Journalist John Cassidy, in a lengthy extract from his new book, How Markets Fail: The Logic of Economic Calamities, explains why Wall Street compensation packages are dangerous for the economy.
When the markets are rising and deals are getting done, traders, investment bankers and their bosses are paid magnificently; when things go wrong, the shareholders of the firms and, in extreme circumstances the taxpayers, suffer the bulk of the losses.
The market failure begins on the trading floor …. Some trading desks give their employees up to half of the profits they generate above a certain target. However, the trader’s downside is capped. If his trades generate large losses, he might lose his job, but he doesn’t have to write the firm a cheque to cover the cost of his mistakes. If his trades turn out badly, the firm has no recourse to his personal assets, or even the bonuses he earned in previous years. ….
[As for CEOs, remunerating them with stock options] amounts to giving them a heavily levered and one-sided bet on the value of the firm’s assets. If the bank’s investments do well, the stockholders, including the CEO, get to pocket virtually all the gains. But if the firm suffers a catastrophic loss, the equity holders quickly get wiped out, leaving the bondholders and other creditors to shoulder the bulk of the burden.
John Cassidy, “What was really behind last year’s market crash?”, The Guardian, 25 November 2009.
What is the solution? Reform from within, argues Cassidy, is bound to fail. “For although the financial sector as a whole has an interest in controlling rampant short-termism and irresponsible risk-taking, individual firms have an incentive to hire away star traders from any rivals that have introduced pay limits.” Only government can enforce compliance.
One question unanswered, at least in this extract, is why don’t shareholders – the owners of financial firms – enforce compliance by shunning firms which give outrageous pay packages to their traders and CEOs ?