The Flaw in the Financial System

The Flaw in the System: The Bankers Don't Care About the Banks

by Cenk Uygur [Subscribe]
Mon Mar 02, 2009 at 08:59:24 AM PST

Alan Greenspan says he is in a "state of shocked disbelief" that the concept of self-interest did not protect the banks from taking excessive risks and destroying themselves. But he, along with Tim Geithner and Larry Summers and many others, are missing the fundamental flaw in the system. The bankers don't care about the banks; they care about the bankers.

The enlightened self-interest of the bank executives has been separated from the interests of the banks they work for. In the 1970's, the banks were still privately owned. So, the guy up at the top wanted to protect his company, his interest and his money. If his executives took unwarranted risks with the boss's money, they were goners. But these days the people at the top of these companies don't own the companies. It's not their money.

Here is how the Wall Street Journal explains it (a useful nugget in an otherwise horrible piece):

"The Wall Street compensation system has evolved from the 1970s, when most of the firms were private partnerships, owned by partners who paid out a designated share of the firm's profits to nonpartner employees while dividing up the rest for themselves. The nonpartners had to earn their keep every year, but the partners' percentage ownerships in the firms were also reset every year or two. On the whole, everyone's performance was continuously evaluated and rewarded or penalized. The system provided great incentives to create profits, but also, because the partners' own money was involved, to avoid great risk."

These days, the way executives make money instead is in the form of bonuses for years where they bring in a lot of return (and often times for years they don't), but the threat of being fired for too much risk taking is minimal. The more risk you take, the more money everyone makes. And it's not the partner's money you're playing with anymore. You're playing with house money. No one is minding the store anymore.

Now think about it this way: if you were going to make ten million dollars in bonuses for taking high risks with other people's money, would you do it? The answer invariably is - hell yes!

If it's your own money on the line, you might be extraordinarily careful with the risk you take. But if you are going to get a multi-million dollar reward for taking risks, but you expose your company to a little bit more risk, what percentage of people would take that extra risk on behalf of their company? I would venture to guess 98%.

And the other 2% are suckers. There is no downside for you. The higher the risk, the higher the return in the short-run (which actually lasted a long time) and the higher your take home salary is. Are you going to be the only guy on Wall Street saying, "Well, golly gee willikers, everyone else is making millions but I really care about my shareholders. I don't want that huge bonus. I want safe investments for my company."? That's not how human nature works.

So, now we have Tim Geithner and the rest of Treasury working so hard to prop up not just these failed banks - but these failed bank executives - because we don't want government running these large companies. The self-interest of the market will do a better job of managing these companies. But it hasn't - because of this fundamental flaw.

These executives did not actually fail. They succeeded wildly. It's just that they had a different goal - to take home as much money as they possibly could for themselves. Mission accomplished!

I don't blame them. The system is set up wrong. Almost anyone in their position would have done the same - and will continue to do the same as long as we are foolish enough to keep pouring money into these companies. They are going to try to move every nickel they can from our pockets into theirs.

The Treasury plan is all wrong. We have to first acknowledge that the boards of these companies are not truly representing the shareholders. They are largely friends with most of the CEOs and they do not have an incentive to reign in out of control compensation for the top executives. Then those CEOs pass on the wrong incentives to the executives below them. The more risk they all take, the more money they take home. And if their company goes broke one day - who cares?

Most of these guys took home millions upon millions of dollars already for profits that never really existed. If the company goes under, okay the gravy train came to an end but they still have all the money they made from all those years. It's in their personal bank accounts. That's enlightened self-interest!

Do you know that last year, as Merrill Lynch was in its death throes, 696 executives got bonuses over a million dollars? 696! As the company lost tens of billions of dollars, the executives took home a combined $3.6 billion that year. Billions in bonuses in the worst year in the company's history. They're not stupid; they're smart. They're looting the store before the cops show up.

This is the financial equivalent of the federal government not showing up to rescue people after Hurricane Katrina. Last year the five biggest Wall Street securities firms lost $25.3 billion. The executives at those companies still took home $26 billion in bonuses. In other words, they wouldn't have lost a nickel if they hadn't taken any bonuses.

Do you think if the guys up at the top still owned the companies they would allow their employees to take home $26 billion in bonuses when they lost $25 billion that year? Self-interest would never allow that. But now no one is looking over their shoulder.

So who cares what the company loses? Take the money while you still can. The Treasury Department still hasn't shown up to take over these looted stores. In fact, they keep pouring taxpayer money into these same shops, as the money continues to move out the back door. Tim Geithner is the worst sheriff in the world.

But we already knew that. Because the main guy who was overseeing all of these banks in New York, as they took these giants risks, was the president of the Federal Reserve Bank of New York - Tim Geithner.

He is under the misimpression that his job is to protect the sanctity of the banks. Not only is that not his job, but that is working against his actual goal. His real job is to stabilize the financial system, with or without these particular banks or bank executives. The longer he keeps these guys in charge, the longer the looting continues.

Somebody send in the cavalry already. Geithner and Summers make it appear as if we are all dense and don't get the urgency of shoring up the financial system. We all get it. But there are several different ways to skin that cat. And their way is not working - and because of the fundamental flaw in the system - cannot ever work.

Even if they stop the bleeding in the short term, if they don't fix the flaw, the executives will be back to the same routine very shortly. Why? For the same exact reason that Greenspan thought the system couldn't fail - self-interest.