As could be expected, the issue of Wall Street compensation raised its head again. And this time there is the weight of the federal government behind it. Banks that have taken TARP money will see their executive compensation capped. And the Federal Reserve has suggested that all large banks that fall under its jurisdiction will be reviewed on on going basis to ensure that executive bonuses do not produce risk taking behavior that could put the banking system at risk.

There are several memes that get mixed up in any discussion about Wall Street compensation in the media. Add a lot of emotion from a distraught public and it becomes for a tangled mess where the media feeds the furore but there’s no real understanding of the underlying issues. Let’s see if we can parse the issues out.

These are the issues as they are played out in the media
- Issue #1 – The taxpayer bailed out Wall Street. How can they pay themselves these kinds of bonuses.
- Issue #2 – The rest of the country is going through agonizing pain – high unemployment, pay freezes and cuts – how can these people pay themselves what they do?
- Issue #3 – Their companies have been (and some still are) hemorrhaging cash. How can they pay their investment bankers so much?

I don’t think any of these issues merit any attention from lawmakers. #1 could be argued many ways but at the end of the day, if the bank has taken TARP money and hasn’t yet returned it, the federal government as shareholder with special rights, can do as it pleases. Politics dictates that compensation should be curbed and so it will be. #2 amounts to appealing to a cold corporation’s heart – a futile endeavor. #3 is the company’s call. They have a board and shareholders. If they think that they need to pay top dollar to retain talent, then that’s what they need to do.

In my mind there are two fundamental issues that need consideration. One, is related to risk increasing compensation practices. The second is a larger issue of high, untrammeled growth in the capital markets in the last two decades.

On the first issue, everyone agrees that Wall Street’s bonus bonanzas encourage traders and management to pile on the risk, collect their super size bonuses and when things turn south, leave the shareholders to pick up the pieces. And when things go really really bad, like what happened to the markets last year, let the federal government foot the bill.

What is not clear to me is why the shareholders just stand there and let this happen. The expectation that the bank is too big to fail and that the fed will bail you out, doesn’t explain it. If you were a shareholder in Citigroup and held the stock prior to the crash, even though you were bailed out, you probably lost your shirt on Citi.

I am not sure what the answer to this is. It could be that in the normal course of things, shareholders don’t really exert any influence on the board of the company. Election of board members and votes on CEO compensation, need to see a lot more vigor in the shareholder meetings, especially in the US.

Or it could be that shareholders think they’re smart and will be able to get out before the stuff hits the fan – a variant of what the trader or management thinks – except that the employee just loses her job, the shareholder his savings.

It could be that there isn’t enough disclosure. That Wall Street companies, on the pretext of not revealing proprietary information on trades and investments, is actually throwing a cloak on dodgy, heads-I-win-tails-you-lose schemes.

There could be other things going on that only behavioral economics can explain. Thinking that if everyone has been doing risky trades for so long then maybe its not that risky, is both irrational and perfectly natural.

Whatever, the reason behind it, this nexus between risk and compensation needs to be tackled head on. It is going to be a very tough problem. But not addressing it is not the answer.

The other question is also a big one. In the last two decades, the capital markets have grown much faster than the rest of the economy. The chart here shows that the profits in the US Financial sector went from about 15% of total corporate profits in 1998 to over 40% in 2007. When an industry grows at that pace, the competitive intensity is low and margins are high. The use of technology raises productivity further increasing margins. In the capital markets the only significant cost is the cost of people. When there is no or low downward pressure on prices, compensation has no place to go but up.

But is the ‘natural’ size of the industry as a share of GDP what it is today or what it was two decades ago? Can an industry that essentially allocates capital, and doesn’t really make anything, have such a large share of the GDP? Is there something in the laws of the land that make it so? For instance the credit rating industry, many say, is a creation of legislation and would not have existed at least in this twisted model of today, had it not been for an easy regulatory environment. Are there other such areas that would wilt in the face of an openly competitive field or lower entry barriers?

I don’t know the answers to these questions. But I do know that if the world has a problem with Wall Street traders, bankers and CEOs making tens of millions a year, not just in today’s recession, but beyond as well, we will need to look at taming the industry, not capping salaries. If that’s even the right thing to do. Or possible at all.

