Posted by Marc Hodak on March 8, 2009 under Executive compensation, Unintended consequences | 
So, is it an “irregularity” or a “misunderstanding?” Those were the terms offered by the BofA and a currency trader, respectively, to describe that trader’s suspected $400M trading loss that had been previously reported as a $120M gain when this operation was still part of an independent Merrill.
Recall that shortly before BofA closed their acquisition of Merrill at the end of ’08, Merrill had paid significant bonuses to certain of its senior executives. One of its $10M men was David Gu, who headed up Merrill’s rates and currency operations. If this report turns out to be more than a misunderstanding, or even an irregularity, this $520M turnaround in the paper fortunes of Mr. Gu’s operations will significantly cut into the profits for which Mr. Gu was rewarded.
Such a turn would bring up the question of clawbacks. How much of a bonus would Mr. Gu have gotten if this unit’s profits were lower by $520M? Will Mr. Gu be on the hook for any of that difference?
A more fundamental question is what Mr. Gu’s complicity might have been in the bogus profit number. I doubt that Gu would have actively participated in fraud on his employer, or even tolerated fraud if he knew about it. But the numbers coming up from his unit are ultimately his responsibility, as are the systems and accounting controls that guarantee the integrity of his reporting. Is it possible that Mr. Gu had less reason to scrutinize the excellent numbers coming from his London currency trading desk than from, say, some poorly performing desks in other areas?
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Posted by Marc Hodak on March 2, 2009 under Executive compensation, Invisible trade-offs, Unintended consequences |
Nassim Nicholas Taleb has written a good description of what is now widely understood to be one of the key perverse incentives that fueled the recent credit bubble–i.e., the trader’s option:
Take two bankers. The first is conservative. He produces one annual dollar of sound returns, with no risk of blow-up. The second looks no less conservative, but makes $2 by making complicated transactions that make a steady income, but are bound to blow up on occasion, losing everything made and more. So while the first banker might end up out of business, under competitive strains, the second is going to do a lot better for himself. Why? Because banking is not about true risks but perceived volatility of returns: you earn a stream of steady bonuses for seven or eight years, then when the losses take place, you are not asked to disburse anything.
Like like many others cognizant of the moral hazards of the trader’s option, Taleb throws up his hands and recommends hiving off the risky portions of banking from the “utility” parts of banking, and heavily regulating the compensation of the latter. So easily said, isn’t it?
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Posted by Marc Hodak on February 18, 2009 under Executive compensation, Politics, Unintended consequences |
This is my public service announcement.
Many firms and a few compensation consultants are still trying to figure out what the stimulus plan restriction on executive compensation really mean, and what they should be considering as a result of these rules. Here are the answers.
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Posted by Marc Hodak on January 14, 2009 under Invisible trade-offs, Unintended consequences |
Why, they create regulations, of course. But to what end? The nominal purpose of regulations is to create the impression of increased safety or security. For instance, regulating workplace safety nominally gets us safer workplaces. Regulating food safety nominally gets us safer food. Regulating financial service providers is supposed to make the markets safer for various participants. People vote for regulations because it makes them feel safer.
Of course, one would hope that regulations create more than the impression of safety. People want and expect that the safety is real. Goodness knows, the costs of regulation are real–one would hope we are getting the benefits.
Larry Ribstein notes a great example of how the impression of safety can actually create greater danger. When the SEC, the promulgators and enforcers of securities regulation, investigated then signed off on Madoff’s fund, they became an unwitting accessory to the confidence game that Madoff was playing with his clients. In the case of the Swiss bank UPB, the SEC literally created confidence in an operation the bank would have otherwise treated with suspicion, costing their clients hundreds of millions of dollars.
