"A Solution to the Principal-Agent Problem"

How to solve the moral hazard problem involved in body swapping:

The Bible Meets Science Fiction: A Solution to the Principal-Agent Problem, Suggested by Lawrence H. Officer, JPE Back Cover, vol. 110, no. 1: “Next, you and the Martian Gentleman will both sign a Reciprocal Damage Clause. This states that any damage to your host body, whether by omission or commission, and including Acts of God, will, one, be recompensed at the rate established by interstellar convention, and, two, that such damage will be visited reciprocally upon your own body in accordance with the lex talionis.”

“Huh?” Marvin said.

“Eye for eye, tooth for tooth,” Mr. Blanders explained. “It's really quite simple enough. Suppose you, in the Martian corpus, break a leg on the last day of Occupancy. You suffer the pain, to be sure, but not the subsequent inconvenience, which you avoid by returning to your own undamaged body. But this is not equitable. Why should you escape the consequences of your own accident? Why should someone else suffer those consequences for you? So, in the interests of justice, interstellar law requires that, upon reoccupying your own body, your own leg be broken in as scientific and painless a manner as possible.”

“Even if the first broken leg was an accident?”

“Especially if it were an accident. We have found that the Reciprocal Damage Clause has cut down the number of such accidents quite considerably.” [Robert Sheckley, Mindswap (New York: Dell, 1966), p. 17.]

Instead of borrowing somebody's body, Wall Street borrows their money. But when they do the equivalent of breaking your leg - when they damage the deposits they are holding - they don't always suffer any consequences. In fact, many of them get to keep the large bonuses they earned for managing the money so poorly, e.g. see Krugman's latest column. A broken leg clause is a bit on the thuggish side, of course, financial penalties are more acceptable, but this does make clear the need for money managers to "feel your pain" in order to get the incentives correct.

Comments

[evagrius]

I don't think that prison is an adequate punishment.

I prefer the ancient Celtic punishment. Thos who were reckless with other people's money should be forced to recompense the offended by restitution, full restition. This would not only be monetary but also a period of labor at minimum wage for a certain length of time.

It would be fascinating to see McDos full of ex-money managers as employees flipping burgers.

[save_the_rustbelt]

There is a need for "clawbacks," the problem is defining and enforcing.

Fraud only? Major errors? Minor errors? How about investors who intentionally took large risks?

We need to do a better job of prosecuting fraud, which means we first need to do a better job of defining fraud in the securities area (did Richard Fuld's optimistic statements constitute fraud?).

[Bruce Wilder]

Breaking a second leg doesn't seem like much of a "remedy" for the first break. But, money is fungible. Transferring the loss from the victim to the accomplice, if not the actual perpetrator, (who is, all too often, conveniently dead, broke or abroad,) is not only justice, it is efficient.

[cm]

evagrius: The presumed resulting risk avoidance (at least on the part of the not criminal but merely reckless elements) will certainly inhibit a good deal of "economic" activity, both in finance as well as activities that won't obtain external financing anymore (e.g. tech startups). At least n the jurisdictions governed by your proposed legislation. But maybe that's the point.

[Bruce Wilder]

You don't have to clawback, if you don't give out in the first place.

The risk-profile limits on labor compensation just makes sky-high bonuses a very bad idea for stars in positions of power. Power has, potentially, high marginal producivity, but the kinetics tends to be bad news. Positions of power have to deliver on disinterested judgment and trust, not a pirate's penchant for desperate gambles.

[Bruce Wilder]

This seem apropos, somehow:
Hedge Fund Bail Out: "The Fed has set up something called the TALF, the Term Asset-backed Securities Loan Facility, which will offer 'low-cost three-year funding to any US company investing in securitized consumer loans' including hedge funds.

Says the Financial Times (reg.req.), 'Since the credit crisis erupted, hedge funds have complained that they cannot get the leverage they need to arbitrage away excessive spreads and meet high hurdle rates of return.'"

Sometimes, I think Ben Bernanke's whole purpose in being is just to challenge the ability of the Daily Show to parody him.

