The University of Chicago’s Ragharam Rajan has a smart piece in the FT on one of my favorite topics–the fact that many people in the financial sector get paid big bucks each year for taking bets that will inevitably go sour a few years down the road. They’re producing not alpha, which is true investment outperformance, but beta, which is systematic risk. Writes Rajan:
True alpha can be measured only in the long run and with the benefit of hindsight – in the same way as the acumen of someone writing earthquake insurance can be measured only over a period long enough for earthquakes to have occurred. Compensation structures that reward managers annually for profits, but do not claw these rewards back when losses materialise, encourage the creation of fake alpha. Significant portions of compensation should be held in escrow to be paid only long after the activities that generated that compensation occur.
The managers who blew a big hole in Morgan Stanley’s balance sheet probably earned enormous bonuses in the past – Mr Mack certainly did. If Morgan Stanley managed its compensation correctly those bonuses should be clawed back and should be enough to pay those who did well this year without increasing the bonus pool.
But why, when times are good, would anybody take a job at a firm with clawbacks built into the compensation plan? That’s why this hasn’t happened and I can’t really see how it will happen unless the market for Wall Street talent totally collapses. But one can at least dream.
Update: Felix Salmon proposes that maybe if Goldman Sachs started with the clawbacks, others would follow. (His commenters say Goldman already sorta does have clawbacks.)
Update 2: My old friend The Epicurean Dealmaker explains why he thinks Rajan is all wet. He goes on and (entertainingly) on. Here’s a little sample:
First, the problem he describes is well known, and of long standing on Wall Street. Among many, it has been known as the “trader’s option.” This option is inextricably embedded at the core of an investment industry that employs and compensates agents to trade or invest other people’s money. The concept is simple: the trader bets the ranch. If he hits a home run, he gets a huge “performance” bonus, and people who gave him the money to invest make a lot of money too. If he loses, he gets no bonus, and probably gets fired, but he can usually land on his feet at another firm without much problem. …
But this is not twelfth level Masonic arcana. Everyone who fell off the turnip truck earlier than last week knows this. Why then, does it continue to happen? Why, to use a common metaphor making the rounds of Wall Street watering holes and mainstream media publications, do investors insist on paying traders to pick up pennies in front of steamrollers? Well, I’ll tell you why: there are a hell of a lot of pennies out there for the taking. Not everyone can make money like Warren Buffett, investing in Main Street America with an investment horizon of Judgment Day. Not everyone can give a few billion Benjamins to Steve Schwarzman to buy illiquid restructuring plays of widget polishing companies. Markets get crowded, and market sectors have limits to the amount of money which can be invested in them before they become commoditized, so investors are always looking for the next pile of pennies to hoover up for their pensioners and shareholders. And, if you want to play the steamroller penny game, who else but a rabid, aggressive, fast-moving trader do you want to do the vacuuming for you?