Reform in finance?

In recent decades -- and culminating in the recent financial bust -- the interests of investment bankers has diverged more and more from the interests of their clients. Nowhere was this more evident than at Goldman-Sachs, which rescued itself from its disastrous speculation in the subprime mortgage bubble by eventually betting (selling short) against its customers.

In order to show the public that it's contrite and takes their interest to heart, G-S and other companies promised to tie its top executives' compensation (or at least part of it) to the value of its stock. Thus, some execs received their bonuses as either stock directly, or as options to buy the stock (over a period of a few years) at a fixed price.

However, the NY Times reports that the greedy investment bankers have been gaming even this very modest "reform." They do this by "hedging" their stock compensation.

Suppose, for example, that as part of your company's compensation package, you are given the option of purchasing a certain amount of the company's stock at a certain price, let's say $90 per share, over a period of say a year. Often this price is actually below the current market price -- say $100 -- but you are not allowed to exercise the option immediately. Supposedly this will make your interests identical with that of your company (and any other shareholders of your company). However, you may be allowed, in turn, to sell an option to buy these shares (at a certain price for a certain time) to someone else, if you think the shares may go down (possibly as a result of your own actions!). For example, you might arrange a contract with someone where, in exchange for paying you $10 a share, you promise to sell that person, over that same year, if they wish, a hundred shares of the stock, at an agreed-upon price -- say the current market price of $100. If the stock doesn't go up any over that year (or goes down), then the person will not exercise the option to buy, so you will pocket the $1000 total fee he pays you. If the stock goes up to $115 he will exercise his option, but you can still buy it at $90 (through your company's option) and sell it for $100, so you make $1000 plus his fee of $1000.

Selling this kind of hedge, or contract, in which you think the stock will go down, so agree to buy it later at a fixed price, is referred to as selling a call. There is an inverse hedge as well, called a put, in which you agree, for a fee, to purchase shares at an agreed upon price.

As you can see from this simple example, you can protect yourself somewhat from a decline in your company's stock; thus, you can sidestep some of the supposed tie-in of your bonus with the performance of your company.

A few high-ranking executives are forbidden to make hedges on their bonuses, and companies, presumably, don't allow their employees to actually sell the company stock short (i.e. bet against the stock in the open market).

However, even if hedging isn't allowed, it doesn't seem likely that this kind of nudge on the wrists will change much of the anti-social nature of modern investment banking. After all, it was Goldman itself which saved its stock prices by selling short its own customers. Investment bankers who bundled subprime mortgages into securities called CDOs (or virtual CDOs) had no intention of keeping these as investments; rather, they unloaded them as quickly as possible on their clients, which included private investors, pensions funds, charities, etc. They were able to do so because of faulty or phony evaluations of their worth by corrupt or incompetent ratings firms -- of which there never seems to be a shortage.

(All of this has been thoroughly documented in the dozens of books that have been published describing the recent sub-prime debacle. "The Big Short"is one of my favorites.)

What is needed is not some industry-sponsored indirect "reform", tying compensation to stock-prices, but direct regulation of the investment banks. Banks should, first of all, be forbidden to speculate using their depositors' assets (as in the old Glass-Steagall Act). Derivatives such as CDOs (Collateralized Debt Obligations) and CDS (Credit Default Swaps) need to be completely transparent -- investors need to know what's "in them" and have available ratings and evaluations prepared by licensed and disinterested ratings agencies. Some important steps have been taken in this direction in the new Financial Protection Law, and the Consumer Financial Protection Agency (CFPA) now being assembled by the President's special adviser Elizabeth Warren.

Even more should be done. Wall Street must be made to pay for killing savings and jobs and many businesses. Taxing speculative capital gains the same as ordinary income will help eliminate the widening gap between whose who create value (workers, researchers, inventors, entrepreneurs) and those who play the market solely for personal gain. We should also make Wall Street pay by enacting a fee on stock transfers, similar to the sales tax: see my blog on The Parasite Tax.

Let's hope that Obama doesn't confuse working with business with working with speculators. He seemed to require a lot of nudging to get him to recognize Elizabeth Warren as the right person to set up the CFPA; we can only hope that she isn't marginalized in his new-found love of corporate America.

(BTW: Warren has been suggested as a possible opponent against Scott Brown in the 2012 fight for the second Senate seat in Massachusetts. At the moment I like Michael Capuano, but Warren might be good also; I simply don't know how she is as a political candidate. She'd have to be better than Martha Coakley ...)