The Question of Compensation


One of the simplest ways of explaining to people why they and their successive generations have been saddled by the biggest credit card debt in human history is to just shake one’s head preacher style and say “Human greed”—-greedy black suits on Wall Street and dumb-ass investors hoping to make thousands on the back of the housing boom essentially gambled away your grandson’s college fund while everyone from Manhattan to Washington DC, being in on the take, looked the other way.

This explanation is comforting mainly because it is simple and understandable while at the same time by and large true.

However, the fly in the ointment in this simplistic attribution of blame is that “human greed” is not fundamentally a bad thing—one may argue that it is the very “basic instinct” that drives human endeavor and the creation of wealth. If one is not greedy, one becomes satisfied with what one has and there never is the incentive to do anything more.

A better explanation, which is a little less simple but similarly abstract, is that the problem lies in the failure of the system to regulate greed through the creation of an appropriate set of negative incentives which if had they been properly implemented would have controlled the recklessly risky behavior that has brought us to this state.

Nassim Taleb (considered a blowhard ignoramus by some and a subversive genius by others) identifies this systemic failure in the compensation system which he argues is asymmetric—while it provides positive incentives when the going is good, there is not an equally compelling negative incentive when things go bad. So while Banker Patel may take home a $500,000 bonus when things are good, noone makes him give back $300,000 when a few years down the road, things go bad. This Taleb argues is not true capitalism because the banker class is only raking in the profits but not taking responsibility for the losses. The financial executives know they can get away with this “heads I win and tails you lose” because the banking system, being too “big to fail”, will be bailed out by society if things go terribly terribly wrong (which is exactly what has happened) and that the consequences for “personally optimal but globally risky” behavior will ultimately be absorbed by the ordinary tax-payer.

Critics of Taleb’s argument would say that he is merely mirroring street blood-lust for bankers when he suggests that somehow financial executives should be expected to pay back their bonuses from previous years. Say Shahrukh Khan is signed on for a three year contract by Yashraj movies. His first two movies are megablockbusters and Shahrukh Khan gets a healthy bonus as an incentive. The third movie tanks spectacularly on a  “Roop Ki Rani Choron Ka Raja” scale.  Would anyone expect Shahrukh Khan to pay back the money he got as bonus for the first two movies to Yashraj ? All that can be expected is that Shahrukh Khan would get a lesser or perhaps even no bonus for his flop and that his future market worth will take a hit. Why should one expect things to be different for Banker Patel ?

The counter-counter-argument is that in the context of performance bonuses, Banker Patel and Shahrukh Khan are not equivalent. When Shahrukh Khan delivers a mega-hit, it is not at the cost of his next movie. The fact that “Om Shanti Om” is a hit does not increase substantially the risk of “Rab Ne Bana De Jodi” being a flop (unless of course SRK is releasing movies every week where audience boredom may come in). However in the case of Banker Patel, he can increase his performance (and by extension his remuneration) by taking risky investment decisions which while profitable in the short run are likely to be disasters in the long.

However because of the way the remuneration system is structured, all that he is expected to do is to show short-term gain.

Looking at it another way, the years in which Patel’s firm does bad, this “doing bad” may likely be a direct consequence of Banker Patel having “done good” two years before by taking unreasonable levels of risk, a cause-effect relationship that is much stronger than between the box office fates of two SRK movies. Once one accepts this, one realizes that Taleb’s idea is not as retributive as it sounds.

Some may point out here that the way performance bonuses are calculated , risk is taken into account. When Banker Patel stands in front of his boss, his boss not only evaluates Patel on the potential earning value of the investment decisions he has taken but also the risk he has brought along with his decisions. Banker Patel’s boss does know that anyone, even an MBA from Jhumritaliya, can promise high returns by taking high risks. So Columbia-MBA Banker Patel is considered deserving of his Porsche only if he has increased earning potential but without a substantial increase in risk. This implies that the cause-effect relationship between the “doing good” and “doing bad” we have tried to establish does not hold and expecting Banker Patel to return his bonus, after he has exercised due diligence and been fairly evaluated against the risk that accompanied his decisions, is street justice.

Let’s go back to this sentence.

So Columbia-MBA Banker Patel is considered deserving of his Porsche only if he has increased earning potential but without a substantial increase in risk

How does Banker Patel show that there has not been a substantial increase in risk? By showing that a certain “measure of risk” has remained roughly the same.

Value at Risk (VaR)  is typically this abovementioned measure of risk. [Link]

VaR isn’t one model but rather a group of related models that share a mathematical framework. In its most common form, it measures the boundaries of risk in a portfolio over short durations, assuming a “normal” market. For instance, if you have $50 million of weekly VaR, that means that over the course of the next week, there is a 99 percent chance that your portfolio won’t lose more than $50 million. That portfolio could consist of equities, bonds, derivatives or all of the above; one reason VaR became so popular is that it is the only commonly used risk measure that can be applied to just about any asset class.

