Protecting the Moral Hazard- No Gain, Feel the Pain

Morale Hazard. Its another way of saying that Failure should have Pain attached to it. Wall Street is not stupid. While spreadsheets define financial risk, contracts define the personal pain of failure. When the financial rewards disappear or go negative, thats when the contracts get terminated or let expire. At which point any Pain associated with Failure tends to be eliminated. Here are a few steps that need to be taken in order to make sure that Pain remains associated with Failure.

1. Repricing of Options: It wont be long until we see the repricing of options in companies who’s stocks have tanked. Its another way to pump up executive compensation.  In addition to stopping Golden Parachutes, this Bill should prevent repricing of options for execs that participate.

For the rest of the public company universe, all option repricing should be required to be approved by a super majority of shareholders who actually vote .

2.  Closing of Hedge Funds: Everyone is a genius in a bull market. Hedge funds take their 20pct of profits when things are good. When things are underwater, not only do they not get 20pct, they often can’t start charging 20pct on profits until they recapture all losses. Rather than working their asses off to get investors back into the black, its not unusual for funds to close up shop.  Why work hard to get your investors their money back, when you can close the fund, start another hedge fund and start collecting your 20pct ?

Its particularly enticing after a bear market because the odds of making huge  money in the new fund improve dramatically.

The amazing part is often they will take the same investors they lost money for in the old fund, to the new fund. Why would investors follow a hedge fund manager who lost them money ? In the Hedge Fund world in a down market,  success is defined by outperforming their peers rather than actually making money. The fund manager may have lost you 20pct, but the market lost 24pct, so this is a good manager and you want to follow him/her.  So they take what money they got back in the 1st fund and put it in the new fund.

Hedge Fund Hopping is not necessarily a bad thing, however, it does encourage leverage and greater risk taking. Why wouldn’t a hedge fund manager leverage to the hilt and take bigger risks ? If it works, they make great money. If it doesn’t , you close up shop, move down the hall and do it all over again.

If we want to keep Risk and Reward, and Pain and Failure attached to inhibit future bubbles and melt downs, there should be a connection between closing a fund that has negative returns to its investors and your obligations to those investors when you start or go to manage a new fund.

If you start a new hedge fund after leaving one where the investors are in the hole within 2 years, some percentage of your profits from the new fund should go to investors of the old.

I will close with a question. Would you give 700 Billion dollars to a company whose CEO is going to leave the job in 4 months and you have no idea who the replacement will be ? Neither would I. The Presidential Candidates have to publicly committ to keeping Sec Paulson on the job (with his agreement of course), or publicly announce who will be running the 700 Billion Dollar fund, so we votes and taxpayers can vett him or her prior to their taking the job

I’m just saying..

38 thoughts on “Protecting the Moral Hazard- No Gain, Feel the Pain

  1. Comments posted by a man whom is a high school drop out, whom squandered away his wife’s & families life savings on puts/options, speaks volumes. Too bad he did not ask the questions before he wiped out a 30 yr marriages assets on options he still does not understand!!!!!

    Comment by Chris Connors -

  2. Today’s announcement is further proof that Hank Paulson is ill-equipped to run the Treasury and should be quickly shown the exit on January 20th.

    http://www.bloomberg.com/apps/news?pid=20601068&sid=aQJ5TomRjJ8k&refer=home

    Now he says that he is no longer going to buy “illiquid” assets from banks. Isn’t that the main reason “we” approved the bailout because he said that the entire U.S. financial market/industry will fail if we did not get these bad assets off of the banks’ books? This is who Congress gave $700 billion dollars to? Priceless.

    Comment by econ365 -

  3. We definitely live in times of “morale” hazard. Nice typo.

    Comment by Sam -

  4. Thank you for pointing out the flaws with hedge funds. I did not realize that but now that you bring that out it makes perfect sense.

