Writing on the op-ed page of The New York Times, William D. Cohan, author of House of Cards: A Tale of Hubris and Wretched Excess on Wall Street, the very informative and often shocking account of the collapse of Bear Stearns, has written one of the sharpest, most succinct, most lucid articles on reforming the banking system that has yet been published. Cohan says that the brand new, 2,200-page Dodd-Frank Act has done nothing to change incentives on Wall Street, and therefore we are no better protected than before.
Cohan says that the basic problem is that risk is divorced from profits: the shareholders take the risks, and the bankers make the money. A generation ago, investment banks were private partnerships, and income and risk were aligned. Then the private investment banks became publicly held corporations. “Fifty years ago, Goldman Sachs had around $10 million of capital, which came from its partners; today Goldman has upward of $74 billion of capital, derived mostly from the generosity of its shareholders and the creditors who have bought Goldman’s public and private securities. Over the past generation, this business model has worked well for one group in particular: the bankers, traders and honchos who work on Wall Street. These days on Wall Street, around 50 percent of every dollar of revenue generated is paid out to its employees in the form of compensation. What other business on earth does this? None.”
Cohan says that when the banks were partnerships, the bankers had skin in the game–their incomes, their equity in the company. Now when money is lost, it is lost by the stockholders. It’s true, of course, that most of the bankers have held huge positions in their own banks and lost vast sums during the crisis, but they surely didn’t lose everything.
He points to Goldman Sachs as a bank that “seems to understand the power of creating internal incentives to monitor and to regulate the risks the firm is taking. When Goldman went public in 1999, unlike other firms it decided that a group of its 400 or so top executives would get paid not out of the firm’s revenues, but instead from the firm’s pretax profits. If the firm has no pretax profits in any given year, these executives get (only) their six-figure salaries, not the tens of millions in bonuses they count on. As a result, the senior brass at Goldman is hyperfocused on making sure the firm is always profitable, and it always has been. This may very well be the precise reason that Goldman alone saw the brewing mortgage meltdown and did something about it. When other firms were losing billions of dollars in 2007 as the mortgage market exploded, Goldman made $17.6 billion in pretax profits, one of its most profitable years ever, and its top three executives split around $200 million. You would think the rest of Wall Street would emulate Goldman’s approach to compensating its top executives. But it hasn’t.”
Cohan has a novel proposal for rectifying the problem and creating “a new mechanism” for tying income and profits to risk. “Each of the top 100 executives at Wall Street’s remaining “systemically important” firms [should] be personally liable for the risks they take. Not just their unexercised stock options or restricted stock, but every asset they have in their possession: from their cars to their fancy homes to their bulging bank accounts. . . . I propose that each large Wall Street firm create a new security that represents — and is secured by — the entire net worth of its 100 top executives. This security would be subordinated to all other creditors as well as to all preferred and common shareholders; in other words, if a firm goes bankrupt, this security is the first to be wiped out.”
Cohan says that Wall Street will argue that this can’t be done. Not so, he says. “Wall Street has all the intellectual capital it needs in its own archives to construct such a security: in the old partnership days every partner signed an agreement requiring him (and rarely her) to put his net worth on the line every day. Surely, clever Wall Street lawyers can draft a 21st-century version of the old partnership agreement. . . . Had this security, or something like it, been in place at every Wall Street firm five years ago, there would have been no mortgage bubble, no financial crisis, no deep and unsettling economic recession with nearly 10 percent unemployment, no need for the Troubled Asset Relief Program, and no need for Dodd-Frank or Basel III.”
Fascinating proposal. Wonder if it will go anywhere. But you know that if one bank would do it, it would enjoy an enormous competitive advantage over its rivals.