It is the simple interpretation of VaR that made it so extremely popular, popular enough even for regulatory authorities. [Link]

In the late 1990s, as the use of derivatives was exploding, the Securities and Exchange Commission ruled that firms had to include a quantitative disclosure of market risks in their financial statements for the convenience of investors, and VaR became the main tool for doing so. Around the same time, an important international rule-making body, the Basel Committee on Banking Supervision, went even further to validate VaR by saying that firms and banks could rely on their own internal VaR calculations to set their capital requirements. So long as their VaR was reasonably low, the amount of money they had to set aside to cover risks that might go bad could also be low.

So as long as the firm’s VaR stayed low, everyone was happy. Which meant if Banker Patel could keep his VaR low, his boss would pat him on his back.

But then such numbers could be gamed by transferring the risk to someone else . And with the incentive to game  being so high, it was only in the nature of capitalism that there would arrive a financial product that would be the gaming solution.

That financial product—-the infamous “Credit Default Swaps (CDS)s or as they are known as “Weapons of Mass Financial Destruction”. [Link]

It thus is not a co-incidence that the epicenter of the financial meltdown is AIG, the biggest sellers of CDSs. For Banker Patel, CDSs were a Godsend, the Lipitor that reduces the bad cholesterol of risky mortgage-backed securities.  Naturally his portfolio became full of these fun financial instruments.

So what are CDSs? Putting it simply, a CDS was a promise from AIG saying ” In case this high-risk mortgage-based security cannot pay up, I promise to make good the amount”. Banker Patels and Smiths all over the world bought these “insurance products”so that when boss asked “Hey are you sure you want to buy all these extremely shaky mortgage-backed securities” they could say “No problem. We are also buying insurance from AIG so that in case these crazy-ass securities indeed go bust, AIG will pay us back the money.” This worked good for the boss because his division was increasing its earning potential by owning high-return securities without taking any of the risk, the risk that AIG was magically removing off their balance books like a gigantic blotter.

Everybody was happy. Everybody drove their Porsches.

For AIG, the CDSs were a huge money earner. Being one of the world’s largest insurers and possessing an excellent credit rating (AAA), a promise to insure from AIG was extremely valuable, like an assurance from Alok Nath to safeguard your daughter.

Normal insurance products are regulated. Which means if you insure $200,000 you have to show the government you will be able to cover a significant portion of that money if all your insurance claims were to be called in. But CDSs were unregulated which means that AIG could sell as many of them as they would want without having to show they had the money to cover the claims.

This was heaven for Babu Batla of AIG. By selling a large number of such financial instruments each of which independently carried a small risk, his own VaR was kept sweet and the bonus was raked in.

Of course Babu Batla ignored the possibility that all those CDSs he had sold could one day, all together, be called in.  All of these mortgages could not go bad at once could they? Maybe one or two—once in a blue moon. That’s okay. We got that covered. But not all together. How could that ever happen? After all the housing market can only go up.

Of course it could not. Not indefinitely.

As the housing bubble burst, all the insured securities went bad. At the same time. The claims came in, far far in excess of what AIG could cover.

AIG simply threw up its hands and said “Shoot me. We don’t have the money”.

AIG was again too big-to-fail. If it stopped honoring its insurance commitments, the risk they had blotted out would flow back to the original balancebooks and many banks, embattled as they are, would have no option than to close shop.

So the only option was government bailout to the tune of an initial $150 billion and then on March 2, another small baksheesh to the tune of $30 billion (all of these are outside the Troubled Assets Relief Program and not bound by limits on executive compensation)

Now if only the system of compensations was such that the Babu Batlas of companies like AIG had their bonuses linked to the long-term effects of their decisions (and not merely the short term), then perhaps the instinct of self-preservation would have somewhat controlled their greed. They then may have sold only those kinds of insurance assurances which their company had the assets to cover. As a result, not such an obscene number of high-risk mortgage-backed securities could have been guaranteed. This lack of insurance in turn would have made Banker Patel’s own instinct of self-preservation kick-in and he would not gone out on a limb and embarked on a high-risk investment strategy.

And so through the flow of this counteracting force of self-preservation through the financial system, the greed that brought down the house would have been controlled  and the situation would not perhaps be as dire as it is now.

{Caveat: I am not knowledgeable about economics or finance. This post is written based on my understanding of the present situation, gleaned from reading articles in popular media outlets }


66 thoughts on “The Question of Compensation

  1. “One of the simplest ways of explaining to people why they and their successive generations have been saddled by the biggest credit card debt in human history is to just shake one’s head preacher style and say “Human greed”—”

    I think, you may have meant to say “biggest credit crisis”…since the credit card debt, till now has not got much to do with the crisis, and that brings us to the brink of another fear: what happens when this personal credit bubble bursts ( all we are seeing thus far has been precipitated by the housing bubble burst, the reckless personal credit is yet to burst, I pray it does not happen).

