Wednesday, April 1, 2009

Financial Literacy, Financial Institutions and Bonuses... Round 2

We've learned again abut a new harsh controversy involving American International Group (AIG) and the bonuses (around 165 million dollars) the company gave to several executives after receiving billion of dollars from the US Government in order to continue operating despite the huge losses the company had during 2008.

During this controversy that contributed to fuel a widespread anger (even President Obama criticized those bonuses), AIG executive Stephen Blake -a divisional head of Human Resources- argued that those bonuses were necessary to "keep valuable employess". In addition, even NY Attorney General Andrew Coumo intervened to investigate this issue. More recently, AIG Chairman & CEO Edward Liddy, offered explanations before a Congressional Committee about those bonuses and assured that the money would be returned.

We've also witnessed a rather peculiar outcome: AIG Executive V.P. Jake de Santis published his resignation letter denying his involvement in any wrong action:

What should the public think about this particular event and its financial and political impact on Wall Street?

Let's consider watching the following two videos; I'm trying to contribute -yet modestly- to create a bit more complete view about this subject not in political terms but in informational and financial literacy terms:

The first video refers Phil Donahue interviewing Milton Friedman about his ideas on free markets as well as governments not interfering and the second one, refers Mr. Edward Liddy testifying before a US Congressional Committee where he tried to justify bonuses to AIG executives.

Even though free markets should work without any interference, given the global financial mess we're grappling with, its outcome and effects, it's also clear (at least in modest opinion) that Mr. Friedman's thoughts could not continue applying nowadays because financial regulators must review what they've been doing to correct their own mistakes (and banker's of course) and become more efficient regulatory entities (and in the process have banks also correcting their own mistakes); free financial markets can't be exactly "free" -for a while- as long as the global financial mess is here.

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Financial Culture / Cultura Financiera
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Ray Lindsley said...

I feel it is necessary to express my perspective on the AIG bonus issue, though it is not likely to make me many friends. The most important thing to make clear is that these were retention bonuses, not performance bonuses. As AIG CEO Liddy stated in his testimony before a Congressional panel, AIG needed to unwind $1.6 Trillion in very complex derivatives over a period of time in a way that would not cause them to blow up and send shocks that would further damage the world’s financial markets. He felt the traders that put these derivatives together were the only ones that could safely unwind them, and the $165 million was worth the mitigation of the risk of the unwind operations.

Let me explain how retention bonuses work by relating my own experience with them. I was SVP and general manager of the broker dealer subsidiary of private bank/wealth manager. When that bank was purchased by a much larger bank about two years ago, a decision was made to close my broker dealer. Obviously, this would mean that my position would be eliminated. Our new owner decided that my involvement in the dissolution of the broker dealer was critical, and as a result I was offered a retention bonus. The contract I signed stated I would receive the bonus if I remained with the firm for a year to close the broker dealer. Any employee in their right mind would start looking for a new job the minute they find out their position is being eliminated. Retention bonuses are frequently offered to employees that are considered critical to operations, and they must be substantial enough to provide financial security to that employee to entice them to stay on.

As Liddy testified, these traders knew that their positions would be eliminated, and the retention bonuses were offered to keep them from leaving until the derivatives were unwound. If these traders were the only ones that could safely perform this function, and they did so successfully, I believe they deserve the bonuses they were contractually promised. However, I do believe that from a moral perspective, they should not have needed the bonuses to undo the damage that they had done.

I think the House legislation to tax 90% of bonuses for firms receiving more than $5 billion in TARP money is an egregious overreaction. Legislation made in haste and anger is never a good idea. We are experiencing a lynch mob reaction to these bonuses without an understanding of the purposes for these bonuses. During the Congressional hearing, Rep. Barney Frank confronted Liddy about the bonus contracts, and Liddy pointed out that Frank was reading the performance bonus contract, not the retention bonus contract. Most people do not understand the distinction. Many are protesting that some of the bonus recipients have already left AIG. How do we know that they did not already complete the unwinding of the products they created, thus completing their contractual obligation?

We need to stop the rhetoric that is fueling the lynch mob mentality and knee-jerk reactions that are so counterproductive. This is beginning to turn into a class war, and that will not help anyone. It is not Main Street versus Wall Street- their interests are one and the same. We need to step back, take a deep breath, and investigate the situation before taking any action. If Liddy’s assertions hold up under scrutiny, it is entirely possible that no action is warranted. I believe that Liddy did the right thing by asking for the bonuses to be returned, and the traders should do the right thing by complying with the request, but the retroactive tax legislation is unconstitutional and absurd.

Mario P. Lopez said...

Dear Ray,

Thank you for a very complete explanation about AIG and its bonuses.

This is in fact a complex issue considering the concrete factors that Mr. Liddy explained to Mr. Frank about the nature of these bonuses during the hearing (I wonder if Mr. Frank understood the explanation he was given...)

The importance of your explanation, deserves not only a reply; I think that the most reasonable thing to do is working on a next blog post on this particular issue based on the information already available making obvious emphasis in your explanation.

Looking forward to talk with you again.

Thank you very much.