[save_the_rustbelt]

Bruce:

Unless you want to have a government compensation czar, there should be a provision for clawbacks.

Clawbacks does not apply only to the outrageous, but also to the unfair.

And I have to agree with CM on his point (see child's fable about killing the golden goose).

[evagrius]

Well, there's reckless, as in gambling in the casino ( which, it seems, quite a few investment strategies seem to consist in), and there's risk, as in investing in new viable technologies.

Further, the one making the investment should know quite well how risky the investment is. There's the rub.

[Noni Mausa]

What a treat to see Mindswap show up here. I quite enjoyed it when I ran across it a few years ago.

My favorite idea from it? "Panzaism." It's the opposite of Quixotism, or seeing the weird and romantic in ordinary life. The person suffering from Panzaism comes to see the extraordinary, the bizarre and the grotesque as normal, even boring.

As I watched the markets and real estate inflate this past few years like a Macy's parade balloon, I have had reason to wonder why so few noticed the craziness of it all, and so many had "gone Panza.'

Noni

[bakho]

Actually, you can buy financial vehicles that allow resets and guarantees against loss of principle. Of course, you pay a percentage of potential gains to the managers to do this, but it is possible.

[DW]

Well, it was stuff the 401Ks, or give the money to the government in taxes in our case.

I always figured we were screwed either way, really.
At least with the 401K I had the fun of laughing at the statements in any expectation that I would ever see any of it, and figuring out the runup in the inflation in the stock market.

[Erick]

The problem is that Bernanke and Paulson demand -- and have -- the ability to counterfeit anyone's savings at any time and for any reason.

People need to *choose* to loan their money to someone. Right now banks just ask Bernanke who *takes* it. If you loan your money to someone who cannot repay and they don't, too bad.

Rescind legal tender laws and the unconstitutional Federal Reserve act. Banks all need to all go.

[calmo]

Stumbled here slightly impaired by an NPR blurb on a "face transplant", something of a landmark in cosmetic and not-so-cosmetic plastic surgery.
But no room for "face-swapping" here as an adjunct to "body-swapping"...it appears, but Noni has rescued me in the past:"Panzaism." It's the opposite of Quixotism, or seeing the weird and romantic in ordinary life. The person suffering from Panzaism comes to see the extraordinary, the bizarre and the grotesque as normal, even boring. Zounds like Zen, rezycled zen to me and the opposite, Panzaism, that stupor after a pub crawl...not so rezyclable...that wannabe Flash in the Pan, only the pan was dirty and not about to reflect anything other than the message that housekeeping chores were lax...Damn LAX.
..but some of us cannot arise, we can't..and we won't.
Sometimes a dirty frypan is a dirty frypan, not a message.

Oh, yes, this post...and these comments: MT insisting on breaking poor money manager's legs disincentives to reduce wreckless wreckful wrecky wreckage underperforming management...of those hard-earned $ (not those sassy leveraged "funds"...no, real stinky dough) from workers (who can have their contracts over-written by Fed whim...obviating the need for unions, lawyers and mo, no?) from clients too busy to manage it themselves.
Thanks Bruce for the latest, TALF, "which includes HFs" sends me to the fridge for a beer...AND ISN'T IT CLEAR THAT THE MIN REQUIREMENT FOR HF PARTICIPATION IS $1 MILLION?...
So, adding insult to injury brazenly insulting us now that we plebs are on the mat?

[Phillip Huggan]

Yes Mark. An intergalactic society including Martians that use brain transplants and near light speed travel yet bases their legal system on the Old Testament, is certainly the easiest way to explain the dichotomy of limited liability unlimited reward.
I've been thinking vaguely of ways of allowing not-to-dangerous medical/health experiments on starving countries or long-term inmates as a way if quickening medical research and lowering poverty/prison-economy. It is an idea fraught with ethical risks. A more benign model would see extra hazard pay for dangerous (such as longevity decreasing or mentally truamatizing) jobs like coal miners, soldiers, and truckers.
It sounds morbid, but if a person is imprisoned for 5 years and unlikely to reoffend, they might be willing to submit to a medical experiment that would take 6 months off their life with no other ill effects. Don't want to subsidize wars or prison economy though, among many other ethical and economic considerations. The way capital is allocated now, to bank CEOs instead of Kenyans and Botswanans, isn't very ethical.