Economically speaking, one would like the benefits of regulation to be greater than the costs. Unfortunately, these things are difficult to measure. The benefits are largely speculative, e.g., accidents that don’t happen, while the costs are relatively dispersed, e.g., a few dollars per item that may be sold by the millions. The lesson, here, is that there is another cost–the cost of misplaced confidence. If one believes that someone else is bearing the monitoring and other costs to improve their safety, then one is likely to save on those costs for themselves. It’s easy to visualize that for every extra dollar I am forced to spend for regulatory compliance for a particular product, I might save a dollar or more that I would have otherwise spent for the Good Housekeeping seal on that product. In other words, by taking on the regulation of a product or sector, the government is socializing costs that would have been otherwise borne by private actors, possibly with a net negative effect.
I don’t rely on any private tester of milk or beef because the USDA is certifying it for me. I know that the SEC is watching over registered brokers and other market agents, so I can trust them. Even if I thought the regulators did an inferior job versus a private certificate of approval, I’m not going to pay double for the inspection. Government regulation will generally crowd out private regulation.
In the case of Madoff, UPB bore the private costs of regulation, but they also knew that the SEC actually looked into the fund’s operations, and gave it an OK. Absent that OK, the bank would have relied on its internal analysts who were sounding warnings about Madoff’s fund.
Unfortunately, these kinds of regulatory embarrassments rarely improve regulation. They more often end up increasing the costs of regulation on a thousand perfectly good firms for every crooked one out there, which can easily be a net drain on social welfare. And then, the government enhances confidence among the credulous voters who have somehow come to believe in the effectiveness of government.
Then, another $50 billion goes poof. And the regulators use that as proof that they don’t yet have enough money and power.
Posted by Marc Hodak on December 14, 2008 under Unintended consequences |
Here are five reasons I believe a bailout will accelerate the decline of the American auto makers:
Congress will run the auto companies: Everyone will report to a car czar. Who do you think the car czar will report to? Anyone following the travails of the Big 3 know that their problem was not a deficit of politicized decision making. It’s almost inconceivable how bad it will get with Barney Frank moving from back seat driver to one of several hands on the steering wheel.
Why would I buy a car from a loser: Even if Congress keeps its paws off of car maker operations, most car buyers will note that only the American auto manufacturers are on the dole. They will figure that Toyota, Honda, Kia, etc. must be better car companies since they haven’t been whining, threatening, or cajoling for handouts. Why would someone buy a car from a bad company? The government stamp of “welfare queens” on GM, Chrysler, and the UAW can’t help their image.
I gave at the office: It is well-documented that as government taxes and spending increase for certain welfare programs, private giving to those programs drops. Every time people look at a GM, they will think, “They already have my money.” Some might succumb to the sunk cost fallacy, but I think it’s more likely that people will question why they should send voluntary dollars after their mandatory payments.
Management pisses me off: Many people were turned off by the spectacle of CEOs flying in their private jets to petition Congress. They were then turned off by the cynical pandering of those executives driving to Washington in non-production hybrid vehicles. Wagoner, Nardelli, and Mullaly are not the most sympathetic characters. The Big 3 would have probably invested huge ad dollars in not putting their faces all over the media for two solid months. But they apparently would not have spent $15 billion to avoid it.
The UAW pisses me off: Gettelfinger is only marginally more sympathetic, but his union has spent a lot of their goodwill in this campaign, too. Sure, many people still think of the union as “for the worker,” but a lot of data has poured forth highlighting the gold-plated lunch-boxes these workers carry. The average Joe, worried about keeping his job so that he can support his parents on Medicare, has heard the UAW arguing to keep much higher salaries and benefits for their laid off workers, who by the way are entitled to superior medical care. Even union members, most of whom don’t belong to the cushy UAW, poll against the bailout.
HT: Commenter on Coyote’s blog
Posted by Marc Hodak on November 7, 2008 under Unintended consequences |
Coyote found a concrete instance where the mere threat of possible unionization may have killed jobs. A Honeywell plant near Phoenix had, a couple of times over the last decade, barely prevented unionization in secret ballot voting. Well, a day after Obama and the Democratic horde won the election, the company announced it would shut down that plant and offshore 700 jobs.