Related posts:

1. Expected Bonuses on Wall Street
2. Bonuses at AIG – Who Wrote that Compensation Plan?
3. More insiders being recruited as CEOs

In my four years at Gridstone, I met many hedge funds on sales calls. We offered a research platform with deep data on public companies which should have been of interest to any analyst who invested in public companies based on their fundamentals. But slowly I realized that there were very few in the hedge fund world that actually researched companies to any depth. Most just “traded the news” or were what is called “momentum traders”.

There were reasons for this. Understanding companies requires time and application. At about twenty companies in one or two industries, you start hitting the ceiling of what is possible for one analyst to cover. Hedge funds often don’t have the assets to be able to afford that many analysts.

But I think the real reason is that it is too damned difficult to beat the index just analyzing companies based upon publicly available information. Everyone is seeking an informational edge over the market. Some of this edge is through channel checks and such legal but proprietary sources. Much of it is through rumors – legal but quasi-public. And some of it is through insider information.

Informational edge is a slippery slope at the bottom of which lies insider information – the most alpha-producing informational edge. If you are a high achiever like most hedge fund managers are, and you have profited from proprietary information in the past, it is almost irresistible to cross the line. It doesn’t help that the difference between the difference between a rumor and insider information is only in how the information was procured. A rumor very well could have started its life as insider information. On large caps, placing a bet that is significant for the fund but small enough to escape being noticed is not too difficult. My belief is that insider trading is far more common than what one major bust every few years will make it seem like.

For Raj Rajaratnam and Danielle Chiesi this was about their hedge funds’ performance. But why did Anil Kumar and Rajiv Goel get involved in this? Perhaps the price of admission to invest in Galleon – which was ironically a fund whose performance was based on insider trading – on their tips.

The other irony here is that two of the major players in the insider trading ring are of Indian origin. So is the prosecuting attorney – Preet Bharara – US attorney for the Southern District of New York.

Related posts:

1. The Fortress IPO
2. The Rise and Rise of Private Equity
3. Indian Real Estate Funds

In the last two months I have gotten hooked on to a puzzle called KenKen. It is similar to Sudoku, but different. I never played Sudoku much so I am not the best person to do a compare and contrast. But like Sudoku it comes to us from Japan. It was invented by Tetsuya Miyamoto, a Mathematics professor.

Will Shortz of the New York Time explains how to play it.

The New York Times has other coverage, besides hosting new puzzles every day.

Try it. It’ll give you hours of enjoyment. Also, if you have school going children, especially elementary school kids, this is a good way to make practicing arithmetic or logic, fun.

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Now the airline rules are very clear and are rigorously implemented by the airline crew:

1. All Portable Electronic Devices (PED) must be switched off during takeoff and landing.
2. No wireless devices can be operated during the flight.

The second rule is pretty unambiguous in how it should apply. All cellphones, laptops and devices with WiFi – anything with an RF signal – must not be turned on during the flight. The Kindle does have a cellular signal which can be easily turned off. Not a problem – the wireless anyway drains the battery real fast and its probably a good thing that you have to turn it off in case you had it on at the time.

But the first rule is a little gray when it comes to the Kindle. I guess you could call the Kindle a PED. But then so are electronic watches and hearing aids. You don’t have to (rather can’t) turn those off. Which is why the attendants making the announcements will often describe PEDs as “anything with an on/off switch”. That takes care of excluding hearing aids and pacemakers from the regulation. But does that take care of the Kindle?

Not really. The Kindle does have an on/off slider. But the problem is that you can’t really turn off a Kindle in a way that an airline stewardess will understand. When you slide the on/off button on the Kindle the current page of the book you were reading is replaced by a sketch, typically of a well known writer like Mark Twain. Most people will see it and liken it to a screen saver which to them means that the device is on.

But the way e-paper works, it isn’t a screen saver. There is no power drawn to hold the image. From the Wikipedia entry on e-paper

…is capable of holding text and images indefinitely without drawing electricity, while allowing the image to be changed later.