    BTW, VaR could have hardly predict the current mess, since VaR is an empirical method ( usually calculated by Monte Carlo simulation) which takes into accout past data to predict the future. We have not seen events of this magnitude in the past, so this loss amounts could very well been confined in that 1% probability

  2. Dodo,

    The rest of the NYT article is about the limitations of VaR in coping with black swan events. However I do not think I said that VaR should have predicted the current mess. The limitation of VaR was however well known and the fact that it can be cleverly manipulated.

    As to the “we have not seen events of such magnitude” in the past, one may say that the reason we have not is because so many people have never been allowed to take so much risk for such a sustained period of time.

    When I said “credit card” debt I meant a “credit card” in a metaphorical sense…note I do not say “personal credit card crisis” . I would have thought that was clear.

  3. cool article. but alok nath did act in softcore porn, so one would not trust ones daughter with him entirely!

  4. But not all together. How could that ever happen?

    Way back in 2005, bloogers like Calculated Risk, Brad DeLong, Brad Setser, Roubini (long before he became a household name), Ben Jones and even some Fed officials correctly identified this argument as total bunk. If you think about it, housing prices are determined by – a) demographics b) interest rates c) income growth (or lack thereof) d) credit availability e) speculation. None of these is localized. So much for “all real estate is local”. But as you said, it’s all about incentives. Rewards for playing along were huge. Incentives for calling the emperor naked, nada. Unless you want to be a broken clock proved right, but after being wrong for 5 years and losing all mainstream cred.

  5. It is because of problems like Banker Patel, that companies often offer their top executives a large portion of their incentives in the form of shares locked in for an extended period (5 or 10 years). This serves as a deterrent to such risky investments. Again, I am not saying the VaR is faulty. Just that it is not the only way.

    Shahrukh Khan may not compensate the producers and distributors for his flops, but our very own Rajnikant routinely does it.

    It is only because of the trust (or lobbying, to be honest) that the government will bail out failing companies, that they had the courage to take such risky decisions.

  6. “…positive incentives when the going is good, there is not an equally compelling negative incentive when things go bad” Spot on!! I found particularly galling the statement by this exec who said “Say I helped create a million dollars. I should get some of that”. Well, shouldn’t he then lose some of his money if he loses a million dollars?

  7. @Anonymous: It is not that crashes of this magnitude have not happened before. In fact they have, the most recent being in the US in 1987. Around the world they’ve happened even more. The VAR models simply did not go back far enough.
    is an excellent article that explains how & why, better than I ever could.
    Also see:

    Page 4 puts the current crisis in a historical context & shows we are still not as bad as the worst crises of the last few decades.

    The second crucial place they went wrong was in assuming that risk was distributed normally, or according to the bell curve/Gaussian distribution. That assigns a very low probability to unlikely events (like systemic crashes) & does a good job of modeling things like human height, where nobody is over 8 feet tall & most people are close to the average. But systemic crashes happen much more often than that, & using the Gaussian distribution just because it’s tractable is shameful — but that’s exactly what they were doing.

    Taleb, in his books, argues that fractal or Mandelbrotian distributions should be used to model the risk in asset prices. Those are very complex, but there are simpler options like Extreme Value distributions & power laws.

    Sorry for the technical statistics-speak. But Taleb & GB are completely correct. The reliability of a VAR model hinges on estimating the R part correctly, not just the V. If you use an imaginary conception of risk because it makes the math simple & gives you nice fat bonuses, & are allowed to get away with it, it represents a deep systemic cancer.

  8. I am sure you would have seen the investigation into Merril bonuses a couple of days befor Bank of America takeover.

    Two excerpts from the SEC investigation doc,

    “Indeed, on January 16,2009, the companies announced that in the fourth quarter alone Merrill Lynch has lost $15.31 billion, and more than $27 billion for the year. In the face of these losses, federal taxpayers were forced to help Bank of America acquire Merrill. Thus, Bank of America also announced on January 16, 2009, that the federal government would invest $20 billion in the deal and provide $188 billion in protection against further losses primarily from the Merrill Lynch portfolio. These investments were in addition to the previous $25 billion in TARP funding that taxpayers had given to Bank of America.”

    ” Bearing in mind that Merrill moved up its bonus payments in advance of its announced $15 billion quarterly loss and $27 billion annual loss, we have determined that Merrill Lynch made the following bonus payments:

    “The top four bonus recipients received a combined $121 million;
    The next four bonus recipients received a combined $62 million;
    The next six bonus recipients received a combined $66 million;
    Fourteen individuals received bonuses of $1 0 million or more and combined they received more than $250 million;
    20 individuals received bonuses of $8 million or more;
    53 individuals received bonuses of $5 million or more;
    149 individuals received bonuses of $3 million or more;
    Overall, the top 149 bonus recipients received a combined $858 million;
    696 individuals received bonuses of $1 million or more.”

