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Did Financial Rules Mandate a Meltdown?

A libertarian look at the current pay kerfuffle for financial services companies suggests regulating executive compensation will not produce healthier capitalism.

If you ask political philosopher Jeffrey Friedman who's doing a worse job, bankers whose companies needed to be rescued in last year's financial disaster or economists and political scientists trying to figure out what really happened, he won't have a hard time picking one over the other.

In Friedman's interpretation it's the bankers whose decisions actually made sense, and the economists and regulators trying to fix what went wrong are the ones who are senseless.

Many bank CEOs were mistaken and ignorant about the risks they were taking, Friedman concludes, but the economists and political scientists, accustomed to using mathematical models, assume the bankers knew the risks and gambled unwisely to win their bonuses. Friedman calls it the "bankers gone wild" narrative and blames it for some of the populist fervor behind the transatlantic campaign for bank compensation reform.

One example of the fervor came from economist Alan Blinder, who called financial CEO compensation "crazy" because he believed it incentivized big gambles and insulated the CEOs from failure with golden parachutes. Yet an average financial company CEO lost $30 million, according to a study by Rüdiger Fahlenbrach of the Swiss Finance Institute and René M. Stulz of Ohio State University. Further proof that the bankers weren't uniformly bonus-hungry and shortsighted, says Friedman, is that banks like J.P. Morgan Chase and CapitalOne steered away from heavy exposure to mortgage-backed securities.

The matter is of more than passing interest. With reports of new, rich Wall Street bonuses, unemployment at 9.5 percent and the U.S. budget deficit deeper than the Grand Canyon, pay limits seem like good moral hygiene for financial CEOs — and suitable punishment. "The whole thing is being done in an atmosphere of anger," Roberto Rigabon, professor of economics at the Massachusetts Institute of Technology, recently told a television interviewer.

The charged feelings about pay and bonuses elevated to a new level this week, when newspapers and Web sites reported some details of the Treasury Department's planned pay curbs for companies receiving bailout funds.

The rules will reportedly cut the compensation in half for the 25 highest-paid managers at seven companies, slashing salaries on average 90 percent and capping them at $500,000. Longer-term incentives will replace some of the lost salary, and some firms will still make total payments of stock and salary in the millions. Of possible greater importance will be the Obama administration's efforts to change corporate governance to give shareholders a more direct voice on compensation — all, of course, in the widely shared presumption that empowered shareholders could have reshaped compensation to head off imprudent risk-taking and 2008's fiasco, if that's what you believe about what happened and why.

Smart, Yes. All-Knowing, No.
The financial crisis entangled economists in issues of human behavior that they seem ill-equipped to explain.

According to Friedman, a visiting scholar in the government department at the University of Texas at Austin and editor of the journal Critical Review, the "executive-compensation theory" is based on a two-part assumption about the bank executives' motives and intentions. The first is that since they could earn bonuses, the executives would do anything to get them. The second is that the bank executives were omniscient, in this case about the risks of mortgage-backed securities.

"Mistakes simply don't fit into standard economic and political models because standard economic and political models take ignorance out of the human equation and focus instead on incentives and motives," writes Friedman. "Desires are not self-actualizing, and to assume that they are might be called magical thinking to emphasize how unscientific it is. ..."

One recent Critical Review article, authored by a team of economists, claims the profession may have set the stage for the mortgage security and derivative blunders "with spurious precision and untested theoretical assumptions" that created the illusion of risk-sharing and stability. On Oct. 12, the Nobel committee seemed to cast a vote against economics as a pure science governed by mathematics by awarding this year's prizes for economics to two social scientists, Oliver E. Williamson and Elinor Ostrom.

Friedman packed the latest edition of Critical Review, an interdisciplinary journal that focuses on political questions, with articles by economists and business professors looking back at the financial disaster of 2008. Even traders, who earn huge bonuses, weren't as reckless as some believe, Friedman says, because the traders bought mainly AAA-rated securities. Banking rules that encouraged banks to invest in mortgage-backed securities inadvertently triggered the disaster.

So let's drop the nonsense about executive avarice, Friedman says.