What this means is that the Kindle draws no power when holding the image of a page. Only when you turn the page, do you use (a tiny bit of) power. Which partly explains why the Kindle doesn’t have a mode that will kill the image completely.

So the Kindle does have an on/off slider but it doesn’t really switch it off the way we understand electronic devices to work. I can foresee trouble if you get into an argument with an airline stewardess. I would advise shutting the jacket of the Kindle, if you have one. Or just keep it away.

It seems like a shame to have to stow it away for the 15 minutes it takes to get to cruising altitude when you can resume reading. If you are not carrying a real book that is 30 minutes of downtime every flight when you have absolutely nothing to do.

So why do you have to switch off your PEDs during takeoff and landing? This is actually an FAA regulation. An article in Slate explains

The rationale for switching off other portable electronic devices is slightly different. Even if a device doesn’t transmit a signal—think iPods, Game Boys, “anything with an on-off switch”—it still emits energy at a frequency that could, possibly, interfere with the plane’s electronics.

It seems to me that the Kindle’s intermittent power sipping can’t really pose a problem. But I seriously doubt that the FAA will make an exception for the Kindle any time soon. Oh well…

The wireless device rule (#2 above) is pretty clear, but as airlines progressively introduce WiFi on board it starts stretching the limits of credulity. The same Slate article has some explanations. But it seems like post hoc rationalization of the rules. For every time one has heard cell phones go off in someone’s bag while the airplane is taxiing, there are a thousand other times someone has left it on and it hasn’t gone off. If this was a serious safety issue, shouldn’t there be stricter policing? Or maybe it is a serious safety issue and strict policing will start as soon as the first plane crash due to RF interference occurs. I don’t know which is worse.

Photo by caribb

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The one untapped source that could easily provide the amount of money needed is the foreign currency market, which handles almost $800 trillion in trades annually, all of which is untaxed. A tiny levy of 0.005 percent on transactions involving the world’s most traded currencies — the dollar, the euro, the pound and the yen — would raise more than $33 billion annually for development, while not hurting the market or affecting the average international traveler.

Earlier this year, Bob Herbert, also writing in the New York times said

The economist Dean Baker is a strong advocate of a financial transactions tax. This would impose a small fee — ranging up to, say, 0.25 percent — on the sale or transfer of stocks, bonds and other financial assets, including the seemingly endless variety of exotic financial instruments that have been in the news so much lately.

I am actually surprised that there has not been a much more active discussion about a financial transaction tax. Politically it should be a very convenient tool. As the Senate Finance Committee wrestles with how to raise revenue to pay for health care reform they are considering measures like capping the Flexible Spending Account. While I think that FSA is a poorly designed, regressive tax deduction (I wrote about it earlier this month) it will definitely hurt some middle class tax payers. Keeping in mind the current economic situation and President Obama’s campaign promise not to raise taxes on people earning less than $250,000, it is hard to see how any such measure will succeed.

On the other hand, a financial transaction tax has minimal if any impact on tax payers. If there is an impact, in the form of reduced trading, it will be on the broker-dealers, who are not exactly popular at this time. So, in fact a financial transaction tax could be politically expedient.

What of the argument that a transaction tax will reduce liquidity and thus harm the global financial system and ultimately the tax payer? To that I have two arguments to offer.

There are countries that already have a transaction tax. India has had a securities transaction tax on equities and equity derivatives since 2004. On most equities it is currently 0.125%. India’s stock markets have not appeared to have suffered at all during this period. On the contrary they are healthy, growing and competitive.

If you take the total of brokerage commission and the transaction tax to be the ‘friction’ to financial transactions, the friction on financial transactions has been steadily (even rapidly) coming down as regulation, innovation and technology have squeezed the margins from when they were quoted in percentage points to today’s basis points. An additional transaction tax will increase the friction, no doubt, but at worst the friction will take you back a few years. At which time, the markets were functioning well enough.

What the transaction tax actually is, is worth careful consideration. 0.25% may be too high. Perhaps it should be pegged to the brokerage commission where that is transparent. Perhaps it should just be a very low tax but on all kinds of asset classes. But that discussion is possible only if a transaction tax is on the table.

