Risk, Disaster and the Windfalls of Wall Street


Nero fiddled while Rome burned. James Cayne, the chairman of investment banking giant Bear Stearns, would have played bridge. In fact, earlier this month, with Bear Stearns about to go up in flames, the 74-year-old Cayne did play bridge -- at a national tournament in Detroit.

Cayne could afford to be somewhat nonchalant about his company's future. His future will forever be secure. As Bear Stearns CEO -- he stepped down this past January -- Cayne pocketed over $232 million in compensation.

What did Cayne do to earn that excessive sum? He helped create what Nobel Prize-winning economist Joseph Stiglitz last week called "the worst financial problem we've had since the Great Depression."

America's top business journalists spent their last week trying to explain just how that problem evolved. By week's end, a consensus of sorts had emerged. Wall Street investment houses, analysts seemed to agree, had routinely flouted prudent business practices. They had followed, as Fortune magazine charged, "a highly flawed business model."

"Put simply," says Fortune, "Wall Street firms used towering leverage to make tons of money in a long-running bull market that blatantly underpriced risk."

The risk should have been easy to see. Shaky subprimes made up just 17 percent of all new mortgage loans in the year 2000. By 2006, researchers at First American CoreLogic calculate, subprimes constituted almost half, 44 percent.

Why didn't Wall Street's financial wizards recognize the obvious risk in those numbers? They were too busy counting their personal windfalls -- and angling to generate even more.

"I blame the system, I blame greed," as Stephen Raphael, a former Bear Stearns board member, noted after the bank's collapse. "Wall Street is really predicated on greed. This could happen to any firm."

Wall Street's "legendary largesse on pay,"Fortune adds, encourages "outrageous risk-taking" and "swashbuckling behavior."

That largesse cascaded magnificently at Bear Stearns. Over the five years from 2002 through 2006, James Cayne and his four top Bear Stearns executive buddies amassed $620.8 million in paychecks and perks and, reportsBusiness Week, another $296.4 million cashing out their shares of company stock.

Rewards this outrageously mammoth, analysts note, give executives the incentive to behave outrageously. And some lawmakers are taking notice.

"It's time to revisit the issue of top executive compensation," Rep. Barney Frank, the chair of the House Financial Services Committee, contended in an interview last week.

The "large amounts of money" pouring into top executive pockets create "perverse incentives," agrees Frank, who's musing over introducing legislation that might require executives, says the Boston Globe, to somehow "pay back money when bets go wrong."

Other analysts want executive bonuses only awarded when "firms are profitable over a sustained period of say, four or five years, not a single year," as Fortune editor-at-large Shawn Tully proposes. The New York Times applauded this approach in an editorial last Friday.

But making bankers "perform" over a longer period of time before they can collect windfall rewards would have done nothing to prevent the Bear Stearns debacle. James Cayne and his fellow power suits did generate profits over a "sustained period." Year after year, they laid big bets on shaky subprimes -- and won. Until they lost.

Bankers will continue to make those big bets so long as they have a financial incentive lush enough to make the risks worthwhile. Capping how much executives can make could, of course, limit just how lush incentives become. But last week's Times editorial on excessive executive pay explicitly rejected anything that smacked of capping.

"Trying to put specific limits on bankers' salaries," the Times intoned dismissively, "is a nonstarter."

Not to Andrew West, a veteran Australian journalist. People worried about excessive pay, West suggested in his Sydney Morning Herald column Friday, might want to "consider reining in executive compensation using a handy little instrument called tax."

Executives ought to pay regular taxes, West believes, on all their pay that runs "up to 15 times the wage of the lowest paid, full-time employee" in their company. But executives with compensation that crosses that 15-times threshold should pay in taxes "95 cents on every dollar thereafter."

Bear Stearns Chairman James Cayne won't likely spend much time worrying about proposals like West's. Two million American families may soon be losing their homes to foreclosure, but Cayne still has a roof over his head. A new one. Cayne, the New York Observerreports, has just bought a $25.8 million Manhattan condo.

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