  9. Well … 2 things:

    1. If compensation packages ware linked to more long term effects of one’s action (Assumption: Short term incentives would still be there) the effects of the financial meltdown would have been lesser.

    Human greed knows no limits, and thinks in the short term. In the long term we are all dead! Even if there was an incentive to create long term wealth through proper investments, Banker Patel and Babu Batla would have taken the route which created highest short term profits for them. Plus Game theory. Banker Gupta would be making short term profits and driving Porsches, do you think Banker Patel would have held back? Maybe better incentives would have delayed this, but it would have still happened.

    2. “The problem lies in the failure of the system to regulate greed through the creation of an appropriate set of negative incentives”

    It is not a failure on the part of the system to control human greed. There can be no system which does that, because the system essentially is made of equally greedy humans. I like to think of this as a necessary consequence of how economies are run these days. Borrowing from future incomes to pay for today’s expenses. But the system works. There will be hiccups on the way such as these, and will occur more frequently too, but on a longer term it works. That is the beauty of a free market.

  10. The Lankan team went there showing solidarity with the Pakistan Cricket Board. Thakfully, none of the players died. 5 policemen died.

    Wa-Allah! The “Land of the Pure” is going through some putrid times.

  11. One of the simple points which exacerbates all this is the effect of competition. When bankers of a particular bank are rolling out structured products and earning hefty commissions, other bankers have to do that otherwise they are out of the game. This applies even though they are aware that this may not be a wise thing to do, they simply have no choice. And when more & more people start doing the wrong thing (without getting punished in a shorter horizon), the collective risk is huge.

  12. As someone who works in the industry (real estate private equity in one of the larger investment banks), the germs of the problem (and a potential solution to the present mess) is as below:
    Until the late 80s, all the investment banks were run as private partnerships, and therefore the partners took all the risk of their company tanking. As a result of this, while everybody was well paid, nobody took the kind of insane risks that we’ve seen in the past few years. Starting with Salomon Brothers and ending with Goldman, going public meant that the money at risk was no longer theirs, and further, they had to meet quarterly as opposed to long term targets.
    The second trigger was the repeal of the Glass-Steagal act, allowing corporate banks, with cheaper capital through public deposits, to compete with the investment banks. This obviously led to even more competition to the bottom.

  13. @Abhijit:Very fair comments. Also add the fact that post then investment banks have become a brokerage/advisory/prop trading unit rolled into one. I for one cannot understand how you can write independent reasearch on securities, have significant client order book knowledge and yet be running a prop book on your own balance sheet without conflict of interest (chinese wall be damned).

    I hope this model dies with the bust. It will be a healthy shift.

  14. @ Tintin-The simple answer is that you can’t. I’ve seen all kinds of shit happen before my eyes, many times. The Chinese Wall would be better described as a Japanese Wall (i.e., made of paper and translucent).

  15. Miyadad – . The world will have to stay united and fight terrorism.

    I wish he said the same in his own house!!!

  16. Wow! Nice, serious post, meticulously culled and lucidly presented. I think you got your answer here: “which is a little less simple but similarly abstract, is that the problem lies in the failure of the system to regulate greed”.

    Being in the industry, I have heard this being said by the top management of a lot of financial companies: “The only reason, India is better off right now than the US is the RBI, the SEBI and all of their highly critisized ‘conservative’ policies.” Who allowed these CDSs to rum amok? Who allowed the VaRs to be mathematically manipulated?

    Now, when you have thought about that, think about this. Why wasn’t US more ‘conservatively’ regulated? One simple fact begs to be remembered: Consumer Spending drives a nation’s economy like no other force. Can a government of a country be purposefully ‘un-regulative’? Then, do the bail-outs come as any surprise?

  17. Agree with metal.

    “But CDSs were unregulated which means that AIG could sell as many of them as they would want without having to show they had the money to cover the claims.”

    It seems some more/broad regulations would act as disincentive for insuarance companies to go for high risk insuarance assurances. So, instead of designing a complex system of compensation linked to long term risks, this kind of regulations might be a better way to avert future financial crisis. But,again it may slow down the economic growth of the country.Really, a tricky situation.

    “….a promise to insure from AIG was extremely valuable, like an assurance from Alok Nath to safeguard your daughter.”

    Priceless 🙂

  18. Arnab: I’m not really knowledgeable about economics or finance either, but I think you have overlooked one major factor. For quite some time, and specially in the last decade (or slightly longer), the federal government had made it a goal to promote home ownership and in pursuance of that had both pressured as well as given incentives to banks to relax qualifying standards for home loans – which is what led to the increase in size of the “subprime” mortage market. That is a root cause for the large number of risky home loans that were made in the first place.

  19. I guess you deleted my earlier comment where I’d said no posts for a week…. dunno its a problem I’m having where I guess your page is not updating on time… I honestly couldn’t see anything beyond Slumdog…
    Will come back with a longer comment on this post… its one close to my heart… needless to say I disagree with much of what you’e written :)..