The argument that minimizing friction and maximizing liquidity in financial markets is an objective that trumps all other objectives runs thin, in my opinion. Which makes it all the more surprising that law makers aren’t considering it as an option to raise revenue.

Related posts:

1. Gimme a break – a tax break
2. What’s So Difficult About a Gas Tax?
3. Company structure – Cross border issues

Such a tax would make our economy healthier by reducing the deficit, by stimulating the renewable energy industry, by strengthening the dollar through shrinking oil imports and by helping to shift the burden of health care away from business to government so our companies can compete better globally. Such a tax would make our population healthier by expanding health care and reducing emissions. Such a tax would make our national-security healthier by shrinking our dependence on oil from countries that have drawn a bull’s-eye on our backs and by increasing our leverage over petro-dictators, like those in Iran, Russia and Venezuela, through shrinking their oil incomes.

Most economists would have preferred a gas tax to the cap and trade legislation that is in Congress. But a gas tax is off the table politically. It is so off the table that there hasn’t even been a serious debate over it. So no one really understands why it is off the table, except, I suppose Washington insiders.

In the US gasoline (called petrol in most countries) costs less to the consumer compared to just about any non-oil exporting country. So why is it that the American consumer won’t tolerate an increase in the price of gas? Because nobody cares about what is the “right” price or the “customary” price of a staple commodity. What matters to voters is the inflation. Just like increases in taxes matter more than the average level of taxation. Or like in India, an increase in the domestic price of diesel leads to trucker strikes, even when the price is well below the cost of petrol. What the voter is saying is in all these cases is “I neither care nor understand what your reasons are for the price hike, I just don’t want it.”

Last year, the price of crude shot up to $140. The price of gas in the US followed suit doubling in just a few months. There was a lot of pain felt but there were no ‘tea party’ protests since (at least in the US) it is OK to be pummeled by prices set in the market. What is not OK is for the government to administer some bitter medicine in the form of a gas tax that can help lower the demand for oil providing a more long-term solution to the many ills associated with our gas guzzling habits. That is the political reality that holds back politicians from even touching the gas tax issue.

How about if a gas tax bill was designed to be totally neutral to the consumer? Whatever consumers spent on the gas tax would be returned to them in the form of say, an increase in the standard deduction. The problem with simple, flat tax ‘give backs’ like an increase in standard deduction is that it would end up hurting some consumers (while benefitting others). If some segments of the population like the rural poor bear a disproportionate share of the burden, the tax would be regressive and wouldn’t stand a chance of becoming law. Other problem areas would be small businesses where the cost of gas can be a big part of their total costs (e.g. a pizza delivery business). By the time you protect all these constituencies, the bill becomes less a simple gas tax and more a huge complex piece of legislation like Cap and Trade which is weaker and has loopholes for special interests.

Eventually, this is about guts. Unlike healthcare where there are 47 million uninsured Americans pushing for reform, there are no voters asking for a gas tax. And if you think the health insurance lobby is fiercely defending its turf, wait till you see Big Oil in action. To go up against these odds, even for something that can do so much good, needs real guts, perhaps even a bit of a death wish. It could end your political career quickly. So its no wonder that a gas tax is not on the legislative agenda.

But then how was Denmark able to slap a $5 per gallon tax on gas and make it work? Maybe they’re just smarter people.

Related posts:

1. Financial Transaction Tax
2. Pay for Performance is Difficult to Implement
3. Does Complexity Have Regressive Social Effects?

Take the tax code for instance. The US tax code is so complex it is almost impossible to deal with for the average tax payer. An example of this is the Flexible Spending Account.

The FSA is supposed to give the tax payer a tax deduction on healthcare expenses that are not covered by their health insurance. It includes deductibles, co-pays and some kinds of health care expenses that are typically not covered by health insurance.

So far there’s not much you can object to. But the implementation is where it gets tricky. At the beginning of the year the employee must elect the amount to be deducted from their pay towards funding their FSA account. They can’t spend more than what is pre-funded in their accounts. If they spend less, they lose the money!