    Comment by Habi Poguz -

  5. History wont remember Mark Cuban for his hair brained bailout schemes that wont pass anyways (yes Mark you are smart), but it will remember him for repudiating the Fed/ FDIC and advocating they be abolished or have their powers severely curtailed

    Comment by You Just Erased My Message -

  6. Bankruptcy relief. What might work and what won’t work.

    ARM loans were first created to allow banks to increase the interest rate they charged if their cost of funds increases. Greed caused banks to use indexes that caused ARM loan interest rates to increase much more than necessary, reasonable or fair. There is no justification for charging 11% or more on an existing ARM loan when new loans are being made at 6%.

    A new replacement loan is not the answer for far too many existing borrowers. While they might be able to actually make the payments, they do no qualify if you consider the home value, their (negative) equity, credit score, and the costs to refinance.

    The loan servicer cannot agree to modify the loan since, in most cases, they do not “own” 100% of the loan. Even with the Fed taking over Freddie Mac and Fannie Mae and buying “toxic” loans from financial institutions they will not own 100% of very many loans. Even if the party owning most of loan recognizes they are better off collecting 6% interest rather than charging 11%+ they can’t do much without potential liability to whoever owns the other pieces of the loan.

    The answer is to give the Judge limited authority to convert a high interest ARM loan to a reasonable interest rate fixed rate loan. This could work if the parameters were spelled out clearly so there would be no reason for a contested hearing. For example: An ARM loan secured between 1/1/2000 and 8/1/2008 secured by a single family residence, condo, etc. that has an interest rate that has been, or within 6 months will be, adjusted to more than 7.5% may have their loan converted to a fixed rate loan bearing 6% for the duration of the existing loan with their payments adjusted as necessary. This could be done without a new appraisal, title report, credit check or loan fee and should benefit many borrowers.

    However if you try to include the power to reduce the balance of the loan the plan will not work. Think this through. First, every borrower that is “under water” (loan balance exceeds what they think their home is worth) could be in a position to seek relief. Second, each matter would become a contested hearing to determine the home value and amount the loan should be reduced. There is no way the court system could handle that volume. Determining the value of most homes would be very difficult as well as expensive. It would take several years to have only a few of these resolved. If a borrower can’t afford to make their monthly payments how in the world could they afford a costly Bankruptcy lawyer and appraiser? Only the rich would benefit from this process and only if their loan was big enough to justify the expense.

    Who benefits? I submit everyone does. Fewer foreclosures=less inventory of homes for sale=sooner recovery in home values. Paying 6% interest=a better loan on the books of a bank compared to an 11% loan in default. Reduced interest rate=lower payments so borrowers can afford their payments until their home value recovers. This is a fast, simple and inexpensive solution for many borrowers that helps in the financial recovery we are all paying for.

    Comment by GrampaB67 -

  7. Mark,

    Shouldn’t we let the Saudi or Chinese offer to bail out AIG? After all they lend us the money that put us in this hole. I believe letting the countries with surplus funds take over one or two of our desperate financial firms is a great idea?

    Happy New Year!🙂

    Comment by Mitchell -

  8. mark-to-market?

    Comment by vic -

  9. We all know that once things settle down Wall Street will be
    back to the same old tricks. We need some solid oversight and
    accounting standards and there has to be some sort of pain
    associated with failure otherwise we’ll be back here again.

    Comment by Gary Lavin -

  10. Both of the candidates are not going to publicly say anything about it, because they are afraid it will cost them votes.

    Comment by Steven Rice (FOOTBALL MAN) -

  11. did you see this article?

    Banks want to shoot the messenger over fair value rules
    By Lynn Turner
    Published: October 2 2008 03:00 | Last updated: October 2 2008 03:00

    excerpt
    The reality is that the bankers are trying to shoot the messenger. They loaned out more cash than they are now collecting. If you make a loan for $100 but only get back $60, that is a problem. But when you do this repeatedly, using money borrowed in the first place, it becomes a crisis as banks run out of cash. It is the same thing that happens at home when month after month you spend more than you get in your paycheck.

    Comment by nathan -

  12. Mark keeps asking ‘Would I pay 700Billion ror???’ and his points are always valid. But I’ve been thinking about this quite a bit, and I have a new perspective. I don’t have 700B. Each taxpayer’s actual share of the 700b is about 3k. I still wouldn’t invest 3k in a company that didn’t include the safeguards Mark is suggesting. However, if it would help my country in a time of crisis, I would certainly do so. Don’t get me wrong, I still believe the suggestions Mark is suggesting are valid and important. But my investment is far less 700b and if I have to do my part, I’m willing to do it.

