Sunday, January 27, 2008

Wall Street Firms Considers Competence Irrelevant

There are two ways of getting successfull in the investment industry. Either you can like for example Jim Rogers and Peter Schiff be successful in identifying good investment objects and either invest yourself in them or advice others to do it. Or you can do a career in Wall Street firms, and create great losses for your company and for the economy as a whole by making all the wrong investment decisions, and subsequently be rewarded with huge sums of money for having created such massive losses.

The latter case sounds absurd, and it is, but unfortunately that does not mean it isn't true. One example of this was one which I already told you about, former Merrill Lynch CEO Stan O'Neal who got tens of millions of dollars in bonuses for profits that have now turned out to be fraudulent. And then after it was revealed that he had caused the company billions of dollars in losses, not only did he not have to pay back the bonuses he received for non-existing profits, but he was revarded by an additional $161.5 million in a severence package. There are many other similar examples of this on Wall Street.

And not only do Wall Street firms pay failed managers and analysts huge sums of money even after it is revealed that they are incompetent, they are still considered attractive on the Wall Street job market. The New York Times reveal in this article that two of the people most responsible for the so far at least $34 billion of losses (a sum that will likely rise a lot before this is over) suffered by Merril Lynch and Citigroup, Dow Kim and Thomas Maheras, are being swamped with job offers despite their proven incompetence. As the article puts it:

"Under the stewardship of Dow Kim and Thomas G. Maheras, Merrill Lynch and Citigroup built positions in subprime-related securities that led to $34 billion in write-downs last year. The debacle cost chief executives their jobs and brought two of the world’s premier financial institutions to their knees.

In any other industry, Mr. Kim and Mr. Maheras would be pariahs. But in the looking-glass world of Wall Street, they — and others like them — are hot properties."

The article later gives several more examples of this irrational system of rewarding failure. However, the article doesn't really go into why Wall Street is different from other industries. Why do these firms survive when they're managed by incompetent managers and analysts-and pays them absurdly high sums of money for losing money?

The answer is that the Federal Reserve keeps bailing them out by their interest rate cuts and emergency credit. As long as this continues, we can expect this irrational system to continue.


Anonymous Anonymous said...

My teachers always used to point out that one of the flaws of capitalism was that executives got paid large sums for doing a bad job. As you pointed out this isn't a problem with the free market, it is a problem with the Federal Reserve and therefore the government.

I am in high school and your blog has given me a better economics' education than all my years of schooling. Thank you!

1:44 AM  
Blogger Wille said...

Another cause for the skewed up renumeration system is the level of regulation:
The high level of regulation effectively keeps innovation (as in business model innovation, not financial engineering innovation) and fresh competition out of the market for investment banking services, which makes the market inefficient and allows them to stick to their opaque ways.

I have several friends and acquintances in investment banking, and they are for all intents and purposes easily replaceable Excel-jockeys, nothing more, nothing less. In an efficient investment banking market they would be paid regular upper middle class white collar salaries, and not the massive, skewed bonuses they get.

There is no good reason beyond inefficiency and lack of transparency that average Joes of average talent and intelligence should be paid massive amounts of money for what amounts to juggling numbers in Excel.
There is no particularly valuable knowledge, nor a shortage of that knowledge that would justify the money they are getting paid if they where in a sane and normally competitive labour market.

4:03 PM  
Anonymous Flavian said...

I think it is a natural market phenomenon that good corporate executives are well-paid, but I believe that the fact that some incompetent financial managers are obviously over-paid is not primarily related to the fact that markets function imperfectly, but far more that markets function even more imperfectly when they are on inflation drugs.

11:53 AM  

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