Recall that Obama promised two things in his campaign. First, he has pledged his support for “card check” unionism, where the secret ballot is replaced by face-to-face cajoling. Second, he promised to penalize companies that “move American jobs overseas.” It’s not a stretch to believe that the Phoenix plant was a highly likely target for successful unionization. It’s therefore not a stretch to think that the company decided to move its operations to Mexico and the Czech Republic while it still had the freedom to do so.
It’s well documented that job growth in unionized companies is far slower than in non-union companies. Labor organizations will never track such a thing. They will track union vs. non-union wages or benefits–the visible benefits of union negotiations. But they don’t have to track job growth. Everyone knows that within any industry–airlines, trucks, auto manufacture, etc.–job growth is much higher among the non-union firms. Everyone knows that unions spend much of their energy trying to prevent further job losses. This is just economic common sense.
The problem for workers is that, while they can see the tangible gains of unions in terms of wages and benefits, they can’t see all the jobs that weren’t created, or were created off shore because the union priced them out of the domestic market. The market penalty of unionism is largely invisible. Of course, the market is working whether workers or politicians or anyone else notices it or acknowledges it. But it is quite possible, if not likely, that Obama’s outspoken support for pro-union policies led to the loss of hundreds of jobs in Phoenix, and goodness knows how many more in the rest of the country between now and the point where he takes those rights away from workers and companies.
Postscript: Those with the jobs, and therefore union votes, have a strong incentive toward blindness about this feature of the market. They could care less about those without the jobs, especially if the reason those jobs aren’t there is because their jobs pay too much. They only care to the extent that the lack of labor competitiveness might affect their job.
Posted by Marc Hodak on August 14, 2008 under Unintended consequences |
Today I saw two stories that illustrate that people pay more attention to behavior than words.
Both stories had to do with illegal immigrants. Most Americans debate immigration policy as if the government is to be considered a trustworthy rational actor in a complicated scheme. In fact, while each agent of the government might be individually rational with respect to their personal incentives and constraints, anyone dealing with the government’s regulatory or enforcement machinery know they are up against a frighteningly irrational and amoral, if not retarded creature.
Illegal immigrants, especially, feel like they have been screwed so much for so long in their dealings with ICE that it’s laughable to consider any program that depends upon their trust and cooperation.
The first story recounts a familiar tale of someone in ICE custody:
In April, Mr. Ng began complaining of excruciating back pain. By mid-July, he could no longer walk or stand. And last Wednesday, two days after his 34th birthday, he died in the custody of Immigration and Customs Enforcement in a Rhode Island hospital, his spine fractured and his body riddled with cancer that had gone undiagnosed and untreated for months.
What the story left out was that the behavior of the authorities, while cruel, was exactly what the system required of them. Yet, the ICE authorities who set up that system act truly surprised when plans that depend on the trust of illegal immigrants work out like this:
A program to induce illegal immigrants to turn themselves in to U.S. federal authorities for a “scheduled” deportation has failed to attract substantial interest. Eight days into the scheme, only six people have surrendered, out of thousands who are eligible.
Posted by Marc Hodak on July 29, 2008 under Unintended consequences |
The nannies in L.A.’s city council are voting a moratorium on fast food restaurants in South L.A. Here’s their logic: People in South L.A. are fat. Fast food makes you fat. South L.A. is rife with fast food outlets. If we limit the number of fast food outlets there, people there will not get so fat. OK?
This is the same city council that outlawed plastic bags for environmental reasons.
The California Restaurant Association has come up with this response:
Fast food “is the only industry that wants to be in South LA,” said association spokesman Andrew Casana. “Sit-down restaurants don’t want to go in. If they did, they’d be there. This moratorium isn’t going to help them relocate.”
Wow, that’s pretty self-serving. Don’t these people get ENFIC?