    Comment by Brian -

  13. Mark,

    I’ll just add that this ‘relative performance’ (meaning I may be bad but relative to the competition, I’m not THAT bad) measurement is not just in the hedge fund world, it’s pretty much part and parcel in all investing including mutual funds and state/corporate pension funds.

    As you stated recently, it is the biggest Ponzi scheme going but we’ve all bought into the fact that this is the best way to secure our economic future (retirement), so we use these measurements to pick the best schemers out there!

    PS- There are plenty of absolute funds out there to chose from too.

    Comment by Debo -

  14. “Regulation is in some sense incompatible with the fundamental role and character of hedge funds, hedge funds are designed by law [to operate] with maximum flexibility. Increased regulation of hedge funds would only destroy or at least reduce the natural setting under which hedge funds operate.”

    Comment by C -

  15. (Updated)Although there is something to be said about the “devil you know being better than the devil you don’t know;” I think that Hank Paulson is not the right man to run this $700B or for that matter fit to be Secretary of the Treasury. After coming to the Govt with 2 decades of Wall Street experience, Paulson should have been able to see this fall out earlier than he did. In fact he did see it but did not do enough. Or more appropriately, he did the WRONG thing. This is what he announced back on March 31st of this year:

    “Today I am pleased to release Treasury’s Blueprint for Financial Regulatory Reform. Or, perhaps I should say – given the last few days’ news coverage — that I am pleased to provide additional details to accompany the release of this Blueprint for Regulatory Reform. We began the process leading to this final report a year ago, in March of 2007, after convening industry leaders and policymakers for a conference on capital markets competitiveness.”

    From his own words, Hank and the Boys have been working on a solution since March of 2007! Please don’t give me the excuse of “the market has deteriorated more since then and the failure of Bear Stearns and Lehman exacerbated the matter.” That’s crap! As I said, they were looking at the market and its financial components with a microscope for over a year. You could smell the stuff that Bear and Lehman was cooking for miles around. Hank wanted to put his stamp on the U.S. Treasury, “reform” the markets, look like a hero, then ride back into NYC on a white horse. This is why it took them so long to come up with Plan A: The Blueprint. He was not interested in saving anyone’s ass unless it was Goldman’s and GS was doing just fine. Remember this speech was given AFTER Bear Stearns failed. (March 14) Plan B: The BailOut came about when he started getting calls from his Wall Street buddies telling him that Bear wasn’t the only one with shit in their pants. He talked this over with Bernanke who said his was not interested in using any of “his” money to bail out these firms, why don’t you get it from the taxpayers. Besides he had to keep the global markets calm (currency swaps) and could offer support in the form on the newly created TAF (short-term, discount special interest loan to banks) to tide him over until he gets the cash from taxpayers.

    Since this was before Fannie, Freddie and AIG, Paulson thought that he could get the job done for about $100-$250B. Once that shit it the fan, he guessed a $1T but knew that it would never pass so he pitched $700B. We all know the story from this point.

    Although this was the long way to explain why Paulson should not stay, I thought the background (as I interpreted it) was necessary. So, the next question is, if not Paulson then who? I agree with Mark about nominating this person NOW and not later and I have a suggestion: Bill Gross of PIMCO.

    PIMCO is the world’s largest bond warehouse and Bill ($1.3B net worth) has 30 years of experience and runs its biggest bond fund. Bill has been angling for this job for his firm but I would tell him that if he wants the job he must come work for the American people for $1 dollar a year with a 1yr renewable contract based on performance. He doesn’t need the money so he can focus on the job at hand.

    Comment by TomH -

  16. I emailed both my senators to tell them to vote “no” mainly because I thought it should be talked out a little more and more of the details should be out there, but they both voted “yes” anyway. Oh well. I agree that we need a long-term manager of this issue, and the whole management thereof should be very well and very openly documented.