  20. Nice post Arnabda!
    The theory that “But not all together. How could that ever happen?” is superficial at best – Infact lot of folks knew what was going on is insane and then fed chairman Greenspan actually called this out back in 05 – but to go against this tide meant doom’s day for your business and no one dared to do it lest they go out of business! It’s not just some banker went crazy greedy, it’s just that the world left no choice for that “sane” banker (I doubt there is one though :)) in this insanely competitive financial world – If any one has to blame I would say it’s more due to the lack of oversight / regulation from the governing body(Read all those rating agencies who dole out AAAs like candy)! This CNBC original “House Of Cards” is a must watch

    -especially the last few words from Mr Greenspan – almost prophetic – “The flaws of human nature are such that – you can not change it- it doesn’t work!”

  21. And I thought you had something to do with engineering? GB great analyses with your self professed limited expertise in finance.

    And yes, this reverse compensation logic does make sense but is far too difficult and impractical to implement. If this was indeed applicable, you would see Bankers changing jobs every 3 years in order to avoid a reverse compensation payment later on or something like this. If not this, the bankers would definitely employ some or the other tactic to wash their hands of the compensation earned.

    I suppose the concept of greed does hold true at the most basic level. When there is only enough supply for a product such as land, ppl shouldn’t be buying more in the hope that they’ll sell it in the future for a profit since demand is never ending. But again, the problem is how can you stop that? When times get better, how can you stop someone from buying a second or even a third house in the hope of capital appreciation?

    I guess, there isn’t an easy solution to this. Yes, you can go ahead and put in more regulations, but there will be increasing avenues to avoid those loopholes in a capitalistic society. This is the cost of capitalism and has to be borne.

  22. @Rakesh: The very fact that some countries like Canada have managed to avoid a meltdown of their banking system by having more conservative regulation means this is in fact completely avoidable.

    You can’t avoid booms & busts & you can’t eliminate human greed. But you can do a lot to prevent a systemic meltdown. Compare this collapse to the aftermath of the dotcom boom. That crash was not nearly as bad, because the worst damages were limited to stockholders & venture capitalists. It was not a leverage & debt-fueled boom.

    @Tanmay: astute observation about how competition drives the worst excesses because no-one wants to be left behind while the others are raking in the moolah. This is why you need restrictions on how much leverage banks can take on, & why this meltdown happened only a couple of years after those restrictions were lifted.

  23. I was a trader and I got laid off because my company cannot afford me anymore.I am taking a six months break to travel and I can afford it only because of I have the cushion of my last year’s bonus ,(by which time i had just completed 6 months in the company and was productive only the last 3) . I am confused.End.

  24. FYI
    Aloknath tries to rape the heroine at very end of a movie.
    Don’t remember the name of the movie though.

  25. I think wat lays really at the center of the crisis (if there is one center that is), is the creation of CDOs themselves. everyone thought that was the future of financial instruments and as their demand went up, it partly caused the boom in real estate too. Ofcourse, the bankers were greedy and lent out sub-prime more than acceptable ratios, AIG was greedy and provided insurance to sub-prime mortgages more than acceptable ratios etc. but i don;t think this is driven by individual compensation.

    Its institutionalized in that a bank either encourages its bankers to make said investments to said levels or not. I can see (from limited exposure to comp structures at banks), that a any bank (or AIG) for that matter, compensation for al individuals at the same rank is the same. There aren’t any star bankers within the less than 7 yr exprience range that r paid a bonus more than their peers, regardless of how they perform.

  26. 1> Yes. And that is why AIG had to be saved as if it failed, then so did the party and the counterparty. CDS was a way of transferring risk.

    2> The main issue about things like VaR, Loss given default, Expected Loss, Unexpected Loss etc is the underlying concept of probability. There is a probability of dying in a plane crash every time we fly. And yet it doesn’t happen often. But it DOES happen like a few days ago. Quant numbers therefore should have been taken as guides rather than precise measures. VaR is just something that the then chairman of JP Morgan came up in the 90s with so that he knew his risk at the end of the day.

    3> I heard Meredith Whitney on Bloomberg say that “Nobody came to Wall Street to save the world”, while defending executive bonuses. I agree with her but I agree with the taxpayers too. You cannot have it both ways. Once you have taken help from the govt, you cannot expect freedom or avoid scrutiny. But I think that the grudge against high executive pays is misguided. The problem lay with having too much faith in the base bonus scheme. What the top mgmt forgot was the fact that people can still get the bonus by means which would be apparently beneficial but eventually self-damaging (giving stated income loans, loans to deadbeats etc).

    4> Obama seems to be a person who will give all bailouts. But at what cost? Can this deficit be managed?