To me this seems hare-brained. If you are expenses go way over say because of some dental surgery expenses where the copays are high, you are out of luck if you didn’t foresee this at the beginning of the year. If your expenses are well under at the end of the year, you either lose the money or in the last month go hog wild buying OTC drugs that you don’t need. Who wants to see their own money go waste?!

To finesse a benefit like the FSA and maximize your gain from it, you have to be well informed, alert and always on top of your spending data. Also, you have to be quite motivated to deal with your benefits provider on a regular basis.

There are many such examples where you have to make active decisions in order to save taxes (IRAs, 529 plans etc.). This is true not just about the tax code but almost everything in American life – from health insurance to frequent flier programs. The complexity of these things – the tax code, health insurance contracts, frequent flier programs – make it difficult for people to make the decisions necessary to get the benefit they were designed to give. Sometimes understanding how the benefit works is difficult. Sometimes taking the action requires too much time and effort. Sometimes its both.

This phenomenon is generally well understood by business and law makers. Take mail-in rebates. Businesses expect a certain redemption rate on mail-in rebates. I think it is something like an x% rebate will result in an x% redemption rate. Which means that if you offer a 10% mail-in rebate you will get a 10% redemption. I can think of other things that should matter, but the point is that the effort of mailing in the rebate form results in a large percentage of buyers not redeeming what is essentially free money.

Similarly, 401(K) plans with opt-in results in about 25% of employee not participating in the plan in spite of an employer contribution. In this case it is the lack of information or guidance that becomes the hurdle, not so much the effort to sign up. Opt-out plans are now becoming more common which on average results in over 90% participation rates.

The big problem here is that the people who tend to miss out on these benefits are the people who could use the benefits the most – people who typically don’t have a college degree and are working too many hours to spend the rest of them on the phone with their benefits provider. They can’t afford professional advice and their friends are all in the same boat.

There are other costs of complexity as well. Complexity hinders change. Healthcare reform will take much longer than it would have if people understood it better. Complexity can sometimes be introduced deliberately to take advantage of the consumer (credit card fine print, for instance). Complexity is expensive for the whole system. If the tax code was a simple progressive tax schedule with a deduction for family size and that’s all, we wouldn’t need tax accountants, most of the IRS and H&R Block and Turbo Tax.

But the biggest reason to simplify is that the burden of complexity in our tax code, health care and consumer finance is borne by lower income households. It is regressive.

Related posts:

1. Financial Transaction Tax
2. Pay for Performance is Difficult to Implement
3. What’s So Difficult About a Gas Tax?

In the Consulting and IT Services we have seen performance or outcome based pricing go through the entire hype cycle without getting any adoption to speak of. It’s not that customers didn’t want it enough or that vendors dragged their feet. It is just too hard to do. As a result, whenever I have seen pay for performance in contracts they have been in the form of bonuses that have never been big enough to impact vendor profitability seriously.

Pay for performance will be difficult to achieve in US healthcare as well. For reasons that are not very different from why they didn’t work in the IT industry. Here are the challenges:

Can you measure the outcome?
This is actually two problems in one. First you have to identify the outcome parameters and then measure it. Is it fewer visits to the doctor? Is it a lower cholesterol? Longer life? You might say that the real outcome you desire is better health, but then how do you define “better health” let alone getting around to measuring it. And isn’t improvement in health a different thing for different people?

Is the outcome driven largely by provider care?
If the outcome can improve or worsen by factors external to the care provided then is it fair to reward or penalize the doctor for it. A simple example could be a patient that does not heed his doctor’s advice to reduce his weight. There could be factors that impact health that are patient related or complete externalities, like say increased pollution in the area.

Can the outcome be gamed by the provider?
Insurance companies’ business models depend upon keeping very sick people out of their network by making insurance unaffordable for them. Will pay for performance transfer all these practices from insurance companies to the providers? Will doctors start preferring patients who are likely to remain healthy because its better for their pocketbooks?

In a healthcare system like America’s with health insurance companies and employer paid insurance I don’t believe this will work out. The place to start would be Medicare, which is a single payer system and thus less complex. If we could even make a small beginning in the form of a performance bonus for better outcomes, it would be allow us to learn more and perhaps take better, bolder decisions in time. But then physicians need to be willing participants in this experiment. But will the American Medical Association play ball?

