Black Swan Free World (2)

On April 7 2009, the Financial Times published an article written by Nassim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…

2. No socialisation of losses and privatisation of gains. Whatever may need to be bailed out should be nationalised; whatever does not need a bail-out should be free, small and risk-bearing. We have managed to combine the worst of capitalism and socialism. In France in the 1980s, the socialists took over the banks. In the US in the 2000s, the banks took over the government. This is surreal.

Most assuredly the socialization of losses and privatization of gains is what has anyone outside of the banking sector furious. Within the sector, everyone seems to believe that they earned their share of the gains. Think about what you hear about the bonus scheme at the banks – the investment banks are said to be paying out about 50% of gains before bonus. I imagine that puts them approximately on par with the hedge funds, if the banks profit figure takes out overhead before calculating the 50% ratio. So the bank incentive comp is based upon the hedge fund incentive comp. Amazingly, the hedge fund managers manage to convince investors to give them their money and lenders to advance them funds to leverage without any hint of a bailout ever in their future. The hedge fund managers generally walk away from the fund when things go wrong and they are no longer have a chance for outsized gains.

Do the bank shareholders understand that they are really investing in a highly leveraged hedge fund? The folks getting those bonuses surely understand that.

Is this the worst of capitalism and socialism? Probably so.

How do we get out of this? It seems that rather than limiting compensation, we ought be assuring shareholders and debt holders of any firms that structure their compensation like hedge funds that they should expect to be treated like hedge funds in the event of failure. Goodbye, no regrets.

One way of looking at the compensation issue is to focus on time frame.  There are four time frames to consider:

1.  The employees – the recipients of the bonuses.  Their time frame looks backwards.  They want to be paid for the value that they created for the firm.  They want to be paid in cash for that value.

2.  The Short Term shareholders.  Their time frame is in quarters.  They are most interested in what will be posted as the next quarterly earnings.  They want to be able to cash out their investment at the point where they believe that the next quarter’s earnings will not grow enough to support future price increases.

3.  The Long Term shareholders.  Their time frame is in years – probably 3 – 5 years.  Which is the expected holding period for a long term shareholder.  They are looking for growth in value compared to share price and will usually sell when they believe that the intrinsic value of the firm starts to catch up with the market value.

4.  The public.  Our time frame is our lifetime.  We need to have a financial system that works our entire lifetime.   The public gets nothing from the changes in value of the financial system but ends up paying off the losses that exceed the capacity of the financial system.

The compensation and prudential capital for banks is a trade-off between the interests of all four of these groups.  In the run up to the crisis, the system tilted in the favor of employees and short term investors to the extreme detriment of the long term shareholders and public.

So the solution is likely to be best if the interests of the long term shareholders are made more important.  Right now, a large, possibly most of the long term shareholders are index funds.  Index funds are extremely unlikely to want to have any say in corporate governance or compensation.

So you could surmise that the compensation aspect of the crisis and the drift of all things corporate to fall under the sway of short term investors is a result of the prevalence of index funds.

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Black Swan Free World (3)

Black Swan Free World (2)

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