Seriously, the council would, if they could, require “healthy, sit-down restaurants” to locate into that area. SInce they don’t quite have that power, not for lack of trying, they will instead use tax dollars to lure such restaurants there. When they aren’t trying to throttle development, of course.
In the mean time, economic logic suggests that:
(a) property values will go down since you’ve taken away one possible, and apparently popular, use for property in that area
(b) taxes will go up to fund this attempt at social engineering
(c) Incumbent restaurants will make more money due to the artificial constraint on competition
(d) Incumbent restaurants may need that extra revenue to defend themselves from a city council that is clearly out to get them…
(e) …making some lobbyists, and likely council members, wealthier
(f) You still won’t have healthy eating opportunities, because, as every nanny should know, punishing behaviors you don’t want never guarantees behaviors you do want.
Which, altogether, means that these people will be simply paying a little more to get fat.
Posted by Marc Hodak on July 23, 2008 under Unintended consequences |
I can’t say the critics are groundless,” says Jung Jaesoo, 48 years old, who runs a consulting firm that advises Korean companies on how to qualify for credits. “But the Kyoto Protocol is a multilateral agreement. It is impossible to make only South Korea an exception now.”
—
As to whether it is sensible for his company to reap rewards for installing pollution-control technology in a highly industrial country like South Korea, Mr. Rosier says the rules of the U.N.’s system were set by the Kyoto negotiators.
And that’s that.
These quotes reference the legal, and oh so critical, distinction in the Kyoto Ptococol between developed nations, like those of the OECD that are expected to bring their emissions to below those of 1990, and “developing” nations for whom the 1990 targets would be even more wildly inappropriate. Without getting into the details, this legal distinction between country types creates a game-theoretic situation appreciated by all incentive experts: arbitrage across the boundary.
The boundary, in the case of Kyoto, occurs around Portugal, a “developed” nation whose economic growth plateaued around 1581, and South Korea, which was plausibly “developing” when Kyoto was negotiated in the mid-90s, but at the time was on a very different trajectory. South Korea’s GDP is now higher, and still faster-growing than Portugal’s. In fact, South Korea is now on par with most E.U. nations.
Still, because a treaty just had to be signed in 1997 so the politicians of the day could have something to show, and because one size so clearly did not fit all in the massive central planning experiment embedded in the treaty, a cut-off had to be made somewhere. All of the politicians back then knew that none of them would be in office to deal with any consequences of their mess.
Since then, businesspersons have studied the rules, just the way they were supposed to, and are now playing them the way they were written, just as they were expected to, though not necessarily with the intended outcomes. These companies were meant to come up with clever and powerful ways to reduce emissions, and they are, in fact, doing that. They just weren’t supposed to benefit so unevenly or unfairly from the treaty. You know that politicians were almost as obsessed about fairness when these discussions were going on as they were with simply getting something signed.
Alas, because the Kyoto Protocol was created by politicians instead of incentive experts, we are now starting to see stories about how completely this thing is going to be gamed. Sure, the experts were invited to Kyoto for some sake and visits to various shrines, but in the end, everyone was compelled to worship at the UNFC Temple of Climate Change.
OK, you want an unnecessary operation, go ahead. But as I always tell my relatives, sure, operations are expensive, but you still shouldn’t be performing them on each other. Hire a surgeon, for God’s sake.
Posted by Marc Hodak on July 14, 2008 under Unintended consequences |
A recent article in the WSJ identified the following incentive to staying alive:
Thousands of high-net-worth Americans who care about the financial well-being of their heirs have a powerful tax incentive to survive until at least Jan. 1, 2009. On that day, the federal estate-tax exclusion is scheduled to jump to $3.5 million from $2 million this year.
The article notes that an even bigger incentive will be provided the following year, in 2010, when the federal estate tax is scheduled to disappear entirely. On January 1, 2011, however, the estate tax is scheduled to reappear with only a $1 million exclusion. What incentive will that create?