    5> Then there is this talk of….er hello….nationalization of US banks. I never thought that this day would come, but with the Dow down in the dumps and share prices like Citi and BofA behaving like options with increased selling pressure, that voice is getting stronger by the day. But I agree with this article about this issue:

  27. While a lot has been said about the greed of bankers (and certainly they are culpable) has anyone thought about the greed (and sometimes stupidity) of individuals taking these loans.

    House prices falling in themselves did not precipitate the crisis. It was when people couldn’t repay and found that they could no longer sell their houses and repay the loan (because it’s price had fallen) did they start defaulting. Which created the problem. For all the sub prime loans, if repayments had cotinued, there probably wouldn’t be a problem.

    And why should falling house prices impact your repayment ability. Because the repayment plan which most people had was to eventually sell their house, at a profit – most people were on interest only mortgages with no other way to repay the capital. A plan doomed to fail, if prices fell. Here in the UK, there were cases, where when house prices rose, people went and remortgaged their house and used the money to go on holiday. Ensuring that they had absolutely no leeway when prices fell. One never seemed interested in repaying the loan…because the asset was appreciating faster than I could borrow…and banks of course, were waiting to dole out more money
    Certainly, the banks were culpable, in being so trigger happy in lending to all and sundry- they too thought that house prices would never fall. But surely, if you take a loan, it is as much your responsibility to ensure that you can repay, as it is the bank’s to assess whether you have the capability to repay. The banks failed! So, did the mortgage taker!
    Frankly, for the last few years, society has been living on borrowed money, based on an assumnption that asset prices will always rise. And it is not just the bankers who are to blame for that. All of us shoulder a portion of the blame. The banks just created far too much complication. But even if there were no CDS’s, no ABMS’s, etc the crisis would still have come – it might have been a bit easier to identify the toxic assets, as they wouldn’t have been so bundled up with the good ones. But the “credit crunch” was waiting to happen.

  28. Here is what I got in a forward.
    Really LMAO on this one..

    “Heidi is the proprietor of a bar somewhere in Europe. In order to increase
    sales, she decides to allow her loyal customers – most of whom are
    unemployed alcoholics – to drink now but pay later. She keeps track of the
    drinks consumed on a ledger (thereby granting the customers loans).

    Word gets around and as a result increasing numbers of customers flood into
    Heidi’s bar.

    Taking advantage of her customers’ freedom from immediate payment
    constraints, Heidi increases her prices for wine and beer, the most-consumed
    beverages. Her sales volume increases massively.

    A young and dynamic customer service consultant at the local bank recognizes
    these customer debts as valuable future assets and increases Heidi’s
    borrowing limit.

    He sees no reason for undue concern since he has the debts of the alcoholics
    as collateral.

    At the bank’s corporate headquarters, expert bankers transform these
    customer assets into DRINKBONDS, ALKBONDS and PUKEBONDS. These securities
    are then traded on markets worldwide. No one really understands what these
    abbreviations mean and how the securities are guaranteed. Nevertheless, as
    their prices continuously climb, the securities become top-selling items.

    One day, although the prices are still climbing, a risk manager
    (subsequently of course fired due his negativity) of the bank decides that
    slowly the time has come to demand payment of the debts incurred by the
    drinkers at Heidi’s bar.

    However they cannot pay back the debts.

    Heidi cannot fulfill her loan obligations and claims bankruptcy.

    DRINKBOND and ALKBOND drop in price by 95 %. PUKEBOND performs better,
    stabilizing in price after dropping by 80 %.

    The suppliers of Heidi’s bar, having granted her generous payment due dates
    and having invested in the securities are faced with a new situation. Her
    wine supplier claims bankruptcy, her beer supplier is taken over by a

    The bank is saved by the Government following dramatic round-the-clock
    consultations by leaders from the governing political parties.

    The funds required for this purpose are obtained by a tax levied on the

    Finally an explanation I understand … “

  29. Excellent, very informative, a gr8 blog. PPL who do such enormous damage deserve capital punishment, much more than individual murderers or robbers do.

  30. One small thing though. Banker Patel paid $1 MM in taxes every year whereas Joe the plumber paid $10 K. So a large chunk of the “taxpayers money” had come originally from banker Patel’s pocket.

    So Nassim Taleb’s argument doesn’t really hold good in my opinion.

  31. I know people are going to be mad at me for this, but I still believe that home owners who signed up for mortgages higher than they could afford are one the primary culprits here.

  32. GB,

    Excellent post and introspective understanding for a non banker.

    Good job! The best I have heard in a while from a non technical person.

    Ex Goldman Sachs Invt Banker
    (who quit to do a startup in India just before the bust!)

