Remember the Fall of 2008?

Times were different then. Here's a reminder:

Good news: AIG is paying back $4 billion to the U.S. government.

Bad news: They must pay back over $90 billion more to gain independence from the state.

The Price of a Pound of Flesh

The United States government hold large equity stakes in some financial firms. It has decided to punish those firms by heavily restricting the pay of the top employees. Proponents say that it is unfair for financial executives to benefit from taxpayer-funded bailouts. Skeptics of this plan agree that it's unfair, but note that this incentivizes the best employees to seek employment elsewhere, leaving the U.S. taxpayer with few qualified employees overseeing the trillions of taxpayer dollars invested in those companies. In fact, the government may wish to pay employees more in order to lure the top talent to the firms with public investment in order to maximize the return on that investment.

Obama sided with the crowd who wants the pound of flesh. The result: employees at Bank of America and AIG have already jumped ship:

Many executives were driven away by the uncertainty of working for companies closely overseen by Washington, opting instead for firms not under the microscope, including competitors that have already returned the bailout funds to the government, according to executives and supervisors at the companies.

"There's no question people have left because of uncertainty of our ability to pay," said an executive at one of the affected firms. "It's a highly competitive market out there."

At Bank of America, for instance, only 14 of the 25 highly paid executives remained by the time Feinberg announced his decision. Under his plan, compensation for the most highly paid employees at the bank would be a maximum of $9.9 million. The bank had sought permission to pay as much as $21 million, according to Treasury Department documents.

At American International Group, only 13 people of the top 25 were still on hand for Feinberg's decision.

That's a 27 out of 50, a majority, who jumped ship before the plan was even announced. These folks were able to get other jobs quite easily, indicating that they have some skills that are highly valued by other firms. The ones who haven't left presumably will in short order if they have similar skills, leaving the least-qualified workers to manage trillions in public funds.

But maybe setting a strong precedent is worth it?

On Wall Street, reaction to Feinberg's ruling was swift, with some executives arguing that it will further handicap the most troubled firms by driving away top employees while making companies unwilling to promote rising stars for fear of bringing them to Feinberg's attention.

But Nomi Prins, a former Goldman Sachs employee, said Feinberg's rulings are unlikely to change the culture of bonuses on Wall Street.

"I don't think Wall Street is afraid of this at all," said Prins, author of "It Takes a Pillage: Behind the Bailouts, Bonuses, and Backroom Deals from Washington to Wall Street."

"It's going to affect a small portion of a small portion of the industry. It won't have a lasting impact."

Great.

(Via MR)

Blame Game

It turns out that the collapse of the global economy was not caused by clueless economists or Gaussian copula functions or even big-headed quants. No, the blame for the financial Armageddon can be laid at the feet of a... political scientist. Well, sort of anyway.

So quick! Everybody get the torches and pitchforks! And after we've grown tired of blaming this guy for everything, I propose we blame Canada. It's always worked before.

(ht: Dani Rodrik)

More on Punitive Taxation

Yesterday I complained that the left-leaning economists in the blogosphere were conspicuous in their absence from the AIG punitive tax debate. Today, we get some comment.

Brad DeLong says that we should give big bonuses to well-performing financial employees, just not the sort of bonuses these guys were given:

But thou shalt not bind the mouths of the kine that tread the corn: traders and financial executives who are willing to work very hard for what are now government-owned enterprises should be offered the carrot of long-term restricted equity stakes: that if they do their jobs well and if the government makes a healthy return because of their skill, forethought, and diligence, they should make healthy returns as well.

In the previous sentence he says that punitive taxation on employees on TARP-taking firms is justified. But the one doesn't follow from the other: if the government sets a precedent that it is willing to retroactively rewrite compensation contracts on an ad hoc basis, then why should employees have any assurance that future earnings will be safe from a similar confiscation? What incentive do well-performing employees have to stick with the troubled institutions and work hard to improve them? Effectively none.

Now, it may be the case, as Sarah argues, that labor markets in the financial industry aren't competitive right now so employees have no choice: either they stay at their present firm, or they don't work at all. Suppose this is true: faced with a 90% marginal tax rate, many of them might just take the unemployment route. Especially since these folks are being accosted at their homes with death threats, and being encouraged by at least one U.S. senator to commit suicide.

In the longer-run, of course, labor markets will be less rigid, and these sorts of actions virtually guarantee that any employees with good track records will move to other firms. Considering the fact that the government will likely be a partial owner of these firms for at least a few years, this can only put downward pressure on the quality of employees these firms will be able to attract and retain.

Krugman, on the other hand, thinks this is bad, unjust, "clumsy," "bad analysis, bad policy, and terrible politics," and demonstrative of a major failing of the Obama administration. Oh, but despite that, there was "little alternative" than to kowtow to "crude populism", so whatever: tar-and-feather the bastards.