    This reminds me, and you should know how this works, of an NBA coach who is fired in Golden State then rehired in Detroit. Um, he was fired because his team sucked. Why rehire him somewhere else? Yes, the circumstances were different, but um, his team sucked. Shouldn’t past performance give you an indication of future performance? Or does that just apply with real people?

    Comment by simply scott -

  17. Okay Mark…You totally redeemed yourself a bit here today. Maybe you just woke up on the wrong side of the bed when you had that idea about the 10cent tax/share on stocks the other day. I agree with you that hedge funds shouldn’t close to avoid having to cover losses if they are just going to open up another fund for the sake of starting in the black. Making hedge funds more accountable for their performance would cut out some of the recklessness for sure. A probation period for those who close up shop due to poor performance might be a good thing. Just don’t try to push for more tax on the investor/trader as suggested in your previous blog.

    Comment by Andrew -

  18. The glamour of wall street needs to go away. Many people on wall street are selling things to customers that they know are junk. They need to stop being rewarded for screwing people. Not sure how this gets done but it needs to.

    Comment by stone -

  19. Keep in mind that deterrents should only be used if they’re
    effective, and we should be more concerned with what we can NOW
    accomplish; we can “blame” later, as Obama tells us, but NOW
    is the time to fix stuff.

    Yes, it’s not a perfect plan but, again as Obama reminds us, we need
    to pass SOMETHING and this is the closest thing to getting passed.

    If it fails a second time, then fine, let’s go back to the drawing
    board–but as for now, let’s do SOMETHING, and once it’s passed, we
    can ALSO implement your ideas.

    Comment by the-cuban-responder -

  20. Great post. On a different note, I have been trying to invite you to a keynote speech at University Venture Fund’s summit at Salt Lake City (http://www.uventurefund.com/conference.php). The venue for this event is an olympic stadium and students from all over the country attend this summit. Students will appreciate a lot if you can come to give a keynote speech.

    I will be very grateful if you can let me know your decision at rohit.aggarwal@business.utah.edu.

    Thank you.
    Regards,
    Rohit Aggarwal
    Assistant Professor
    Information Systems
    David Eccles School of Business
    University of Utah, Salt Lake City

    Comment by Rohit Aggarwal -

  21. Your post recently have been right on. It just confirms that you are very smart and have the ability to think with a slution in mind that is fair and reasonable. I read you blog and your ideas are rock solid…but unlikley to see the light of day with this financially illiterate congress. Thanks as always Mark.

    Comment by Bill Ross -

  22. very good point in that closing paragraph.

    Comment by dc -

  23. It’s hard for me to under stand why stock options ,puts/calls,
    do not require that you actually own the stock mentioned.
    After all, this was the reason the option process was created and naked options would seem to only cause volatility that isn’t needed in good or bad markets.

    BTW- I’m the guy that said,
    “if I owned a Dairy Queen, he’s the guy I’d want running it.”
    on the Skip Bayless show on the “Ticket”.

    Comment by Bear Kidwill -

  24. One word: BLOATED. What started off as a ridiculously short, 3-page document and turned into a decent 110-page bill is now a 451-monster that has so many attachments that it has lost its initial intention. Although I didn’t read the whole thing, I don’t think that it is all bad. I especially don’t understand the need to increase FDIC insurance to $250k when 70% of Americans can barely keep $10k dollars in a bank account and if you have more than $100k and you didn’t know about CDARS then you deserve to lose your money. (or at least fire your accountant) The funny thing is I expect this one to pass because it has now accommodated everyone’s constituents.

    While we were watching the BailOut, a $634B bill was just signed by Bush with a $25B bail out going to the automakers and no one said a thing. They initially asked for $6B in January but with Congress handing out $700B, they decided to up the ante. The auto makers intend to ask for another $25B next year to follow the decline of their revenues. This is American ingenuity at its best! The managers cannot figure out how to put out a product that can compete in the marketplace but they know enough about finance to land a multi-billion dollar bail out when they suffer losses. What really needs to be change is the hiring practices of the major companies. Instead of just looking for JDs from Yale or MBAs from Harvard, they need to develop then give all applicants a common sense test.