[bp]

a retroactive police action
of tortuous retribution

to rectify agents
of free markets

which already protect principals
from giant Ross Perot sucking sounds

with bush preemption doctrine
nip-it-in-the bud efficient markets

like the hundred dollar bills never on the sidewalks
agents uncloned from their principals don't exist

they can't - some principal would already have fired them
some sheriff would have jailed them

like Japan, the Keynesian socialists just make it worse
policing all those eyeballs and teeth with Taliban penalties

now you've gone and done it, like Amity Shlae's FDR
made it even worse with protectionism for the victims

[Alex Tolley]

This strikes me as the same argument for "aligning CEOs interests with their firms" which mean being larger shareholders, but became stock options, corrupt compensation committees etc.

Arguably, with money managers, you could have them put substantial assets in the same investment pot so that they bore the same risks and returns as their clients.

[Julio]

And the Typo of the Day Award goes to:

bakho

"Actually, you can buy financial vehicles that allow resets and guarantees against loss of principle."

(Tempting, in a Panzaist sort of way, but I think I'll stick with leg-breaking.)

[Roger Chittum]

In olden days, circa 1980, "executive officers" could not sell stock within 6 months of exercising options. If the stock price cratered within 6 months after exercise, they could lose all the spread. Wasn't a rare event. Then the rules got changed to allow immediate sale upon exercise, totally eliminating the exerciser's market risk. A good start would be to restore the old rules.

[Bruce Wilder]

RC: "In olden days, circa 1980 . . . "

It's remarkable the extent to which, in "olden days" (before 1980), people seemed to have a grasp on risks and rules, which we subsequently lost.

What happened in 1980?

[Roger Chittum]

BW: Not a particular incident in 1980, but ramping up to the 1980 Presidential election we had supply side economics, "only money matters," free market fundamentalism, "create shareholder value" by manipulating the balance sheet without improving operations, the worship of entrepreneurs and investors, and the shifting of tax burdens from wealth to working, followed by globalization, the Washington Consensus, and the general financialization of the economy. With the election and reelection of Reagan, these memes became "conventional wisdom.”

[Alex Tolley]

Roger: "If the stock price cratered within 6 months after exercise, they could lose all the spread. "

You don't need to sell on the liquidity event. A brokerage firm can construct a put option as insurance for the top executives and may even roll the cost into the banking fee. This leaves everyone else in the company at the mercy of the market, a common event with dot.coms.

[Roger Chittum]

AT: Good point, but in the olden days options were available only on a few companies. So if we restore the 6-months rule, we have some loopholes to close. The sanction was the insider trading sanction--that all profits from the transaction were forfeited to the Company, and a shareholder could push the matter in a derivative action. I don't recall if insiders now have to report option transactions on their monthly Form 4, but that should be required.

[cm]

evagrius: As for reckless vs. taking calculated risks, the problem that STR already alluded to is that there is no objective definition of where the boundary lies. A related problem is that investing usually works through intermediaries (the people with the money usually don't have the expertise to evaluate investment opportunities, and/or prefer to leave managing that to others, and/or funds from several investors have to be bundled), and it wouldn't be the first time that disappointed absentee investors sue their agents for negligence or malfeasance when the expected returns don't materialize.

That's not to say that useful classes of financial transactions can't be identified for more stringent regulation and liability.

[evagrius]

cm- which is why Madoff made off with so much.

The onus is partly on the investor to check on the validity and veracity of the firm entrusted with funds and the firm itself to check the validity/ veracity of the possible investment.

That's obvious.

But when outright fraud, as with Madoff, is evident, and there was a laxity, indeed outright laziness on the part of investing firms, then I think the Celtic model is quite applicable.

[Noni Mausa]

calmo appears by his frenetic typing to have been cebrelating, as have I. A nice potluck toniht, with a chocolate fountain, for heaven's sake.

That is all. See you tomorrow, happy solstice,

Noni

[Lafayette]

The devil's handiwork

First, I submit, is required "due process". Without this, there is no indictment and therefore no trial.

Ours is a land of law -- which is sometimes hard to believe, but true nonetheless. This present instance (SubPrime + Madoff) shows the full extent of that notion.

We can't throw "all of them" in jail, simply because the mess stinks to high heaven. It would be nice, however, to see some perp walks on TV. It will be difficult, nonetheless, to show "cause for indictment" in many, even most cases. The avarice was so pervasive, it was like breathing air.

Footage of Madoff plying the streets of Manhattan in a carefree manner after his indictment went up my left nostril. He should be sleeping in a cell. And, anyone found guilty should be banned forever from the Finance profession. Of course, this is what happened to Miliken and Boesky (et al) ... and what good did it do?

No, an ounce of prevention is worth a ton of cure and banishment from the profession or even hanging from the you-know-whats.

Talk about the devil's handiwork ... this one was biblical in its proportions. This country is not only in an economic crisis, but a moral crisis as well.

Be all you wannabe! Even a crook! Hey! It's a free country, aint it?

[ScentOfViolets]

Interesting - I read 'How to solve the moral hazard problem involved in body swapping' and immediately thought of this classic. Probably because Sheckley remains one of my favorite authors. Some of his stories are more than fifty years old . . . and still readable.

Anyway, I'm posting because of another relevant bit in the same book. Early on, Marvin is warned to watch out for 'metaphoric deformation' during his travels. Metaphoric deformation, he is cautioned, is the perceptual danger of blurring the line between X is like a cow, and X _is_ a cow. Of course this happens, with Sheckleyesque consequences like confusing a large telepathic beetle for a saddle bum.

In the real world, it seems that metaphoric deformation has happened on a grand scale, with not so amusing consequences, and worse, it was deliberately self-induced.

[Meh]

Deal Journal - WSJ.com : Is It Illegal to Pay Out Wall Street Bonuses In Junk Bonds?

http://blogs.wsj.com/deals/2008/12/19/are-junk-bonds-for-wall-street-bonuses-illegal/

Credit Suisse yesterday announced a bonus plan for 2008 that, depending on whom you ask, is either brilliant, or heartless, or heartlessly brilliant.

But is it legal? Deal Journal asked employment lawyers, who believe the plan might meet with some serious legal challenges.

Credit Suisse's plan is a simple, if creative, flip to the usual cash-and-stock bonuses that bankers usually get. The cash portion of investment bankers' bonuses-usually about 50% of a total bonus-will be subject to a "clawback" provision that will allow the bank to take back 2008 compensation if a banker leaves the firm within two years. The stock portion of bonuses will be mostly replaced by interest in a new "partner asset facility," or PAF, which will consist of leveraged loans and commercial mortgage-backed securities that the bank cannot currently find buyers for.

The PAF plan was scorn from Credit Suisse investment bankers, who were angry about having the bonus system changed drastically just before they expected to cash in. "Who the heck knows what this is? It's a bunch of junk that they can't move in the market, and they're handing it to us. To me, it's worth zero. It's two lumps of coal and I was looking for the gumdrop," said one. "How many different ways can they tie you to the firm? At some point, you have to decide you actually want to work here. It's stick, stick, stick, and where's the carrot?'

[Lafayette]

Moral hazard

There is no sure-fire way to assure that some people do not manipulate a market to their own benefit. That has always happened and will continue to take place.

What must be avoided is the winner-take-all mindset that overcame this nation, nor just in the corporate office or on Wall Street. Any individual who could willingly sell a predatory credit-agreement to someone who was patently non-creditworthy was indulging in fraud. Regardless of their self-exculpation with "Well, everybody was doin' it!"

Everybody committing fraud does not make fraud honest. Never has, never will. Where were the ethics classes in MBA-school that taught this simple notion?

