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Wednesday, January 27, 2010

Shareholders' rights

There has been a lot of anger over the amount of money that Wall Streeters are getting paid one short year after the taxpayer-financed bailout. And the taxpayers have good reason to be angry, especially with the AIG payouts to banks which made bad bets. Shareholders have a good reason to be angry too.

Obama's proposals for a bank excise tax and reinstituting Glass Steagall are an obvious attempt to cash in on this populist anger. But these proposals not only would fail to prevent another financial catastrophe like the one we had in the fall of '08, they don't really render justice. The financial crisis was caused by a number of factors, too numerous to list here. But the main culprits were the overextended real estate market and the prevalence of unregulated financial products. Chief among the unregulated products were collateralized debt obligations (which sliced and diced mortgage payments into so many different permutations that even the people who created them eventually didn't know what they were worth) and credit default swaps (which effectively allowed hedge funds and investment banks to bet on the downfall of other financial entities). The fact that J.P. Morgan and Citibank could trade for their own accounts had virtually nothing to do with the crisis. And the bank excise tax smacks of a windfall profits tax, which merely penalizes corporations for being successful.

In order to prevent another financial crisis the government has to establish an over the counter, regulated market for credit default swaps, where the people who sell these products have to put up some sort of collateral in order to insure that they can pay off their obligations, similar to the way the futures market is run by the Commodities Futures Trading Commission on a centralized exchange.

And in order to see justice done the government also has to figure out some way to claw back the money it paid out on the backside of the AIG bailout, to Goldman Sachs, Credit Suisse, Deutsche Bank, and Societe Generale, among others. Each of these banks were paid over ten billion dollars apiece for their bad bets with AIG.

The other major reform which is long overdue is one concerning shareholders' rights. For far too long executives of public corporations have been paying themselves way too much, at the expense of the shareholders. The only people who are going to say no to an executive are the board of directors, and when the executive has staffed the board with his cronies, it is a license to steal from the shareholders. Congress should pass a bill making it mandatory for shareholders to get a vote to determine how much their CEO and other executives are paid. An executive who effectively pays himself is, to put it mildly, experiencing a conflict of interest. (In fact the conflict is so major as to not be a conflict at all.)

There was an article in the NY Times this morning which listed the percentage of revenue each of the major banks were paying out this year. Goldman Sachs was paying out 45 cents to its employees for every dollar of revenue it got (and the profits would have been a lot less without the AIG handout). JP Morgan paid out 63 cents, Bank of America 88 cents, and Morgan Stanley 94 cents. Citigroup actually paid out $1.45 for every dollar it took in, and thus had a loss for the year. But even when the banks turned a profit, the shareholders just got the leftovers.

This isn't just true of banks, by the way, it's true of any public corporation. I have a hard time believing that most Fortune 500 executives are worth what they get paid.


Anonymous said...

John, I couldn’t agree with you more. Many Boards today are tight oligopolies of corporate chieftains and their cronies indulging in mutual back-scratching for personal gain with little regard for shareholder interests and fiduciary responsibility.
I’m very pessimistic about the potential for reforms to fix the system because so many failures conspired together to precipitate our economic near-Armageddon and I fear that most of the issues will go unaddressed:

1. Ultra low interest rates were the core engine of the debacle, stoking the demand for mortgage lending and driving increasingly desperate yield hungry investors to more exotic instruments like CDOs and CLOs in order to try to meet their actuarial return targets. Yet there is no general agreement that the Fed keeping rates were way too low way too long was a core contributor – hence little chance of policy reform.

2. The gigantic market for the toxic instruments could not have existed without investor demand. As everyone’s favorite banker Blankfein noted in his recent testimony to the Commission, these investors are supposed to be experts. Should we believe that these “experts” were duped by Wall Street or did they also do a shitty job of investor due diligence? I think a lot of the latter. Also, if they didn’t have the expertise to assess these investments properly they should not have bought them! If there had been smarter buyers, Wall Street wouldn’t have sold as much of this toxic s**t. (For example, Calpers and Calsters, both gigantic funds investing on behalf of public employees in California were huge investors and losers. See for example Ironically Angelides, the Commission Chairman as California Treasurer was the key man in the governance of these funds at the time they were investing in this stuff.) I’d say governance and management of these huge investment funds is another area in dire need of reform.

3. The failure/corruption of the rating agencies is well documented. Has this been addressed sufficiently?

4. The size problem is acute: the weaker of the big banks are too big to fail, too big to manage, too big and too complex to risk manage and too big for any chance of effective regulation or governance. (Do we really think either the regulators or the supposedly “smartest guys in the room” are going to get any smarter?). They also wield way too much political power. The breakup of the old trusts was good for our long run economic health – we need the same for the megabanks. But the responses to the just-too-big problem are likely to be very strongly resisted by these super powerful institutions and thus be half-hearted at best.

I could get into some other issues, but I’m already boring you or depressing you or both!

John Craig said...

Guy --
Thanks for that comprehensive and well-informed response. You're certainly not boring me, though I have to admit your prognosis is slightly depressing.

I don't think we can really blame low interest rates for the debacle, I see that as sort of a circumstantial cause. Was the Fed wrong to keep rates so low for so long? Probably, but it's not exactly the kind of thing you can legislate away.

I totally agree that there was a severe lack of due diligence on the part of the buyers, and I also suspect that the investment banks may have been less than 100% forthright when describing the risks of the various new exotic instruments.

There's no question that the rating agencies were totally at fault. I don't even know whether they were officially censured in any way; they haven't been in the news much recently.

Of all the banks considered too big to fail, Citigroup is really the only one which is still considered a basket case, and it seems to be divesting itself of a lot of its non-core businesses and offices. The funny thing is, I don't think Morgan Stanley and Goldman Sachs ever modeled themselves after real banks after "converting." (I have yet to receive junk mail from either institution offering me a great rate if I open up a checking account with them.) They only did it so they could borrow directly from the Fed. If Obama does succeed in bringing back Glass Steagall, I don't see it as hurting either of them, though it would hurt the traditional commercial banks.