    Comment by TomH -

  25. My fears of this presidency have all come to pass and now that most americans are at the lowest possible point, they want us to fork over billions to bail out the cause of most of our troubles? Yes, I want to see the economy prosper again, I want to see the american people making a prosperous life in the process too. Bail out the american people, those who work their whole lives to live the dream only to see it turn into a nightmare. Wake up everyone and let someone hear the voices of those with calloused hands and twisted backs, the ones who pay and pay just to be denied when they are in need and are now asked to give more??? What is wrong with this country’s leaders?!!!

    Comment by Anita Foster -

  26. Hi. You mentioned on some of your blogs about markets that you believe you have an informational advantage which is why you have been successful in picking stocks. I would be interested in what technology stocks you think will be good investments once this market bottoms if you care to share? Thanks

    Comment by Dave -

  27. Also: FASB and SEC is clairfying “fair value accounting”…stand by for even more billions to roll-up as losses as there is decreased transparency into the valuation of assets.

    Hold on to your wallet when regulators provide “clairification.”

    Comment by Terry Johnson -

  28. are hedge fund managers required to be licensed? is that license specific to the fund that they manage? how about tying some pain to that license (if it exsists).
    as far as who is going to manage the 700b, yes that should be a concern. but more important to me is who is going to be managing the assets once they are purchased. most of the mortgage companies and servicers can’t handle their own REO, how the hell is the gov going to handle it?

    Comment by Shawn Shepherd -

  29. Here a concept Mark, I read today that average CEO compensation has ballooned to 265 times average worker pay. Why not tie CEO pay to a multiple of Median worker pay. Then if the greedy bastards wanted to get rich they would have to up the average workers pay. This is trickle down I can buy into. how bout 100 times median worker pay for CEO’s and do away with all the bullshit option funny money.

    Comment by Mark Maynor -

  30. How about you don’t invest in a hedge fund you don’t trust.

    If the managers of a fund had failed spectacularly before, why would you invest in them? and not someone with a clean record and solid returns??

    The free market works.

    Comment by Hop -

  31. I totally agree with Mark on this one. Hank Paulson is a stand-up guy who has the courage and intelligence to get us out of this mess. The last thing we want is for him to leave his post. Perhaps he should be offered a percentage management fee for managing this package for us, like any other fund manager would. Perhaps 1/2 percent to 1 percent would be enough to entice him.

    Comment by Jack -

  32. Good points, Mark. Honestly, I am still unsure whether or not this bailout is the best way to go. but, i guess it’s not good enough to get voted for, anyway.

    http://www.jdiazblog.wordpress.com

    Comment by jdiaz -

  33. Re: “… taxpayers can vett him or her prior to their taking the job”. Isn’t that mechanisim alreayd in place? The new secretary of the treasury will have to go through Senate confirmation.

    From MC> Actually the confirmation process is exactly why we need to know about the candidates before then. Could you imagine what happens if/when the process becomes politicized ? We literally could have no one running the fund for an extended period of time

    Comment by nemo -

  34. I still don’t even like putting that much money into a bailout even if Sec Paulson stays another couple years. We have other options. From what I can understand about this issue I agree with Dave Ramsey’s plan here: http://www.daveramsey.com/common_sense_fix.txt

    Comment by John Mark Parsons -

  35. I’ve seen on Meet the Press that Paulson emphatically does not want to be Treasury Secretary after inauguration. I believe it was the episode that Meet the Press did in China during the Olympics.

    Comment by Derek -

  36. I would add a number (3) Private Equity firms going back to ACTUAL private equity deals and stay away from the ‘hedge fund like’ activity. (i.e. buying minority stakes of public companies) My friends at TPG took a hit ($1.35B) on WaMu, of which they can easily absorb, so I think others will be more gun shy when they get a call from a public company CEO asking for a PIPE transaction.

    Comment by TomH -

  37. I think the biggest risk by far is letting congress critters who received a ton of money from the companies that will benefit from this bill vote on it. See http://www.maplight.org/node/43109

    Comment by Jason Kolb -

  38. Not only do I think we need a commitment from a full-time Manager,
    tax payers need to be able to access the performance indicators
    frequently.

    Comment by Don Coble -

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