholders would be even better served and America might once again begin to trust Wall Street when they award the bonuses in elevator, not escalator, equity. Currently, with escalator equity the executive receives a reward if the stock stays flat, receives a bigger reward if the stock goes up, and the only loss suffered is the value of the stock grant if the firm goes bankrupt. Were the bonus paid in elevator equity, however, the executive would have the same upside potential, but if the firm went bankrupt, his or her personal assets could be attached to repay losses suffered by non-executive shareholders. And, unlike today when the former CEOs of failed banks remain wealthy men, executives who held elevator equity would be pushed to personal bankruptcy when their firm fails.

Michael Jensen, explaining the success of LBOs in the 1980s, said that "nothing so focuses the executive mind as the threat of bankruptcy." This observation needs to be updated in order to reduce the temptations of OPM on Wall Street — nothing so focuses the executive mind as the threat of personal bankruptcy. Creation of deeper, more meaningful fear in Wall Street executives will do much to dampen the imbalance toward greed we have seen in the form of excessive leverage.

The second means to restore better balance between fear and greed on Wall Street is better enforcement. History provides several lessons. Recent history provides two pithy examples. The first is self enforcement within the financial firms. Some policed themselves better than others and, not surprisingly, those are the firms that survived,

New respect for risk officers
A subtle, but very important, cause of our financial troubles was the relative lack of respect with which the risk officers at the major Wall Street firms were held before the crisis. In 2007, the CFO of Goldman Sachs was paid 84 percent as much as the CEO (the highest such ratio at any major Wall Street bank). At Lehman Brothers that same ratio was the lowest of any major Wall Street bank at -11 percent . Recently, in announcing its 2009 bonuses, Goldman Sachs went a step further by rewarding its CEO and its CFO with equal bonuses.                             

To insiders on Wall Street compensation is seen differently than it is seen from Washington or from anywhere else in America. Washington and Main Street see Wall Street bonuses as huge amounts of money, which in many cases is undeserved. On Wall Street the bonuses are seen as badges of honor - signs of respect. From its earliest days, Goldman has had a tradition of rewarding executives whose major responsibility was risk management and putting them into positions of enormous respect and senior authority. They do not get rolled over by anyone trying to take on excessive leverage or other imprudent risk.

As it is in the NFL, so it is on Wall Street: offense sells tickets, but defense wins championships.

Posted March 17, 2010

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