Economics & Finance

AIG Bonuses

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Anyone want to talk about the AIG bonus situation?

A few thoughts to start things off:

1)Clearly, AIG has been terribly mismanaged. And the U.S. financial sector as a whole has become too large, in terms of its total size–including employment and employee compensation–relative to the economy as a whole.

2)The fact that a company has been mismanaged does not necessarily imply that everyone in it has done a bad job. Almost certainly, there are people in the bonus pool at AIG who have successfully achieved their individual goals, regardless of the failures of top management.

3)Bonus plans, in my experience, generally have two components: success of the individual in meeting his own goals, and overall success of the business. (“Business” does not necessarily mean the corporation as a whole–for example, an engineering manager at GE Transportation might be bonused based more on the results of the Transportation business than the whole company.) In general, it makes sense for the proportion of the bonus tied to overall business results to go up with the individual’s organizational level. It appears that there wasn’t much tie to the overall results for the people in the AIG pool being discussed.

4)Bonus plans are usually a part of an individual’s compensation package and, as such, are legally enforceable contracts. I believe that in some states, failure by a company to pay compensation that is owed can result in additional damages, above and beyond the payments themselves.

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The GSEs’ Special Status

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This post is mostly for reference so I can link to it in further posts. Below is a section from a Congressional Budget Office report issued May 2003  when the Bush  administration  was trying to allow the SEC to regulate Freddie Mac, Fannie May and the Federal Home Loan Banks (collectively, the government sponsored enterprises or GSEs). It nicely  summarizes  the special status of the GSEs and explains how the market reacted to their special status. (Scroll down to the section,  The Benefits of GSE Status.)

Current law treats the GSEs as instrumentalities of the federal government, rather than as fully private entities. As a consequence, they are afforded exemptions from many taxes, fees, and regulations; and for many purposes, their securities are treated as government securities.

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Government and Moral Hazards

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Sometimes, I hate Glenn Reynolds of Instapundit. I started writing a post on moral hazards in the financial system last night and then I pop onto Instapundit today to find a link to  a Popular Mechanics article he wrote about moral hazards. He even uses the example of auto-safety improvements that I intended to use.  

*Sigh*

Glenn makes something like the   point I intended to make:

This approach could be taken beyond the world of personal transportation. We’re in the current financial mess in part because things that were actually dangerous—from subprime mortgages to risky financial instruments that no one fully understood—felt safe and ordinary. Modern financial markets, with computers, regulations, deposit insurance and bond ratings, felt as routine and as smooth as that four-lane highway in Spain, causing a lot of people who should have been paying attention to doze off. Investors might have been more careful if it had felt like they were driving down a twisty mountain road with no guardrails, especially since we really were engaged in the financial equivalent of high-speed mountain driving, only without the discipline of fear.

The current financial crisis definitely resulted from government generated moral risk. The massive federal-government-created and -managed enterprises, Freddie Mac, Fannie Mae and the Federal Home Loan Banks, aka Flubs, (henceforth, collectively the GSEs) are ground zero for the crisis. They were simply too big not to  dramatically  impact the market. Collectively, the GSEs purchase half of the mortgages issued in the U.S. Collectively, they issued most of the mortgage-backed securities (MBSs) currently in circulation. By design, these institutions created a vast moral hazard that built up over four decades until the system collapsed under the weight of risky behavior.  

The GSEs created moral risk in several ways.  

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Son Of Flubbers

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This article highlights the role the  Federal Home Loan Banks, aka Flubs, played in building the market  distortions  that led to the financial collapse. Read the whole thing.  

Key graph:

It didn’t have to turn out this way. In 2002 and 2006, the Federal Deposit Insurance Corporation attempted to take steps that might have discouraged the kind of excessive borrowing from FHLBs we’ve seen during the mortgage bubble and collapse. The agency proposed charging higher premiums of the heaviest borrowers.  The idea was simple: Normal insurance companies charge higher premiums when more money is at greater risk, so why shouldn’t the FDIC? During the current mortgage crisis, a bank with a large appetite for FHLB loans has been the equivalent of a Ferrari driven by a teenager. [emp added]

Normal insurance companies would be those evil free-market companies run by greedy capitalists. The Flubs by contrast answered only to wise, prudent,  altruistic  politicians.  

more:

“If you look at some of the firms whose names have been in the headlines, some of them were the largest borrowers in the FHLB system,” adds Mark Flannery, a finance professor at the University of Florida. “It suggests, with hindsight, that the ability to borrow that money might have been a factor” in the current wave of bank failures.

Gee, you think? Of course our wise and wonderful political masters understand that people play a lot more recklessly with other people’s money than with their own. They do, right? I mean, they would never create a system which used government money to induce reckless behavior, right?

I keep coming back to this central concept: The Federal government over the last 40 years has set out to distort the market in the direction of making risky loans. Now we have a crisis caused by making too many risky loans. Who do the leftists blame for the crisis? The free market.  

Really, we’re supposed to take these people seriously? The banking system did just what the leftists wanted it to do and now the free market is to blame?  

Negative Net Worth

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The Chicago Tribune business section has a series where readers write in with their financial issues and the columnists seek professional help and recommendations and publish the results. This column is titled “Law Degree on Her Side” and shows the plight of a woman under 30 who is a lawyer but is struggling under a mound of student debt and is considering bankruptcy.

BALANCE SHEET VS. INCOME STATEMENT

A big element in our economy’s struggle is the fact that the analysts and “experts” were focused on the income statement and not the balance sheet. An income statement view focuses on profits, or the difference between earnings (in her case, salaries) and expenses (rent, living expenses, etc…) and what remains each year. Companies often report earnings EBITA which stands for “Earnings Before Interest, Taxes and (depreciation) and Amortization”. In this model, you become a lawyer because you can make a lot of money (top line revenue) and use it to support the rest of your living expenses.

However, this “income statement” model ignores the debt needed to finance education and expenses related to education. This debt keeps piling up and is a negative item on your balance sheet, which is the long term debt that you owe others, along with the annual interest that you need to pay to service this debt. In an analogy to the stock market, it is the debt payments, along with the fact that companies can’t come up with the cash to pay off principal (or roll-over debt) that is causing the liquidation of companies like Circuit City, Linens & Things, Mervyns, and soon to be many others.

In this lawyer’s case, her balance sheet is “negative” meaning that she is insolvent or has a negative net worth. She has a tiny amount of assets (a bit of retirement savings, some cash on hand, and maybe equity in a car or something) which is all she can show to offset a mountain of debt.

I don’t have exact statistics but I would venture that most Americans have a negative net worth nowadays. By this I mean that the value of their debts exceeds the value of their assets. I also run a site called “trust funds for kids” and I often tell my nephews and nieces that even the relatively small amounts that we put aside ($10,000 or so), as long as they don’t accrue debt, will make them better off than most Americans who have worked their entire lives, since they will have a positive net worth. Obviously some of this is tongue-in-cheek since you need a steady stream of income to pay minimal living expenses but there is much fundamental truth in that analysis in that if you pile up debt you will never accrue enough assets to offset this debt. And if you have a negative net worth, you can never stop working (retire) unless you have a guaranteed string of income high enough to offset your living expenses, interest costs and principal repayments.

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