Saturday, March 21, 2009

The Day Wall Street Dies


In less than a week, Congress reacted to the AIG bonus 'scandal' with competing House and Senate proposals that are draconian in concept. If anything remotely resembling either of them becomes part of the Tax Code, Wall Street in its current configuration will die.

That may not be such a bad thing. The compensation system was a leading (perhaps the leading) contributing cause to the current crisis, and rather than being tweaked or overhauled, perhaps it should be savagely dispatched.

As I understand the proposals, the House would impose a 90% tax on any bonus paid by any financial institution which has received funds greater than $5-billion from the Treasury under the Troubled Asset Relief Plan. The Senate proposal would impose a 70% tax on any bonus from any financial institution which has received more than $100-million. Either approach would severely limit the compensation to the highest paid employees of essentially all of the major capital markets banks.

That would certainly suck the oxygen out of the room at BofA, Citi, Goldman, JPMorgan, Morgan Stanley, etc.

Rather than accepting at face value the shrill protests of the leaders of those institutions about losing the best and the brightest, it's worth giving some balanced consideration to the likely consequences of enacting punative bonus taxation (particularly as some form of punative taxation certainly appears in the cards). First, the best and the brightest made the mess, but they may not be mission critical to cleaning it up. The honest and the competent, not the best and the brightest, may be what's called for. Second, in the short term, exactly where are the incumbents going to go if they lose their chance at great wealth? No one is talking about cutting these heroes back to the minimum wage. I think it's still possible to live well on a million dollars a year, even in New York.

Think back to Enron. After it collapsed, any number of high flying traders found themselves stuck, ruined financially, and occupied cleaning up the mess they had made for their base salaries, with no incentive comp to speak of. Yeah, most of them eventually moved on, but the entire industry sector melted down, so that process took awhile, and the cleanup wasn't in the least bit complicated by any lack of people to get the work done. So, it's safe to ignore the shrill bullshit of Ken Lewis, et al.

In the longer term, though, the result of effective limits on compensation paid by the TARP recipients may have a positive consequence for Wall Street. Right now, the TARP recipients are institutions comprised of three very different kinds of activities: a utility function (traditional banking intermediation), a casino activity (their capital markets operations, what sunk them) and a cruise line (providing various kinds of asset management, mergers and acquisitions advisory and similar services that are not particularly capital intensive).

The utility function can function effectively under salary caps. It may not be very exciting, but the work will get done. The casino gets shut down under salary caps. Actually, the hedge funds can continue to operate, but they'll have to produce alpha without leverage as the utility bankers will be incented to ration credit away from speculative and towards more socially productive activities. And the non-capital intensive advisory services will simply move out from under the umbrella of the financial supermarket model, and resume the independent existence they led prior to the great consolidation of financial services in the last fifteen years.

That last is probably where the money will be in the future.

Isn't life interesting after a sea change? So much for deregulation, and thank you, Phil Gramm, for your contribution to putting the politics back into political economics.

Friday, March 20, 2009

Housing Dux and Redux

I had lunch earlier in the week with a guy who works for a very large (more than 400 agents) real estate brokerage. He is in administration, he is not an agent. Here are the relevant factoids: his firm's commission volumes are down 40% from the peak (from $1.9-billion to $1.1-billion), there not too much agent attrition yet but its coming, the worst home to own in this market is 5-6 years old in an outlying suburb that wasn't completely built out when the boom ended, the only warm spot in the market is in the $250-350,000 range, and the higher end of the market is DOA. So, the Portland, OR market is not that dissimilar to the Santa Fe, NM market. Not that surprising. Both of them are in the West, neither of them overheated spectacularly, but each did enjoy some abnormal price appreciation before the bust.

There will be two bottoms in the housing market. One bottom will occur when new home construction, home sales volumes, real estate commissions, levels of mortgage financing activity, and so on hit bottom. For the general economy (and to my friend), that's the bottom that matters.

The other bottom is the one that matters for individual home owners. That's the point at which existing home prices stop declining. That's the one that matters to most aging boomers.

The two bottoms will not occur at the same time. The first one very well may be occurring even as I write. If not, it is very close. And when it occurs, and when there is a very mild pickup, that will be very good news indeed for the general economy. Hint, though, think L, not V.

The second one is a ways off. The rent to buy comparison still favors renting. The media is full of comments like (earlier this week) 'There is no rational reason to buy a house in today's economic environment.' The animal spirits that operated to exacerbate upward price trends a few years back are now operating to futher deflate prices. Experience in the sand states suggests that when prices drop by 40-50% new buyers come into the market, but the rest of the country is only half way to price declines of those magnitudes. The upper end of the market (anything requiring a jumbo to finance) has frozen up, and the only way it will thaw is with a price blowout (which, in my humble opinion, is ultimately inevitable, though it can be delayed).

So, basically, residential housing investment losses will continue to be a drag on the economy. But the adverse impact of declining levels of housing related activity (construction, sales, financing, major appliance and furniture purchases, etc.) has already been absorbed. Time to pay less attention to housing and let the homeowners suffer quietly, trapped wherever they may have been when the music stopped, until a day of reckoning when growing paper losses are ultimately realized.

Thursday, March 19, 2009

AIG Theatre and the Political Dialectic

A hoary dramatic device is to use a small incident as a vehicle to explore all the facets and ramifications of a much larger issue. The AIG bonuses are currently serving that purpose. In themselves, they represent small sums, as compared to the rather larger amounts of financial support the federal government has provided AIG and all the TARP participants. However, compared to the compensation most taxpayers know personally, they are obscenely large 'payments for failure' at best, and theft, at worst.

So, the matter will be addressed. All the ventilating underway merely shadows deeply felt views that will be expressed in the resolution of larger issues. I do think that the political classes in the country have collectively lost confidence in the financial elite. And I think the public wants its pound of flesh.

And, attacking the compensation structure is actually a reasonable way of taking a first step towards re-regulating the financial services sector and confining it within the parameters appropriate to a utility function. By removing the motive for speculation and risk taking, you will surely diminish it considerably.

I doubt very few employees impacted to a vastly curtailed compensation structure will be able to jump ship to hedge funds where they can resume their shennanigans. And I suspect fewer and fewer hedge funds will find sources of funding for the leverage that substituted for alpha in their heyday.

Wednesday, March 18, 2009

Of Sea Changes and the Dialectic of Politics

The tone out of Washington, D.C. is changing. Somewhere, somehow, some conclusions have been drawn about how to handle the financial and economic crises. They aren't being publicized yet, most likely they haven't completely jelled. In a nutshell, there has been a complete loss of confidence among the political classes of the ability of the financial elite to manage its own affairs and a corresponding shift in the balance of political power.

This is not a partisan matter. The Senator who called on the responsible AIG executives to do the honorable thing and commit suicide was a Republican. The suggestions that the AIG bonuses be confiscated through punative taxation are bipartisan. Vikram Pandit and Ken Lewis are increasingly coming across as shrill, defensive and utterly out of touch.

I suspect that to some extent this shift is a product of public mood, and to some extent its the product of reasonably accurate short term economic forecasting. The public is beginning to bay for blood. That blood lust is only going to intensify as the strength of the recession is increasingly felt by more and more people. Totally unrelated, a further declining in housing prices is almost inevitable, and any economic modeling of that will predict the demise of much of what's left of the financial services sector. Basically, the big banks are on their collective deathbed. I'm sure there will be survivors, but they will be the survivors that the government has selected.

In a nutshell, it's time to start thinking in terms of the political dynamic, rather than in terms of the existing structure of the financial services sector and the ordinary functioning of capital markets. Not that anybody is ready of a such an adult conversation in public.