Early in my career I remember hearing stories about a fellow portfolio manager who fancied himself an expert billiards player. He regularly trounced the salesmen from brokerage houses he dealt with when they met socially for dinner and a game or two. Then he changed jobs, to become an investment strategist for a broker, that is, a colleague of his billiards buddies rather than a client. As I heard it, he never won a game again.
Stunningly Large Losses…
I don’t know very much about AIG other than what I’ve read in the news. But the sheer magnitude of the losses AIG’s Business Products division rolled up implies operating ineptitude of heroic proportions. As my story above suggests, it’s a standard strategy for a trading counterparty to downplay his own competence and inflate your ego. After all, you trade more often and less cautiously if you think you’re outsmarting the other guy, rather than worrying that he knows more than you. But everyone on Wall Street should know this and try to apply a little objectivity in assessing business relationships and one’s own job performance. Apparently AIG didn’t.
If AIG was such a bad trader, why did counterparties overload it with losses and kill the goose that was laying golden eggs? It’s possible they saw the big bonuses AIG traders were collecting and misread the extent of its losses. It’s also possible they thought the AIG people were so bad as to be beyond saving, and that if they didn’t take AIG’s money someone else would.
..But A Bonus Plan Where Losses Hardly Counted
I’ve also just skimmed, courtesy of the government, the AIG bonus plan. (Here’s the link, if you’re interested:
Several things strike me about it:
1. The plan is called a “Retention” plan. Employees were to share 30% of Business Products’ profits, with no cap set on the maximum paid, and with a minimum guarantee. That guarantee, which presumably was the amount paid out for 2008, was set somewhat below the amount paid out for 2007.
Any realized losses above $225 million are not applied against 2008 earnings. Instead, they’re carried over to following years and reduce a given year’s bonus pool by a maximum of 30% of that number, or $67.5 million. The minimum guaranteed bonus is also reduced by the overhang of past years’ losses, again at a rate of $67.5 million per year. Given that this unit appears to have realized losses of, in round numbers, $200 billion in 2008, the guarantee shrinks to nothing in at most two or three years. The overhang of losses looks like it lives on, depressing bonuses, into the twenty-fourth century. All the plan really seems to do is to allow one more round of large bonuses, before encouraging anyone who can get another job to leave. So it is a “Retention” plan only in the sense that it “retains” a final year of undeserved incentive pay.
2. The plan is dated December 1, 2007, and replaces an earlier plan. The differences are not described. I would bet, however, the main change is that the earlier plan did not limit, as this one does, the extent to which realized losses could shrink the bonus pool.
3. Bonuses are based, not on economic profits, but on realized gains and losses, that is, on transactions that were closed out during the year. I find this very unusual. The bonus pool can easily be inflated by cashing out profitable trades and keeping losers on the books. The plan specifically states that unrealized losses are excluded from the bonus calculations.
4. It’s hard to see why AIG’s management would okay a plan like this, other than that 70% of the Business Products’ so-called profits become earnings of the parent company, on which presumably top management’s bonuses are calculated.
5. It’s also hard to see how former Secretary of the Treasury Paulson, a veteran Wall Street manager, did not hear the alarm bells that this bonus plan sets off.
An Ugly Story
The losses are huge. The bonus plan is shameful. No one in government or new management caught on. Retroactively changing the tax code may be emotionally satisfying, but it doesn’t seem to me that punishing Wells Fargo or JPMorgan employees for something AIG did helps the country a lot. A better direction of attack might be maintaining that in trying to “game” the system with this bonus plan, AIG violated its obligations to shareholders.
One more thought on the House action. Is the House really being as hysterical as its rhetoric and voting make it appear? Doesn’t it realize it is putting at risk any future private-public cooperation in rebuilding the financial system? Or is it calculating that it can be as bombastic as it wants, because the retroactive tax increase doesn’t have the votes to pass in the Senate? My guess is that our representatives are relatively unaware of the risks, but are actively betting that nothing they resolve will survive the Senate. The coming week will most likely tell.