Too Messed-up to Fail

AIG, Citi and the other former behemoths of Wall Street embarked on a new strategy after the 1987 crash: become too big to fail. That worked, until it didn’t. The new strategy? Too messed-up to fail.
“We cannot attract and retain the best and the brightest talent to lead and staff the A.I.G. businesses — which are now being operated principally on behalf of American taxpayers — if employees believe their compensation is subject to continued and arbitrary adjustment by the U.S. Treasury.” --Edward Liddy, chief executive, American International Group

After 25 years on Wall Street, I would say “continued and arbitrary adjustment” is a pretty fair description of the industry’s approach to compensation in general. Why should the U.S. Treasury’s approach be any different? To paraphrase the description often given by a former executive at a now defunct, storied old firm: “Your bonus depends on five factors.“ He would tick them off on his fingers, ”your performance, your desk’s performance, your department’s performance, your division’s performance and the firm’s performance” And then, explaining the effect of yet another bridge loan gone bad--”if the rest of these go bad...” folding his fingers back down one-by-one, “and all your left with is your own good performance, well...” Guess which finger was left standing?

Wall Street’s bonus system is supposed to turn fixed employee costs into variable expenses that reflect the ebb and flow of the industry’s performance. When I received my first big (by my standards then) bonus in the 1980s my boss explained to me that my compensation wasn’t going up--I should still expect to make the same amount over time and that a future bonus would probably be zero to make up for that year’s outsized payment. That was 1986, as it turns out also the year I first learned to model an interest rate swap. You see things have gotten a lot more complicated since then. The top base salary at most firms barely budged while compensation costs skyrocketed. Getting a big “bonus” helped boost all our opinions about ourselves--if I’m getting a big bonus, I must be good. And as long as we all bought the argument (“He got a big bonus, he must be good”), we had a nice little positive feedback loop going. Fixed compensation costs weren’t out of control, so management must have been doing a great job--they deserved a big bonus, too.

Thinking about this while listening to the ranting heads go on about the AIG-FP bonuses I’m struck by one refrain in particular. “You need these people in their seats at AIG to deal with these wickedly complex transactions.“ The response to which is “Where are these people going to go? Nobody’s going to hire them.”

Well, two points:

I have no direct knowledge of any trades that are currently on AIG’s books--but I am willing to bet that I could understand any of them with a few weeks access to the appropriate records. Further, I am positive that there are hundreds of other people available who are more capable than I am to deal with these trades.

If these very clever folks weren’t at AIG, do you know where they would go? They would go to AIG’s counterparties, where their job would be unwinding these same transactions. The hedge funds and dealer banks suffering from exposure to AIG would presumably only pay these experts if they successfully extracted them from this mess.

AIG, Citi and the other former behemoths of Wall Street embarked on a new strategy after the 1987 crash: become too big to fail. That worked, until it didn’t. I predict the same success for the new strategy...too messed-up to fail.

Book Recommendation: While it doesn’t deal at all with Wall Street, Relevance Lost : The Rise and Fall of Management Accounting, by Thomas H. Johnson, is a great introduction to the problems managements have tracking what’s actually going on in their businesses, and how easy it is for management to fool itself into believing whatever they want to believe about their business. Check it out in the bondgeek bookstore.

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