The more egregious lapses into criminal activity should be punished, yes. But, I maintain nonetheless, with which I will bore you once again, my conviction that the only way to deal definitively with cupidity in high-places is to neuter its motivation -- by extraordinarily high marginal taxation.

Marginal tax rates never, never should have come down so far. Lowering them was like giving a license to steal in high places where the amounts of compensation involved had become stupendous.

There is no need, economic or personal, for such sums in compensation, they are so blatantly excessive. A legal framework is necessary to surround any activity that allows compensation to be managed by a select few within any publicly owned company. Shareholder property rights are being trampled upon. Stock options exercised are compensated for by lower market valuations, since they increase the supply of stocks on offer. Of course, in up-markets the loss is not seen, but that does not make stock-options fair to shareholders who had to purchase theirs at the full price.

As for Wall Street, the system of commissions must be reviewed, since clearly risk has been detached from capital ownership. We clearly need to reward motivation. Arbitrage Risk, however, is altogether another matter due to its uniqueness. One does not conduct arbitrage without taking risks; it is intrinsic to the operation. Exaggerated returns, however, are not due to arbitragers in the form of commissions, but to their employers. These should be taxed as corporate profits and not compensation.

We cannot avoid Risk Management in a capital markets, it is the very nature of the beast. We can avoid it getting the better of us, however.

[save_the_rustbelt]

I would point out that many of us did not get greedy, did not entrust our money to crooks, and consider risk-vs-reward very carefully.

As did many on Wall Street.

Problem is, a few at the top were able to create a massive tipping point, as a fat kid jumping on the teeter-totter with the intent of sending the little kids on the other end flying.

We need to be able to police the evil and the greedy without putting everyone in the stockade.

Not an easy task.

[Lafayette]

Yes, it's really Tough Times for our friends on Wall Street.

Poor things, just look what they must put up with (NYT, 18DEC2008): At Goldman, for instance, partners who were paid $12 million to $15 million last year will be paid $3 million to $4 million this year — an 80 percent reduction, people briefed on the matter said. But everything above $222,000 of those lofty sums will be paid in restricted stock and stock options. Workers at Goldman who are not partners could receive more than that amount in cash in their bonuses.

Just 3/4 megabucks. But only stock options above $220K! That must really hurt Top Management! There goes the Christmas hope for new His & Hers Ferraris ...

These people must be born catlike. Throw them down a deep pit ... and they will still land on their feet.

[Lafayette]

Yet another story of how bad, bad, bad it is for our Wall Street Golden Boys, here.

[Lafayette]

Vladimir's revenge (Act 2)

And now, finally, even Russian Oligarchs are feeling the pinch. The news gets better by the day.

Just look at the conditions that Putin is seeking. Quick, somebody tell Paulson to have a look see to understand how its done. Entitled, "Bailouts for Dummies": Vnesheconombank, the Russian state lender known as VEB, is responsible for handling the bailouts. In return for one-year loans, VEB is requiring a representative at the company and the right to veto any debt or major asset sale, according to the bank’s Web site. Putin, 56, is head of its supervisory board. Borrowers offer shares, assets or export revenue as collateral.

“It’s extremely unlikely they’ll all be able to repay in a year,” said Zina Psiola, a money manager at Clariden Leu AG in Zurich with $220 million in Russian equities. “Some oligarchs will no longer be oligarchs.”

Oh, that does cheer the heart, doesn't it.

Talk about clawback? No, just do it.

[Eric Dewey, Portland, Oregon]

Fine in theory, hard to carry out in practice - as witness the legal wrangling over the concepts of the "fiduciary duties" which Boards of Directors owe to a company's stockholders.

Which regulator would you trust to break legs? Sheila Bair's the only one that seems willing to even contemplate it.

[GeorgeNYC]

This is not really that hard. Put simply, certain types of risk-taking should be off-limits for limited liability corporations. Such liability limitation is a grant from the State and not an inalienable right. It was designed to encourage investment in capital-intensive ventures that provide a benefit to society as a whole. Not as a shield for thinly-capitalized entities to basically steal from others by taking advantage of temporal arbitrage.

it may mean smaller entities but certainly more focused employees.