Related posts:

1. What’s So Difficult About a Gas Tax?
2. Conflicts of Interest in Healthcare
3. Does Complexity Have Regressive Social Effects?

There are a few disadvantages of course. The biggest one is the price. At $360 or so you don’t want to leave it on the airplane! You can’t loan a book to someone else. Books with illustrations won’t offer the same experience for a while (no DC comics on the Kindle so far). You are forever tied to amazon.com as your supplier of books. Much like the lock-in that music downloads from iTunes created for the iPod until Apple also moved to mp3 downloads. Funnily, the DRM that the publishers insist on creates a lock-in that benefits the device manufacturer the most.

Kindle, and hopefully other e-books, will change the economics of the book publishing industry. I can’t say if it will be for better or for worse for the publishers (probably worse) or authors (probably better). But the readers will certainly have more choice. And this can be very, very good for Amazon’s shareholders.

The marginal cost of a book is quite a bit more than a for a music album or a DVD. I would put at about 20 to 30 %. It would be somewhat less for hard covers and technical books with specialized readership as compared to paperback and popular fiction.

With e-books that marginal cost goes down to zero. This allows the price of the book to be lower, even while (I suppose) Amazon makes a higher % margin though perhaps a similar dollar amount per book. A lower price can seriously expand the market.

Then there is the convenience. To be able to instantly gratify the need for a new book can only mean more sales of new books.

The marginal cost being zero means a few other things as well. Classics whose copyright has expired are available for next to nothing. The entire collection of Dickens is available for $1, for instance. A Raja Sharma has a whole collection of summaries of classics for around a buck each. I’m sure there are thousands of high school and college English lit students who will plump for the summary.

The reason why the summaries are interesting is much more than the genre of summaries itself, which existed before the e-book. It is interesting because it totally bypasses the publisher. The author gets a 33% cut of revenues from Amazon, regardless of the price. Amazon keeps the rest. Might this become more of a trend in the future? It just might. New authors can avoid the publisher entirely with a combination of Kindle and Print on Demand. You’d have to do your own marketing, but then if you are a new author, it’s not as if the publisher is spending millions on marketing your book anyway.

Question – are summaries of books that are still copyright protected, an infringement of the copyright? Business book summaries are regularly advertised in the Economist and given that the summary almost always will eliminate the need to read the book it seems reasonable to assume that there is some contractual arrangement between the summarizer and the publisher of the actual book. On the other hand can ‘remixing’ a book be deemed an infringement?

In an earlier post Paperbacks in India I wrote about how publishers were releasing cheaper paperback versions of books in India simultaneously with hard cover releases in the US. With an e-book release that won’t be possible, which means that publishers will lose the ability to geographically price segment the market. Which hopefully means that the book will cost less everywhere. Although it’ll be a long time before e-books become a factor in India. The readers just cost too much today. But get some real competition going and the prices should come down quickly. Maybe from Sony, or maybe these guys.

Related posts:

1. Paperbacks in India
2. Book: No Elevator to the Top
3. Open Letter to the Bollywood Music Industry

Andrew Biggs compares spending on veterinary services and healthcare spending in the US. The case he makes is that the issue with healthcare is not the rate of growth of spending but the absolute amount of spending. He presents this chart as evidence of both. But it is a totally inappropriate way to represent the data.

The first thing that the chart hits you with is that the ’slope’ of both lines is roughly the same. And the fact that Biggs’s conclusion is that the growth rate over the period is roughly the same for both might lead you to think that they are connected. But they aren’t. The lines are on different scales and so a comparison of slopes is meaningless. If you interpolate the data points, you get growth rates over the entire period of 267% for healthcare and 261% for vetcare. Close enough that the conclusions don’t change. But that’s not the point.

A chart of this kind (Y1/Y2) is the wrong choice to show similar growth rates. I could take any two time series and design the Y1, Y2 scales in such a way that they appear to be growing at the same rate. The right way of doing this would be an indexed chart such as is used to compare the performance of two stocks or a stock against an index.

Related posts:

1. More IT Services Bashing