jump to navigation

Goldman’s Gain, America’s Risk: A Poster Child for Financial Insanity July 15, 2009

Posted by kbianews in Uncategorized.
trackback

From the New York Times blog, Room for Debate:

Having earned $3.44 billion in the second quarter, Goldman Sachs announced that it would be setting aside a compensation pool of $11.36 billion for the first half of 2009, or nearly $400,000 each, on average, for its roughly 29,400 employees and temporary workers. That level of per-worker compensation is close to what it was in mid-2007, when Wall Street was booming.

Many taxpayers might find the comeback of fat pay packages perplexing, especially since the federal government was throwing cash into the bank not that long ago. Is it reasonable to be critical of this kind of largess at Goldman when the rest of the economy is still floundering? Or is this a sign that the financial industry is stabilizing and that government aid is doing what it was supposed to do?


A Poster Child for Financial Insanity   

William K. Black

William K. Black, associate professor of economics and law at the University of Missouri, Kansas City, is a former financial regulator. His book, “The Best Way to Rob a Bank is to Own One,” focuses on the role of “control fraud” in financial crises.


It’s difficult to decide which is more insane: the efforts of the Bush and Obama administrations to recreate the failed financial markets, e.g., collateralized debt obligations that produced the worst global financial crisis in three generations, or continuing to make obscenely wealthy the financial idiot-savants that caused the crisis.

 

Goldman Sachs is the poster child for both forms of insanity. The news that Goldman has purportedly earned astonishingly large profits in the latest quarter and plans to pay many billions of dollars in “bonuses” to people who are already in the top 1 percent of the wealth distribution raises issues in two categories: performance and pay.

Goldman’s profits show that government is maximizing moral hazard at firms that pose a risk to the entire economic system.

 

Personally, I’m more concerned by the performance. I care about pay primarily because it creates perverse incentives to engage in accounting/securities fraud and other forms of abuse. There are two possible explanations of Goldman’s performance — and they are both frightening. “Economic recovery” is not a possible explanation. Reports of “green shoots” simply means that things are getting worse at a slower rate than six months ago. The recession, already our worst in modern history, is getting worse.

 

Goldman is the textbook case of “moral hazard.” It recognizes that both administrations have guaranteed that it will not be allowed to fail no matter how badly it is run. (Treasury Secretary Geithner, in a portion of a speech ignored by the media, twice used the phrase “capital insurance” to describe our new policy. The taxpayers no longer insure only depositors — we insure the shareholders, or more precisely, the senior officers.)

 

“Moral hazard” is well known in insurance and economics. If there is little downside to the senior officers and if they can capture the upside, e.g., through massive bonuses, then it pays to either engage in ultra high-risk gambles, or the sure thing, accounting fraud. Either explanation is frightening because it is simply a matter of time before this strategy causes an even bigger financial crisis than this one.

 

Of course, you can’t send out a memo to 10,000 employees and tell them explicitly to engage in either ultra high-risk strategies or accounting fraud. That’s the genius of bonus systems — you can send the same message without risk of prosecution. When the Business Roundtable was looking to respond to the Enron and WorldCom wave of “control frauds,” they choose as their spokesman Franklin Raines, then chief executive of Fannie Mae. A reporter asked him why there were so many scandals on Wall Street. Mr. Raines replied:

“Don’t just say: ‘If you hit this revenue number, your bonus is going to be this.’ It sets up an incentive that’s overwhelming. You wave enough money in front of people, and good people will do bad things.”

Goldman’s profits should teach us (1) that our policies are maximizing moral hazard, (2) at firms that pose a systemic risk to the entire economic system, and (3) changing executive compensation to minimize the perverse incentives is not “merely” a matter of fairness — but essential to protecting ourselves from future crises.

 

 

 

Advertisements

Comments»

No comments yet — be the first.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: