Why should the top officers of a company receive multimillion-dollar-pay packages? In many cases these top executives receive total compensation packages that are hundreds of times those of middle managers. How many of these executives make major contributions to their firms? How many Steve Jobs are there? More importantly, is it a sound management practice to establish such a skewed, two-tier compensation system? These organizations would be better served by spreading the wealth around to other deserving employees. Furthermore, providing millions of dollars in remuneration in any one year for employees can be counterproductive. These employees have automatically become independently wealthy. Companies that structure compensation packages that reward good performance over many years are providing a better incentive to maintain talented employees for longer periods of time. In addition, substantial compensation for short-term performance may create ephemeral rewards.
A classic example of how to structure remuneration properly was Goldman Sachs. It was one of the most successful partnerships. Partners had to keep the bulk of their money invested in the partnership. This led them to invest wisely for the long haul and avoid risky, alluring short-term bets. On the other hand, a case study in what not to do is Citigroup. This was an institution that attracted many talented, dedicated people due to progressive working conditions and compensation policies that were a cut above many of the other banking institutions. It was a tremendous institution until Sandy Weill literally single handedly destroyed its successful framework and corporate culture. He created a star system of so-called rainmakers that required the destruction of the compliance department and a level of compensation that the bank could not sustain without taking on more and more risk. Wall Street has created so many of these rainmakers that our financial institutions almost drowned.
Excessive pay for management and the board of directors has been building for years. Now it has reached a ridiculous level that is having a very corrupt influence on many companies. Time and time again, we have witnessed situations where the board has not performed its fiduciary duty to stockholders. Executives are receiving huge bonuses despite dismal performance, which is reflected in poor earnings and crushed stock prices.
AIG is now the poster child for poor management and the risk of improper government involvement. This company that was rescued by taxpayer dollars recently handed out 165 million dollars in bonuses. This, understandably, has created public outrage. However, in response to the public’s furor, The House of Representatives has hastily produced a confiscatory tax bill. The bill proposes to tax bonuses at a 90% rate for those individuals who make more that $250,000 at any institution who received more than five billion dollars in TARP money. This is the danger of having government involved in the day-to-day running of these financial concerns. Hopefully, this measure will not become law since it is counter productive. The whole purpose of the TARP was to stabilize the financial system by providing needed liquidity. Many of these institutions will try to get out from under punitive government control and pay back TARP money too quickly. This could undermine the purpose of providing for this liquidity in the first place. More importantly, such ex-post-facto, punitive laws are what our founding fathers warned against called “Bills of Attainder”, which undermine good principles of social compact.
As I pointed out in my commentary, “The Way the World Works”, government should act as a referee between the public and private sectors. Good government policy will permit the capitalistic system to function properly. If a company is mismanaged, we have to let it fail. This is called “creative destruction”, a term that was coined by the famous 20th century economist Joseph Schumpeter. This rejuvenates our capitalistic system by making sure capital is being used efficiently. The government’s role is not to rescue failed companies. That rewards and perpetuates failure, which is a misuse of capital. Its role should be to make sure that companies do not become so large that failure is no longer a viable option since it would put our entire financial system at risk.
Sunday, March 29, 2009
Wednesday, March 11, 2009
“The Way the World Works”
That is the title of a book written by Jude Wanninski, who is considered one of the fathers of supply-side economics. This book has a profound influence on my economic and political philosophy. One of the important tenets that Mr. Wanninski establishes is that the primary role of government is to act as a referee between the public and private sectors. Government should not place a wedge between promoting economic growth in the private sector while pursuing what it considers policies for the public good.
Confiscatory taxation can create this wedge. When tax rates reach a very high level, it discourages work on the margin. Moreover, higher taxes may not produce a dollar-for- dollar increase in tax revenues. Taxpayers will find all kind of ways to avoid taxation, legally or illegally. In fact, it has been documented that the wealthiest tax payers actually contributed a higher percentage of overall tax revenues after the Kennedy and Reagan tax cuts. Furthermore, empirical evidence demonstrates that tax rate cuts have an incentive effect that works to promote growth in a short period of time. The best evidence of this is the 1963 and 1964 Kennedy/Johnson tax cuts, the 1981, 1983 and 1986 Reagan tax cuts and, finally, the 2003 Bush tax cuts. Refer to my blog commentary, “Economics is a Dismal Science.”
Many economists point to the Clinton years as a repudiation of supply-side economics. The highest marginal income tax rate was raised from 28% to 39.6%. Nevertheless, this was one of the most productive periods of rising employment and economic growth. While President Clinton raised taxes, he also kept spending under control. Federal government deficits were reduced, thereby, creating less supply of government debt, which helped to promote lower interest rates. This was Treasury Secretary Rubin’s gambit. Just focus on the bond market in order to reduce interest rates and economic growth will follow. Another important driver of economic growth during this period was President Clinton's embracement of free trade. Thus, there were countervailing forces to compensate for the negative impact of rising taxes, therefore; overall government policy was pro growth.
Today we have the opposite problem. We have very low interest rates and an exploding deficit. President Obama’s gambit is to raise the deficit in order to stimulate economic growth in this period where the economy is contracting sharply. Unfortunately, the government is increasing spending to unprecedented levels that could be forming the wedge Jude Wanninski talks about. The current amount of deficit spending is so large, even if the economy recovers, deficits may not be effectively reduced to a manageable level in the future. The Government will not only have to cut back spending some time in the future, it will probably have to raise taxes on more than the top 3% of income earners that Obama has outlined in his ten-year budget. The reason for this is that many economists believe Obama’s yearly GDP growth projections are too optimistic.
In fairness to President Obama, he did not create our current economic problems. However, his policies have the potential to make these problems much worse.
Historically, it has been very difficult for the Government to rein in spending. The Government never seems to be able to reduce actual spending. What is reduced is the rate of growth of spending. President Reagan found this out the hard way. He made this Faustian bargain with congress that if he would raise some taxes in order to reduce the projected deficits, congress would cut back spending on a 2 to 1 margin. Congress never fulfilled its part of the bargain. Nevertheless, President Reagan substantially lowered the marginal tax rates on individuals from 70% to 28% at the end of his eight-year term in office. This created an important foundation for the economic growth we experienced in the 1980s.
Unfortunately, President Bush and President Clinton did not strike the appropriate balance between free markets and government regulation. Under President Clinton in 1999 the Glass Steagall Act was effectively repealed. This act separated commercial banking from investment banking during the depression. The idea was to prevent banks from investing in more risky activities that could compromise their financial integrity. In addition, the regulators under President Bush, along with Chairman Greenspan, permitted our financial institutions to increase leverage to imprudent levels. Moreover, there was absolutely no regulatory oversight for the credit-default- swap market. These obligations are basically insurance contracts on bond obligations. AIG was rescued by the Federal Government with billions of dollars of tax-payer’s money. This company was one of the largest insurance companies in the world. It overextending itself in this market and nearly caused a major collapse in our financial system. Currently, it is a mere shell of its prior existence.
Jude Wanniski is correct in stating that the proper role of government is to act as a referee between the public and private sectors of the economy. While it will never be perfect, government should endeavor to pursue an appropriate balance between its policies for the public good and overall economic growth.
Confiscatory taxation can create this wedge. When tax rates reach a very high level, it discourages work on the margin. Moreover, higher taxes may not produce a dollar-for- dollar increase in tax revenues. Taxpayers will find all kind of ways to avoid taxation, legally or illegally. In fact, it has been documented that the wealthiest tax payers actually contributed a higher percentage of overall tax revenues after the Kennedy and Reagan tax cuts. Furthermore, empirical evidence demonstrates that tax rate cuts have an incentive effect that works to promote growth in a short period of time. The best evidence of this is the 1963 and 1964 Kennedy/Johnson tax cuts, the 1981, 1983 and 1986 Reagan tax cuts and, finally, the 2003 Bush tax cuts. Refer to my blog commentary, “Economics is a Dismal Science.”
Many economists point to the Clinton years as a repudiation of supply-side economics. The highest marginal income tax rate was raised from 28% to 39.6%. Nevertheless, this was one of the most productive periods of rising employment and economic growth. While President Clinton raised taxes, he also kept spending under control. Federal government deficits were reduced, thereby, creating less supply of government debt, which helped to promote lower interest rates. This was Treasury Secretary Rubin’s gambit. Just focus on the bond market in order to reduce interest rates and economic growth will follow. Another important driver of economic growth during this period was President Clinton's embracement of free trade. Thus, there were countervailing forces to compensate for the negative impact of rising taxes, therefore; overall government policy was pro growth.
Today we have the opposite problem. We have very low interest rates and an exploding deficit. President Obama’s gambit is to raise the deficit in order to stimulate economic growth in this period where the economy is contracting sharply. Unfortunately, the government is increasing spending to unprecedented levels that could be forming the wedge Jude Wanninski talks about. The current amount of deficit spending is so large, even if the economy recovers, deficits may not be effectively reduced to a manageable level in the future. The Government will not only have to cut back spending some time in the future, it will probably have to raise taxes on more than the top 3% of income earners that Obama has outlined in his ten-year budget. The reason for this is that many economists believe Obama’s yearly GDP growth projections are too optimistic.
In fairness to President Obama, he did not create our current economic problems. However, his policies have the potential to make these problems much worse.
Historically, it has been very difficult for the Government to rein in spending. The Government never seems to be able to reduce actual spending. What is reduced is the rate of growth of spending. President Reagan found this out the hard way. He made this Faustian bargain with congress that if he would raise some taxes in order to reduce the projected deficits, congress would cut back spending on a 2 to 1 margin. Congress never fulfilled its part of the bargain. Nevertheless, President Reagan substantially lowered the marginal tax rates on individuals from 70% to 28% at the end of his eight-year term in office. This created an important foundation for the economic growth we experienced in the 1980s.
Unfortunately, President Bush and President Clinton did not strike the appropriate balance between free markets and government regulation. Under President Clinton in 1999 the Glass Steagall Act was effectively repealed. This act separated commercial banking from investment banking during the depression. The idea was to prevent banks from investing in more risky activities that could compromise their financial integrity. In addition, the regulators under President Bush, along with Chairman Greenspan, permitted our financial institutions to increase leverage to imprudent levels. Moreover, there was absolutely no regulatory oversight for the credit-default- swap market. These obligations are basically insurance contracts on bond obligations. AIG was rescued by the Federal Government with billions of dollars of tax-payer’s money. This company was one of the largest insurance companies in the world. It overextending itself in this market and nearly caused a major collapse in our financial system. Currently, it is a mere shell of its prior existence.
Jude Wanniski is correct in stating that the proper role of government is to act as a referee between the public and private sectors of the economy. While it will never be perfect, government should endeavor to pursue an appropriate balance between its policies for the public good and overall economic growth.
Monday, March 2, 2009
Nationalization of American Banks – Stop The Presses.
The more we hear that nationalizing banks is being contemplated by our elected officials, the more it will destabilize our financial system. Bank stocks like Citigroup and Bank of America, which were rumored to be on the short list of banks that could be nationalized, have been decimated. This kind of irresponsible commentary is having a self-fulfilling prophecy. Another bogus line of thinking is that since these banks received TARP money, the government is in effect running these institutions resulting in a de facto nationalization. While there are certain strings attached to banks receiving this money, like putting a cap on salaries and bonuses, this is a far cry from nationalization where the Government actually takes over running the entire bank. We hope the government is smart enough not to encumber Citigroup’s day-to-day activities after taking control of 36% of its common stock. If you think a lot of these banks have been run badly, wait to you see what the government will do.
Bill Seidman, who was Chairman of the FDIC and head of the Resolution Trust Corporation that took over many of the failed banks during the 1980s savings and loan crises, is advocating the same approach today. He makes nationalization sound easy. However, Citigroup and Bank of America are not small savings and loan organizations. We are talking about organizations that are a great deal larger and more complicated than the savings and loans that were rescued. Do you really think the Government can run a trading desk or a credit-default-swap operation? More importantly, how is the government going to handle the so-called toxic assets? Currently, there appears to be no active market for these securities. This is the major fallacy regarding nationalization. It would take the government a long time to get rid of these toxic assets in a prudent way, and we are assuming that the government has the capacity to get reasonable prices for these assets.
This is the crux of the problem. Many of the underlying mortgage pools that support these securitized obligations are paying off at rate which is not being adequately reflected in the current market value of these securities. If the current market prices for these securities are understated, why are we forcing the banks to use mark-to-market accounting? A better solution would be to modify the mark-to-market accounting convention that was implemented at the end of 2007. If it is going to take a while for the government to sell these toxic assets, why not give the banks an opportunity over a few years, either to sell these assets and/or amortize these losses based on an average market price during each year. Aren’t these banks in a better position to deal with these assets than the government? If the banks have more time to unload these assets, there could be less supply for sale at any given time. This, combined with the potential for higher prices due to improved market conditions, may provide the banks an opportunity to capture more favorable prices for these securities in the future.
Mark-to-market accounting is unnecessarily impairing the bank’s balance sheets by forcing banks to write down all these toxic assets every quarter based on the last market price. This is analogous to someone on your block selling a house at very distressed price because they need to raise money quickly. In effect, the value of your house has also been marked down. The banks have accumulated these assets over many years, and the accounting convention that was used for many years has changed. Since these toxic assets were not very liquid, the banks have historically used a market-model-approach to value these securities. The concern about market-model-accounting is the potential that banks may overstate the real market value of these distressed assets. Investors need to be confident that there is transparency, and that these assets are properly valued. However, due to mark-to-market accounting, coupled with the troubled state of the economy, the banks are currently dealing with target prices for these illiquid assets that are constantly moving and shrinking. Thus, bank managements continue to be in a quandary about forecasting and assessing their capital requirements, which is having a negative impact on lending. This uncertainty is causing a circuitous process as banks curtail lending, the economy is negatively affected, which in turn adversely affects lending and the price of bank stocks. This vicious cycle needs to be broken in order to stimulate economic growth.
While we should not completely eliminate mark-to-mark accounting, it needs to be modified in order to factor in illiquid market conditions. If we do not make this accounting adjustment, the cost to the Government and ultimately the taxpayers will continue to increase as more and more capital is required to make these troubled banks solvent.
Bill Seidman, who was Chairman of the FDIC and head of the Resolution Trust Corporation that took over many of the failed banks during the 1980s savings and loan crises, is advocating the same approach today. He makes nationalization sound easy. However, Citigroup and Bank of America are not small savings and loan organizations. We are talking about organizations that are a great deal larger and more complicated than the savings and loans that were rescued. Do you really think the Government can run a trading desk or a credit-default-swap operation? More importantly, how is the government going to handle the so-called toxic assets? Currently, there appears to be no active market for these securities. This is the major fallacy regarding nationalization. It would take the government a long time to get rid of these toxic assets in a prudent way, and we are assuming that the government has the capacity to get reasonable prices for these assets.
This is the crux of the problem. Many of the underlying mortgage pools that support these securitized obligations are paying off at rate which is not being adequately reflected in the current market value of these securities. If the current market prices for these securities are understated, why are we forcing the banks to use mark-to-market accounting? A better solution would be to modify the mark-to-market accounting convention that was implemented at the end of 2007. If it is going to take a while for the government to sell these toxic assets, why not give the banks an opportunity over a few years, either to sell these assets and/or amortize these losses based on an average market price during each year. Aren’t these banks in a better position to deal with these assets than the government? If the banks have more time to unload these assets, there could be less supply for sale at any given time. This, combined with the potential for higher prices due to improved market conditions, may provide the banks an opportunity to capture more favorable prices for these securities in the future.
Mark-to-market accounting is unnecessarily impairing the bank’s balance sheets by forcing banks to write down all these toxic assets every quarter based on the last market price. This is analogous to someone on your block selling a house at very distressed price because they need to raise money quickly. In effect, the value of your house has also been marked down. The banks have accumulated these assets over many years, and the accounting convention that was used for many years has changed. Since these toxic assets were not very liquid, the banks have historically used a market-model-approach to value these securities. The concern about market-model-accounting is the potential that banks may overstate the real market value of these distressed assets. Investors need to be confident that there is transparency, and that these assets are properly valued. However, due to mark-to-market accounting, coupled with the troubled state of the economy, the banks are currently dealing with target prices for these illiquid assets that are constantly moving and shrinking. Thus, bank managements continue to be in a quandary about forecasting and assessing their capital requirements, which is having a negative impact on lending. This uncertainty is causing a circuitous process as banks curtail lending, the economy is negatively affected, which in turn adversely affects lending and the price of bank stocks. This vicious cycle needs to be broken in order to stimulate economic growth.
While we should not completely eliminate mark-to-mark accounting, it needs to be modified in order to factor in illiquid market conditions. If we do not make this accounting adjustment, the cost to the Government and ultimately the taxpayers will continue to increase as more and more capital is required to make these troubled banks solvent.
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