Excessive executive compensation vs risk taking

Posted by Shyam Moondra

Last week, the Federal Reserve Board disclosed that it is reviewing the compensation practices of the financial sector for the CEOs, traders, and loan officers. It's a well known fact that top-notch traders and loan officers can walk away with tens of millions of dollars in performance-based compensation that invariably leads to excessive risk taking. The housing bubble of 2007 was partly created by mortgage loan officers, who routinely approved mortgage applications of credit-unworthy home buyers; the more mortgages they sold, the more money they made. The investment bank Lehman Brothers collapsed because their traders took excessive risks in trading mortgage-based securities that led to crushing losses. Many of the investment banks and hedge funds were leveraging themselves by as much as 40:1, creating the potential for severe consequences if their bets didn't go their way. The failure of Lehman Brothers and the possible failure of another financial giant AIG forced the federal government to risk taxpayer's money by aggressively infusing liquidity into the largest financial institutions to avoid a catastrophic systemic failure of the entire financial system.

The aggressive actions taken by the Congress and regulators helped avoid a massive failure of the credit markets, although they couldn't save the economy from slipping into the most severe recession since the depression of the 1930's. Now that credit markets are steadily coming to normalcy and economy is gradually recovering, the question everybody is asking is could this happen again. President Obama has made it clear that if financial institutions take extreme risks and get in big trouble again, the government will not bail them out, even if they are too big to fail.

The former Fed Chairman, Alan Greenspan, said that unless a way can be found to change human nature (about greed), another financial crisis is inevitable. The root of the problem is the present compensation system, which rewards excessive risk taking exorbitantly. Some of the top-performing traders are known to have earned hundreds of millions of dollars a year. Recently, the Citigroup CEO Vikram Pandit disclosed that Citi's top trader would earn $100 millions this year and he admitted that that kind of compensation is excessive. In fact, the largest five financial institutions have put aside $50 billions for bonuses this year.

One of the easiest ways to bring discipline and sanity in compensation practices of the financial sector would be to impose caps on the compensation of the CEOs, traders, and loan officers. However, Republicans and conservative Democrats vehemently oppose such caps because that would amount to direct government interference in the free-market capitalist system.

Here are a few things that Congress and regulators could do:
· All financial institutions with assets of more than $1 billion must not be allowed to have a leverage of more than 4:1. The capital ratios of the financial institutions must be closely monitored and enforced by the regulators.
· In the second quarter of 2009, Goldman Sachs reported unexpectedly large profits; however, a big chunk of those profits came from trading in stocks, bonds, and commodities and not from traditional investment banking functions (such as mergers and acquisitions, IPOs, etc). These trading profits don't directly contribute anything positive to the economy. Big players manipulate markets, cause market volatility, and make money at the expense of less sophisticated small investors. It's time the Congress put restrictions on computerized day trading by large financial institutions. Specific restrictions could include: limiting short sales in a company's stock to 1% of its outstanding shares, banning naked short selling, reinstituting the "up-tick" rule for short selling, limiting how much trading they can do in derivatives (e.g., stock options), requiring the financial institutions to hold the stocks they buy for a certain minimum period (e.g., 20 business days), and imposing a hefty 80% tax on capital gains realized by financial institutions from short-term trading. In fact, former Fed Chairman, Paul Volcker, has suggested that banks be barred from trading with their own money (they can trade in their client's account but not in their own account).
· Regulate hedge funds in the same way as mutual funds are regulated. Many of these hedge funds are funded by large banks, so if hedge funds fail because of excessive risk taking, they might bring down their sponsoring banks.
· Impose corporate governance rules that would require compensation plans for executives, traders, and loan officers to be approved by the shareholders.
· Impose a tax surcharge on companies that pay their CEOs and other highly paid employees more than a pre-specified limit. Also, the excessive compensation could be made non-deductible for tax purposes.

Democrats: Either exercise power and govern or get lost

Posted by Shyam Moondra

The White House, Senate, and House of Representatives are all controlled by the Democrats and yet they are unable to move forward on a number of defining issues such as health care and regulatory reforms. The Democratic Party lacks discipline and unity. They have wasted so much of their time bickering on health care that other important issues including regulatory reforms, executive compensation, Afghanistan, energy independence, climate change, and education still remain to be tackled.