Friedman, who characterizes his own views as "Rawlsian libertarian", traces the disaster to bank capital rules. According to an account in Critical Review by New York University professors Viral Acharya and Matthew Richardson, international accords written in Basel, Switzerland and implemented between 1988 and 2007 allowed banks holding AAA-rated tranches of "collateralized debt obligations," as the bundles of mortgages were dubbed, to back them with less capital than other investments — a huge opportunity for profit. So from February 2006 to late summer 2007, banks such as Citigroup and UBS loaded up on these CDOs backed by subprime mortgages, with Citigroup taking $55 billion worth alone. And all this while the housing market was sinking and subprime lenders had begun to expire.

Bonuses certainly invited traders to exploit this opportunity to the fullest. At UBS, for example, the bank booked the profit from trades involving CDOs as it was recorded, so trader bonuses were unaffected if the trading position eventually led to a loss. Tragically, UBS and other banks held the CDOs for their own account, hoping to profit on the carry trade, rather than selling them to outside investors and thereby spreading the risk among a larger population.

The only risk was if large numbers of subprime mortgages defaulted at once — but the market for the CDOs didn't price in this risk, or any of the risk, to the entire financial system or to average taxpayers, even though plenty of warnings signs had already appeared. Once homeowners started missing payments and CDO losses struck banks covered by federal deposit insurance, or those banks deemed to large to fail, the circle was complete.

On Main Street, that meant good-bye 401(k), hello populist posse.

Intentions vs. Rules
Friedman blames the confusion between CEO ignorance or misjudgment on the one hand and greed on the other, on economists succumbing to "the intentions heuristic." That's a conceptual mistake and habit of mind that Friedman says should remind us of "how fundamentally destructive of good social science the heuristic can be."

"Economists are poorly equipped to recognize ignorance when it is staring them in the face — because most economic models assume that economic actors are rational representative agents and are, in effect, omniscient," Friedman writes.

Differences in judgments, about risks especially, are the heart of a healthy capitalist system, says Friedman.

Regulations, on the other hand, belong to a sad category of human endeavor that foul up the things they mean to set right, or worse, provoke disasters through unforeseen interactions with other regulations. Friedman makes the case for rethinking the entire role of regulatory government. He believes all the regulations involved in last year's disaster - bank capital rules, deposit insurance, mark-to-market or "fair value" accounting - set the stage for what went wrong.

"Even sweeping regulatory programs may be plagued by their designers' ignorance of unanticipated effects," Friedman writes.

That doesn't bode well for pay reforms.

The G20 ministers also are writing new pay rules. They agreed in principle at their recent meeting in Pittsburgh to delay much bank compensation, possibly by "clawing back" bonuses placed in pools for three years and to delay other forms of compensation (but not to cap absolute pay). Some companies have already adopted such pay measures voluntarily, and others have plans to limit golden parachutes for exiting executives. Financial services industry lobbyists pledge to fight anything beyond these measures.

There are as many cures as there are doctors, and most are what could be described as reluctant regulators.

Richardson, Acharya and several co-authors favored bonus pools and claw-backs, saying that existing compensation structures are too short-term and "induce perverse risk-taking." Their views comprised a section of a book called Restoring Financial Stability (Wiley, 2009).

Writing more recently in the Financial Times, Richardson says that with some of the curbs on bank pay now being considered "the cure will be far worse than the disease" because restricting compensation will "stifle innovation, shift top-priced talent from the regulated to the unregulated sector."

Still another reluctant regulator is Richard A. Posner, the law professor, judge and author of A Failure of Capitalism (Harvard University Press, 2009). He believes some pay reforms are in order, but he's wary because the actual trading decisions are made lower down in a corporation, and "it is hard to see how the government could fix the salary schedule for the entire professional staff of a bank." Lawyers will create loopholes to get around the rules, he says.

Posner suggests raising marginal tax rates on the most highly compensated people in all fields as one way to limit repugnantly lavish paydays. And if that means fewer bright academic stars will be heading to Wall Street after graduating college, he adds, that might not be the worst thing.

Or, in a world of unintended regulatory consequences, it might.

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