  33. ps: you have missed out on the role of rating agencies which are supposed to rate the CDS’ and CDOs. All of these instruments are structured and then rated. And entities like AIG or guarantors like MBIA, Ambac, FGIC etc (all of whom have gone bust now) are required to follow strict capital adequacy norms. The sad fact is that the staff of rating agencies are not of the best calibre (as in an earlier pre bust era, they’d rather be at banks where the compensation is a multiple of what they’d earn at a rating agency). Also, they are severely short staffed and stand no chance on facts or analysis to counter the indepth coverage of the instruments by the banks who design them. One would assume that an institution that acted as a quasi regulator for investors would know better, however that is not the case and most analysts at these agencies merely skim the surface. Its unfortunate that there hasnt been enough public debate on these agencies and there is no change in their structure or functioning. They continue to have ibanks as their clients who pay them for the service.

    I also agree with your comments on VAR. It is only as good as historical volatility of underlying instruments and a smooth rise up or down as with the upward movement on housing just doesn’t cut it to measure the vol. The interesting question is – how does one determine the fundamental value of any asset? The simple economic answer is the point of equilibrium where demand matches supply. However, in sophisticated markets it is hard to determine how much of the demand is driven due to fundamental factors such as a rise in GDP and therefore incomes and how much is fuelled by the credit bubble. Its hard to isolate them technically and therefore hard to understand what the correct valuation is. Which is why even the real experts are unable to ever predict a bubble until it has burst.

    My views on the current state of the world is that a lot of it is sentiment driven. Yes, there is correction. But the current crisis is many times the magnitude of that correction. people have lost confidence and do not want to spend. a recession of this magnitude is understandable if there is a real loss ie oil has run out and we dont have alternative fuel technologies developed. Or that a giant meteor crashed on the earth destroying much of our resources. none of that has happened. sentiment is one of the biggest failures of free markets, just in keeping with its name – its free and not controlled by any govt. even if one argues that finance is a bloodline to other industries, the nature of this crash has affected way too many for it to only be a liquidity crunch issue. the governments need to work hard at restoring confidence. bank nationalisation is not necessarily a bad thing, though the rest of obama’s buy american hire american policies are and bear no economic logic.

    anyways, ended up being much longer than what i wanted to say.

    bottomline – good job!! i thought the earlier piece you wrote on this was naive, but this is a pretty well introspected view and i can see the effort you put into understanding this.

    keep writing.

    ps: billu review?? it vanished from the screens here in a week!

  34. Dibyo,

    Sorry to have to rain on your parade. Thanks to GWB’s tax cuts, it was Joe the Plumber who gave a proportionally higher percentage of his income to the pot than Patel the banker. This goes against the grain of every principle of taxation. Extending the raining part to the second comment, those owners who signed up for high-risk mortgages on leverage have had their homes repossessed and are now out on the streets or in rented places. In short, they are being made to pay for their actions in the true spirit of capitalism. However Patel the Banker is being bailed out. This is the fundamental problem.

    Excellent post GB as usual. I enjoy your serious posts sometimes even more than your funny ones because they are so well-argued and informative. Try finding any article like this in Business Standard or Economic Times !

  35. “But surely, if you take a loan, it is as much your responsibility to ensure that you can repay, as it is the bank’s to assess whether you have the capability to repay. The banks failed! So, did the mortgage taker!”

    Not really. The mortgage is backed by the collateral; i.e., the house. If the house value falls precipitously and the borrower loses his/her job, what do you expect him/her to do? They can’t sell it and get enough to pay off the bank. Do you expect them to stay in the same house and somehow keep making their payments to the bank? The least harmful thing they can do is to turn in the house and walk away because you they no longer have the ability to pay the mortgage. And the law allows it precisely for this reason. The borrower (“mortgage taker”) didn’t fail in the systemic sense. He/she always had some risk of defaulting. They most likely accounted for the fact that in case they couldn’t pay the mortgage they would have to give up the house. And they did. In addition, they will pay for their irresponsibility, if you want to call it that, through damage to their credit rating. They won’t get a new home loan any time soon. They, along with all taxpayers (to different degrees) will also pay for these gov’t bailouts one way or the other. Of course, this doesn’t all apply to the real estate investor-owners. They probably have more to answer for but even they are paying for it by losing whatever they had invested in these houses. But look at the bank/financial-co management. They made the much more ridiculous assumption that housing market will always go up and that they would never have any significant number of defaulters. They took their investors’ money and invested it in a highly irresponsible manner. But now, instead of them paying for their mistake, they will still collect their bonuses, get government bailouts and have nice retirements. You tell me who made the bigger mistake and who is actually paying for it?

  36. Nicely argued. But I beg to differ. The whole point of a high-paying job is to attract the top talent, because well, money is often the largest motivator. A risky environment that involves employees paying back their bonuses to the company in bad times would not be conducive to attracting the best talent.

    Yes, the so called “top talent” has landed us in this mess, but that does not mean we abandon the hope of finding the right kind of leaders. And compensation is a major factor in doing so. I’ve blogged about the compensation system, do check it out if you’re interested:

  37. @Anonymous : “Thanks to GWB’s tax cuts, it was Joe the Plumber who gave a proportionally higher percentage of his income to the pot than Patel the banker.”

