(no subject)

[steuard]

I've had trouble looking away from the turmoil in the financial markets this week. Between the possibility that the economy could plunge down a cliff and the possibility that we're going to be collectively saddled with a trillion dollars of new debt, it's awfully likely that something tremendously significant is happening. Unfortunately, I don't know nearly enough about the underlying issues to have any good sense of what the "right" response might be, individually or as a society. A couple of thoughts, in no particular order:

• I am surprisingly bothered by the notion that when the dust settles, some people will have gotten rich off of these subprime loans. I can accept that the government may have to step in and bail out the economy in this situation, but if the corporate executives who made these high stakes gambles waltz off into happy retirements with golden parachutes I know that I'll resent it. Perhaps the right way to handle that is to combine extreme government spending with extreme government enforcement: have federal, state, and local law enforcement go over every aspect of the subprime mess with a fine toothed comb and throw the book at people for every little infraction that contributed to the disaster. I'm a little disturbed to realize that I'd feel better about those golden parachutes if the profiteering executives and predatory lenders had to enjoy them from prison.


• This is sort of situation is precisely why I've long been skeptical of extreme privatization and deregulation. The government is going to stick its nose into issues like banking and retirement, we just have a choice of when and how. If we leave markets entirely free without regulation, we'll get occasional major busts when competition for the highest immediate profit leads to erosion of standards and collective stupidity, and the government will be politically forced to step in to bail the rest of us out. If we privatize retirement investing, there will come a time when a major market drop leaves half a generation of the elderly destitute, and the government will be forced to step in to make sure the elderly don't have to live on cat food. The alternative is to set up some level of government involvement in advance, in the hopes of making government involvement more predictable and more fair. It's a tough balancing act to do that without stifling the positive effects of free markets, but I think it's still a better choice.

Comments

[jminnis.livejournal.com]

Keep in mind that one major problem is the half-assed privatization of Fannie May and Freddie Mac. The market gave them a pass on a lot of things because of the government backing. The government was asleep at the wheel in terms of monitoring them. Because of this, Freddie and Fannie became the dumping ground for bad mortgages. I suspect that a lot of companies would have behaved better if they hadn't been planning on foisting off any problems on the US treasury.

I'd also say that this is another fine example of the danger of tying executive compensation only to short term stock prices for the company. If an executive gets multiple million dollars for hitting a particular stock price in a given year, there's a huge incentive for them to fudge the books or do other things to make it happen. You'll notice that pretty much all of the major company collapses have that aspect of executive compensation (and that aspect of executives working to meet their compensation goals) tied to them.

[beth_leonard]

*nod*

Also part of the problem is that mutual fund managers get *annual* bonuses for beating the market in any given year. There is tremendous pressure to "beat the market" which is hard to do without leverage. In an up year, they leverage more so annual returns are better than "market" returns, but it means that when the market starts falling, even slightly, their problems suddenly compound much much more quickly. However, if you make a $2M bonus 4 years in a row and $0 bonus for bankrupting your mortgage-backed-securities mutual fund in the 5th year, as an individual you still come out ahead.

The investors in said funds however...

There's a reason Jon and I start with market indices as the base layer of our portfolio. Of course the market as a whole is (was) over-weighted in financials, so that's not so great on a day like yesterday.

--Beth

[steuard.livejournal.com]

I recall that Patri has talked in the past about people looking for better weighting schemes for stock index construction than market capitalization. Weighting by market cap gives investors extra exposure to overpriced companies and less to underpriced ones, exactly the opposite of what you'd want. The claim was that practically any other weighting method would be better (number of employees was one example) simply because you aren't mixing the weighting variable directly with the reward variable (or something like that). I'll be interested to see if those ideas eventually take off.

[jminnis.livejournal.com]

This is a very good point, an one which I had never really thought about. I've never heard of a fund that does anything like this, though.

[jminnis.livejournal.com]

I think that it would rock if mutual fund managers got paid their bonus in shares of their fund, which they could only cash out 10% per year for the decade after the bonus is awarded. Something similar could be done with executive compensation.

I invest in market index funds and individual stocks. I avoid managed funds like the plague.

[steuard.livejournal.com]

Yeah, I think we can pretty much all agree that an ill-defined patchwork of free market and government incentives is the worst of all worlds for a company. If the government didn't intend to guarantee Fannie and Freddie, they needed to make that abundantly clear all along. If they did intend a guarantee, that should have been out in the open from the start (and factored into the expected costs of the program when it was approved). As it was, the sudden switch from emphatic denials that there was a guarantee to emphatic promises of one (followed by acting on it) was yet another thing that's frustrated me about how this story has played out.

I also totally agree on executive compensation being tied to short term stock prices. I would have thought that the whole point of having a CEO would be to have someone looking out for the long term health and plans of the company. People react to the compensation structures they're given (just as my students react to the grading system I impose). So who exactly is it who's pushing for this short term focus? Are corporate boards run by day traders?

[pmb.livejournal.com]

It's important to note that Fannie and Freddie were originally a single government entity and did have explicit government backing. Then in the 80s, Reagan half-assed deregulated that one agency into two (for competition) on the theory that some free market was better than none.

[jminnis.livejournal.com]

Actually, the biggest step in deregulation was in 1968, when it was made a 'private entity.' It's taken 40 years, but the sin of half-assing the deregulation has definitely caught up with us.