Finally, as Henry Blodgett points out, this tax covers all household income over $250,000. So if you are a mid-level AIG employee with a compensation package skewed towards bonuses for good performance, and your spouse is a corporate lawyer who makes a $250,000/year, then nearly every penny you earn will be taxed at 90%. Blodgett closes:

Believe it or not, hidden inside these companies are thousands of decent, competent people whose households bring in more than $250,000 a year. Many of these folks had NOTHING to do with the gambling addiction that bankrupted their firms. Many of them still have a choice where to work. And now that they've learned that their family's pay will be capped at $250,000 indefinitely, many of them will quickly decide that now is a good time to pursue their careers elsewhere. (That is, unless their firm takes the easy and obvious step of just paying them a fatter salary, which just renders the whole thing a farce.)

Will everyone leave these firms? No. The folks whose households don't have the education, desire, ambition, skill, or time to make more than $250,000 a year won't. But a lot of the rest will. And however little our massive investments in these companies are worth now, they will soon be worth a lot less.

Of course, this says nothing of the moral hazard (needy firms now have incentives to refuse or return government investment), or legal complications, or the fact that $2.5bn in bonuses to Merrill Lynch employees aren't subject to the tax (total bonuses to AIG employees is roughly $170mn). But still.

(ht: Marginal Revolution for the Blodgett link)

Pop Quiz

Q. How do you simultaneously achieve all of the following?

1. Encourage excessive risk-taking in the financial sector when sobriety is desired;

2. Drive the best and brightest employees from firms under de facto government control, thus ensuring that taxpayer dollars are entrusted to less-qualified handlers;

3. Set a (possibly unconstitutional) precedent of retroactive punitive tax policy that effectively nullifies previously-made legal contracts.

A. Do what the House of Representatives just did.

I'm less sanguine about this than Conor Clarke, because I think that his mild cynicism/optimism mix is the absolute best-case scenario; The worst-case scenario has some major financial institution refusing necessary government assistance so as not to subject their past and future income to 90% tax rates, which causes that company to collapse, which triggers another Lehman-like counterparty panic, the government is forced to buy up the shards of the company, all the best employees flee like rats off a sinking ship, and the taxpayer is on the hook for even more than we would otherwise be.

Incentives do still matter. Srsly.

And the silence from the progressive economists in the blogosphere (read: Krugman, DeLong, Thoma) has been deafening.

Frankly, if public shame is in order, wouldn't've been better for the country to let them keep their bonuses and instead make them eat some grubs on Fear Factor as punishment? Or get yelled at by Simon Cowell? Or get out-smarted by a 5th-grader? Or be forced to appear on a sitcom with Charlie Sheen?

Live Together, Die Together....?

Remember that factoid of money markets "breaking the buck" the other day?  Well, central banks around the world didn't take the news lightly, as the NY Times reports today.

Wow, look at all the tacit cooperation going on!  And the turn towards government regulation doesn't stop there.  The SEC has brought back rules against naked shorts, which are basically a strong bet on a stock going to zero.  Now there's talk of making all hedge funds publish their short positions - all in the hopes that those pesky speculators won't be able to destroy stock prices so fully and so quickly.  (Really, though, the most effective regulation might be to take a page from Russia's playbook and just shut down the whole exchange for a week.)

On last interesting tidbit - is anyone else struck by the news that Morgan Stanley (the investment bank that advised the government in the AIG deal) is now looking for buyers, possibly in China?

Risky Business

Continuing the incredulous unraveling of the financial markets, AIG has become the latest recipient of US Fed and Treasury orchestrated and US tax-payer funded bailout (see here - NY Times free account needed - and here).  Adding to mass hysteria is knowledge that a prominent money market fund dipped below a $1 NAV yesterday (it sounds mundane, but basically realizes risk in the traditionally most riskless and liquid asset class available).

It's hard for most to conceptualize just how recent events on Wall Street will effect the global financial environment, mostly because the financial instruments that got us into this mess by failing to accurately assess risk are so hard to understand (see here for a basis primer on derivatives).  The proliferation of esoteric credit derivatives on the global financial market has made a lot of people a lot of money, but it's also contributed to increased opacity of information and a decrease in the ability of governments to regulate.  And now, the chickens are coming home to roost.

As Alex mentioned in his previous post, the events of the past few weeks (and really the past six months) beg the question of what appropriate regulation looks like and how to get there.  In an interconnected financial world, how much space are we willing to give to free market machinations?  When do you think the government, governments, or institutions should step in, if at all?  How will the effects of a systemic under-estimation of risk change investor behavior going forward (especially large investors like oil-rich countries and sovereign wealth funds)?