    Could you please explain the above statemnt with some simple figures. I’m sure my understadning of taxation laws is a little suspect and thereby I am not able to appreciate your counter argument.

    My simple math here is, Patel paid almost half his bonus in taxes. (That has been the case since 2005 atleast).

  38. Dear Anonymous,
    So according to the Post, banker Patel and s/w engineer Reddy paid 83% of the total taxes in 2004 and 83.1% in 2000. Now the federal aid to banks are critical for both of these characters to survive. So how, may I ask is the bail-out plan unjustified ?

  39. Dibyo,

    Ram gives 5 paisa to the pot out of the 15 paisa he has in his pocket. Raghu gives 10 paisa to the pot out of the 100 paisa he has in his pocket. (Rich give at a lesser rate under Bush)

    Pot= 15 paisa

    Raghu gets back 10 paisa in federal aid. His net contribution= 0 out of 100 paisa. Nothing changes for Ram.

    So Ram who should pay tax at a higher rate than Raghu actually pays no tax.

    Once you understand that the principal of taxation is that he who earns more gives more you would realize that this is the most unfair thing possible.

  40. Correction:

    So Ram who should pay tax at a higher rate than Raghu actually pays no tax.

    should be

    So Raghu who should pay tax at a higher rate than Ram actually pays no tax.

  41. And oh by the way who told you that software engineers are being bailed out? The government is paying taxpayers money so that bankers can get their 300,000 bonuses. I do not think that software engineers will benefit from the largesse in any direct manner.

  42. Anonymous,
    I kinda disagree with your Ram/Raghu example. I believe that taxation on bankers bonuses are close to the 40-50 % region.

    So if Ram earns 15 paise, he is taxed (after returns) 4 paisa.

    Raghu earns 1000 paisa and is taxed 450 paisa. Now if they pay this for five years –

    Ram’s net tax = 20 paisa
    Raghu’s net tax = 2250 paisa

    Now Raghu gets back 1500 paisa in bailout.

    We are ofcorse discounting the fact that Raghu eats at Morimoto, shops at Louis Vuitton and drinks MaCallan 18yrs. (All heavily taxed)

    Ram eats at Dominos, shops at BJs and drinks Miller Lite.

  43. Your belief does not change the fact of the US tax structure. Your analysis of the spending habits and their impact on the economy is also rather naive. Raghu may eat at Morimoto but the effect of 3 Raghus eating at Morimoto is swamped out by the effect of 1000s of Rams eating at Domino in terms of money flow.

  44. Anonymous,
    Again net tax paid. Anyway, let’s agree to disagree. I am not too thrilled about the manner of the bailout either, but it is not as unfair as it is made out to be by the anti-bailout people.

  45. Suppose you go AC or Las Vegas and play for 100$ and win 50$ in the first hour. Then you play the next hour and loose 80$, are you expected to return the 50$ in the initial winnings for lack of long term performance?
    Investors are expected to understand this risk and take their decision accordingly. Agreed that the housing bubble had to go bust and top executives like Banker Patel did not realise this what even a 5th grader would have. But Banker Patel & Co reputation and good-will is so bad that even a local convenience store would not employ them.
    Tax payer have to suffer as governments we forget ideologies when we are not doing good.Finally, would also add that individuals always claim credit for good times (No one said thank you Banker Patel in boom times) but want to blame someone else for their misfortune.

  46. @Sanket

    Comparing Financial investments/ Banker’s performances to gambling is at best ridiculous. You don’t have any control of the variables at play in many forms of gambling and even in forms, where you could control, the scope is abysmally limited and your performance impacts only you. But when comes to banking and finance or any job for that fact, there are so many variables you control and a responsible person should know the impact of his acts/work.

  47. My two cents to this well written article. I think one of the primary reason which abets manipulation in Trading is the accounting method used to calculate PnL. Regulators allow MTM(mark to market) accounting which accounts unrealized PnL in total PnL- which is root of all the problems. If we use plane Cash accounting to measure traders’ profit his numbers would not look so nice. Simple example will demonstrate this: Suppose, you buy a house for $10000 and rent it out for a year. At the end of the year the value of the house is $12000 and you rake in $1200 on rents. Your PnL will be:
    Under Cash Accounting -> PnL = $1200
    Under MTM accounting ->PnL = $ 1200 + [12000-10000](unrealized part)=$2200.
    MTM accounting pushes up your PnL.
    So, by using Cash accounting, the compensation can be made unglamorous.
    Other point is the valuation (or MTM of your asset) basically prices your risk (which can be manipulated by VaR like measures). The risk measured by VaR is reduced if asset classes are correlated. One way of being more conservative in your risk measurement is to assume that all assets are not correlated, then the risk measured by VaR will bump up( In reality all assets are correlated, hence they all go bad at the same time (black swan event) ). By assuming them to be uncorrelated the variance of all assets will overestimate the risk (it still not the prudent number) – which is more conservative.

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