Pay for Performance
Blogentary from Enduring Investments
What, you may ask, is Blogentary (/blawg-en-tare-ee/)?
It's a word I just made up, I think, for something that is much like a commentary but posted on a blog. Not everything on the Enduring Investments blog will be blogentary - some of it will be conventional blog-like material. But I like the freedom of length and format that a document editor allows, so I (and occasionally my partners here) will occasionally be posting something in this fashion.
We - my two partners at Enduring Investments, and I - appreciate your interest in reading some of our thoughts. Let me briefly explain what I think you will read in these postings.
Each of us has his own opinion, and his own slant on events, and his own way of analyzing and explaining things. We don't plan to restrain these differences of opinion, because as traders and investors we don't believe that differences of opinion are to be feared. Indeed, we welcome your comments, critiques, and thoughtful rejoinders. (Just remember not to hold Bob and Jake responsible for my opinions, and vice-versa!)
On some topics, we all agree. As an example, we all agree with Fed Vice Chairman Kohn's statement in a June 25th speech (released today) that "Traders' pay should be tied to their performance." I would go even farther and say that the world would be a better place if everyone's pay were tied to their performance, although such a regime would not necessarily be welcomed by, say, Senators and Fed officials.
This isn't completely fair to Kohn, since the headlines on Bloomberg were taken out of context. What he actually said was that "The solution, in addition, lies with more closely tying traders' compensation to the long-run performance of their portfolios." That's meaningfully different, but also very difficult to accomplish in a bank/dealer structure. The 'solution' he is talking about is to the problem that unscrupulous traders will tend to load up (Kohn's term) on risks that are underpriced at the level of bank capital standards. In other words, traders will game the system.
There are many other solutions. One solution to the problem of poorly-constructed capital standards is to penalize the trader for not doing it correctly even though doing it correctly might penalize the institution by forcing it to hold more capital. Another solution is to remove a lot of the specificity to capital standards that create the system to be gamed. One is a paternalistic solution; one is a libertarian solution. I do not judge; I merely point out that assuming more regulation is the right answer is, perhaps, a premise that ought to be debated.
As buy-side denizens, however, we agree that compensation ought to be tied to long term performance, and we embrace incentives that are structured in that way.
I do worry that we are spending a lot of time pointing fingers about who caused the crisis while the crisis is not yet behind us. Despite all the talk of green shoots - which the market seems over the last week or two to be finally treating with some skepticism - I think there are real reasons to be concerned that while the worst quarters of the contraction are probably over, the economy is still not responding to the tender ministrations of the Fed and the Congress.
Consider the chart at right, which shows the growth of bank credit of all commercial banks (Source: Federal Reserve). Since 1974, the lowest 52-week growth rate has been around 2%, in the midst of the recession of the early 1990s as the system repaired itself following the S&L crisis. The recession of the early 'Aughts also saw the rate of growth bottom around 2%. In both cases, bank credit began growing faster about 3-6 months after the ISM index bottomed and proved a reliable sign that the economy was beginning to recover. In a creditdriven society, if the banks aren't lending then people and companies aren't buying and the economy isn't growing.
Of course, this is exactly what the unprecedented intervention by the Fed was supposed to do: ease credit conditions! The chart, however, gives reason for pause. There is no sign of a bottom being formed in this series. Moreover, the true series is even worse than the official numbers look. If you calculate a growth rate from the official series, then you get the red line, and the low (so far) is 2.51%. But, my friends, this is deceiving because we have two more 'banks' this year than we did one year ago: Morgan Stanley and Goldman Sachs. On the week those institutions converted into bank holding companies, Bank Credit jumped more than 3%: more than $300bln. (A distant second place was the week of 9/11, at 2.4%, when banks really did lend the money that was pumped into them.)
The green line on the chart shows the 52-week average with an adjustment made for the series discontinuity just mentioned. What it shows is that aggregate bank credit is unchanged over the last year, and shows no real signs of that situation changing any time soon, despite truly epic liquidity being pumped into the banking sector's veins. That's not good.
How long with this malaise last? I haven't a clue and am making no predictions here. What I will say is that there is no evidence that we have yet turned a corner. Recent economic activity appears to be an improvement only from the standpoint of the post-Lehman crater, in much the same way that even a single win from the Detroit Lions this year would represent improvement. But the Lions won't make the Super Bowl at 1-15, and the current pace of Initial Claims doesn't represent anything resembling recovery.
What are the implications of this for inflation? I'll talk about our opinions on this topic in some detail next week.