Monday, February 23, 2009

Paul Volcker Laments

In the previous post ("Saving Capitalist Banking from Itself") we excerpted part of the first item John Mauldin1 included in his "Outside the Box" e-mail today. The second item Mauldin included in today's e-mail was the text of a speech Paul Volcker recently gave in Toronto. The main subject of the speech was the sort of financial system Volcker envisions we'll have when the dust eventually settles. The speech isn't very long and is worth reading in full on Mauldin's site, but excerpted below is a brief passage that jumped out at me as I was reading it:

One of the saddest days of my life was when my grandson – and he's a particularly brilliant grandson – went to college. He was good at mathematics. And after he had been at college for a year or two I asked him what he wanted to do when he grew up. He said, "I want to be a financial engineer." My heart sank. Why was he going to waste his life on this profession?

A year or so ago, my daughter had seen something in the paper, some disparaging remarks I had made about financial engineering. She sent it to my grandson, who normally didn't communicate with me very much. He sent me an email, "Grandpa, don't blame it on us! We were just following the orders we were getting from our bosses." The only thing I could do was send him back an email, "I will not accept the Nuremberg excuse."



1JohnMauldin@InvestorsInsight.com

8 comments:

JK said...

Wired.com had an article yesterday about financial engineering, lightly explaining the Gaussian copula function for the layperson.

DaveinHackensack said...

Thanks for the link, J.K., but I don't understand why anyone would have assumed a Gaussian (i.e., normal distribution) in this context. Even Level 1 CFA books note that securities returns aren't normally distributed. This has been, as far as I know, well known for years (which is why kurtosis and skewness are part of the CFA curriculum). Why the folks working with complex derivatives would assume that these things worked according to normal distributions -- when even plain old stock market returns don't -- I don't know.

JK said...

I guess they thought that *mortgages* were more "normal" and reliable than other financial instruments, ignoring the fact that the securities had been built up quite far from their brick and mortar foundations. According to the article, Li and other financial engineers knew that their formulas were being used incorrectly by investors. Not that they made a big huge public fuss or anything.

At any rate, it wouldn't be the first time basic CFA info is ignored, see Long Term Capital Management, who thought they were too good to have to pay attention to kurtosis risk.

I'm also not convinced that this just happened because of ignorance, as you note there were basic mistakes. A lot of people knew that what they were doing was unsound but wanted the big bonuses. Once you make a personal fortune then you can retire and not worry about whether or not there is a financial system to come back to. Who can really say they'd act differently, in all honesty. It's hard to turn down the big payday because of mere integrity, without the threat of consequences.

DaveinHackensack said...

That point about the perverse incentives of the comp system is one that most seem to have gotten now that the horses have left the barn. I'd be surprised if a move toward contingent deferred bonuses weren't part of an eventual regulatory response. The idea that a handful of guys in London, for example, could make hundreds of millions of dollars stuffing AIG's balance sheet with time bombs and keep that money after the company blew up makes no sense.

db said...

That point about the perverse incentives of the comp system is one that most seem to have gotten now that the horses have left the barn.


Really?? And just yesterday, John Thain defended giving out $3.6BILLION in bonuses, likely illegally. British bankers demand raises to offset the decreases in their bonuses. And Morgan Stanley is handing out $3Billion in bonuses to their brokers.

You really think they've gotten the message? I think Santelli's rant demonstrates just how grossly out of touch the financial industry really is.

DaveinHackensack said...

"Really?? And just yesterday, John Thain defended giving out $3.6BILLION in bonuses, likely illegally."

"Most", not all. John Thain's move to move up the bonuses before the awful earnings report raises some obvious questions. He's also been incredibly tone-deaf, if nothing else, recently.

Morgan Stanley's retention bonuses to its brokers are another animal though. Brokers keep the lights on at a brokerage, and if you can't retain them, you don't have a business. It's not the same thing as salaried bankers who have nowhere else to go; there's always somewhere else for a producing broker to go. He's a revenue center, not a cost center.

db said...

You are talking about the same brokers that were hawking the same POS securities that are at the heart of our current mess, right? I wonder how it is that the other company mentioned in the same article(Wells) manages to stay compentitive without ludicrous payouts to the same pool of "talent". Perhaps they are adopting a compensation strategy more similar to industries that aren't awash in cash.

Incidentally, these were just the handful of references I found for the last day or so. But your willingness to defend these practices speaks volumes.

DaveinHackensack said...

"You are talking about the same brokers that were hawking the same POS securities that are at the heart of our current mess, right?"

For the most part, I doubt it. I doubt the average retail broker at Merrill Lynch was selling tranches of subprime CDOs to his clients. Generally, that was sold to institutional investors.

"I wonder how it is that the other company mentioned in the same article(Wells) manages to stay compentitive without ludicrous payouts to the same pool of "talent"."

I'm not an expert on Wells, but bank brokers generally don't make as much (although they often have higher commission payout percentages) as brokers at firms like Merrill Lynch. There are two reasons for that: 1) they don't have the books (and generate the commissions and fees) that Merrill brokers do, and 2) most of their clients get effectively handed to them by the bank. E.g., Susie the teller introduces Bill the bank broker to Granny Smith. Bill sells Granny a fixed annuity with a 5% vig that he splits with the bank. Susie the teller gets a fancy pen/free lunch/some other show of appreciation from Bill.