Most of the blame for non-performance of Democrats, of course, lies with their leaders:
· President Obama has not done much to unify his party. He lacks strong leadership skills. He is way too conciliatory (President Lincoln once said, "Be sure you put your feet in the right place, and then stand firm"). Being the president means you listen well, but it also means you lead based on your convictions and twist some arms if you have to. So far, on health care, Obama has been more of a follower of a chaotic process characterized by Democrats going in thousand different directions and there is no one with a strong personality to bring them together. Obama shouldn't hesitate to withhold money for states (or threaten to close military bases in those states) whose senators and congressmen have been creating obstacles in the passage of his agenda in the Congress.
· The Senate Majority Leader, Harry Reid, is a total disaster. He is very weak and he has almost no control of his senate caucus. Reid should immediately step aside. The Senate Democrats need to elect a new leader, someone with the hardedge political skills of the late President Lyndon B. Johnson, who became the Senate Majority Leader in 1955 when Democrats had a majority by just one vote.
· The Speaker of the House, Nancy Pelosi, is one of the most polarizing political figures in the country. She is extremely disliked not only by the House members but also by the population at large, as is evident by her very low approval rating. On most issues, Pelosi tends to be far left of the center where most of Americans are. It's no coincidence that many Democrats and almost all of Republicans in the House mostly vote against her. If Democrats elect a new Speaker, it will help them immensely to unify the Democrats and also win over at least some of the Republicans in the House.
· DNC Chairman, Tim Kaine, is the most invisible Chairman in the history of the Democratic Party. No one really knows where he is and what he is doing. Kaine needs to be more proactive in playing a leading role in bringing in the strayed senators and congressmen to the fold by using campaign money and other prerogatives as bargaining chips.

With the Democratic control of the White House and both houses of the Congress, they should be able to move on most issues simultaneously with a lightening speed, especially when Republicans are bogged down with their ideological tendencies (that most Americans don't agree with) and they have nothing new to offer. Unfortunately, every Democrat is playing his or her own tune - that's not the way to get things done. The so-called "Blue Dog Democrats" may get self-gratification by showing off their power but they should remember that they can't govern if they are not united. And if they can't govern then the American people are less likely to put them in power the next time around. The Democrats have a golden opportunity to get big things done but only if they could unify and work together for the good of their party and country.

President Obama's speech on health care was effective – the ball is now in the Congress' court

Posted by Shyam Moondra

President Obama did a good job in outlining his health care plan in an address to the joint session of the Congress last night. The speech was well crafted and effectively delivered. Now the ball is in the court of the Congress that must deliver the legislation by the end of the year.

Prior to this address to the Congress, Obama was steadily losing ground in terms of public opinion because of his aloofness from the legislative process that many viewed as exhibiting lack of leadership. Also, his inadequate engagement with the Congress led to a lot of misinformation propagated by those, primarily conservative Republicans, who wanted to kill the initiative altogether.

This is what I liked in Obama's speech:
1. He articulated clearly that something had to be done on health care this year or else the whole economy will suffer in the long-term.
2. For the first time, he talked about tort reform that is essential to stop over-prescription of tests and treatments. The doctors and hospitals tend to order excessive tests and treatments just to protect themselves from potential malpractice lawsuits. These excessive tests and treatments significantly add to the cost of health care. The trial lawyers, who contribute heavily to the Democratic Party, generally oppose any changes in the malpractice laws; therefore, it was significant that Obama brought it up in his speech.
3. His three examples of how the late Sen. Ted Kennedy partnered with the prominent Republican senators to pass health care laws for children were particularly effective. Those examples will sway the attitude of many moderate Republicans who will now work harder to pass the health care legislation this year.
4. He successfully laid to rest misunderstandings about "death panels," government plan coverage for abortions, and the government plan driving insurance companies out of business - conservative Republicans had been using these misunderstandings to drive the public opinion against the health care reforms.
5. The government option will be started in a limited way, accounting for less than 5% of the total population.
6. The reasons for making health care coverage mandatory (just as most states require all drivers to buy no-fault car insurance) were explained better than before.
7. The proposed plan will be paid for without adding to the budget deficit.
8. He stated that he was open to adopting any new innovative ideas, Republican or Democrat, to make his proposed plan better.

This is what I didn't like in Obama's speech:
1. He listed three main goals of his plan: reduce the ranks of uninsureds, stop insurance abuses, and reduce costs. During the campaign, he always emphasized reducing costs as the primary goal of reforms, which I thought was right on the mark. If health care costs are brought down, many uninsureds will be able to afford to buy insurance and thus the problem of uninsureds will go away over time.
2. His price tag for the plan, $900 billions over ten years, will continue to turn off conservative Republicans and Democrats, especially at a time when federal budget deficit is running at record levels. Most Americans think that any tax increases should be used to reduce budget deficit and not for starting a new entitlement program.

Overall, Obama's speech was very helpful to Americans in understanding clearly what he was proposing and why. I am very optimistic that his speech will prod Democrats and Republicans to work together and hammer out a health care reform bill before the end of this year. Should Congress fail to pass a health care bill this year, Republicans will be blamed for this failure and they will pay a price in the mid-term elections of 2010.