Fund Managers Still Don't Outperform

Fama and French have a new paper out on the ability of stock fund managers to outpredict the market. Short answer: no. In their words, 'we cannot reject the hypothesis that no fund managers have skill that enhances expected returns', even after adding back their explicit costs.

Alfred Cowels came out with a paper on stock market professional predictive ability back in 1933. His paper was titled 'Can Stock Market Forecasters Forecast?' His conclusion then: "It is doubtful". It is one of the seminal works of the Efficient Markets Hypothesis.

Active fund managers are still way more popular than passive funds. At least, fund manager commissions no longer have a 8.5% load as they did until the 1970's. Index funds really took off in the 1980's, but still only have about 20% of the market. It is interesting that after such a long, consistent documentation of the failure of mutual fund managers, most people prefer to pay extra to add the idiosyncratic risk of the fund to their equity allocation.

Alchemy of Finance

I was reading George Soros' book, the Alchemy of Finance, and was impressed by the fact that it has a Foreward to the second edition, a foreward to the First Edition, a new Preface, and a new Introduction. That's a lot of throat clearing.

Getting to his big insight, he posits to key 2 assumptions to reflexivity:
1) markets are biased in one direction or the other
2) markets can influence what they predict

Now, reflexivity is Soros's Big Idea, but I find it rather unexciting. Point #1 basically says markets are unbiased. Unless one can identify the characteristics of an upward bias, as in contrast to a downward bias, that is just a description of asset price fluctuations. That an efficient market researcher would say the asset price has a return equal to the risk free rate plus white noise, is observationally equivalent.

Many critics of efficient markets point to price changes as evidence this theory does not work. Only if one is offering a theory on the particulars of a bubble ex ante, without hindsight. Otherwise, its just another lament on our inability to predict price declines.

Observation #2 is true enough, just think about asset prices falling, leaving to insolvent banks, which creates a multiplier effect. But many models have that mechanism, where a crisis in confidence create self-fulfilling implosions. I think Soros' own experience pushing down the pound during the 1992 European Union currency crisis makes him think this is a bit more radical than it sounds. There are 'bear raids', and these happen, but they usually happen only when there is fundamental weakness. That is, Soros selling the pound in 1992, or John Paulson selling mortgages in 2007, would not have worked if these assets were not also inherently overvalued at that time. I think he gives his correct calls too much credit in creating their own success, as opposed to 'merely' forecasting them.

So, the latter observation could be interesting, but his mechanism for how speculators can create what they predict needs more structure. It's plausible, and surely every price bubble has its share of enthusiastic bulls on the way up and bears on the way down. But it is not clear to what degree they are conspicuous statistical correlates irrelevant to the process.

Lots of really smart people have pet Big Ideas. These are usually pretty lame. Of course, it's a high standard, a Big Idea, as there aren't a lot of new, true and important ideas out there.

Obama Might Allow GM to go Bankrupt

Great news. It would be nice to actually see a big company fail. Currently, GM bonds trade at an average price of 18 cents on the dollar. This would not shock financial markets. Anyone lending to them already has taken a big hit. The stock trades at a value of $1.7B, on $91B in assets--option value. Implied vols are around 220%, the short rebate is about -87% (you pay 87% annually on the proceeds generated from a short sale).

Thus, it's already dead. Bankruptcy would not 'disrupt' the firm, it would clarify the situation.

AIG Trader Writes Letter

Jake DeSantis explaining why he feels entitled to a $740K bonus (after tax!) rings a bit hollow. This article takes it apart pretty well. Basically he tells DeSantis:

1) There are only 400 employees in the AIGFP, with two offices. The statement you knew nothing rings hollow, because with that much money flying around, people talk about how it was made ($3.5B in last 7 years doled out to those 400 employees).
2) If you did know nothing, there is no reason to pay you $1MM to unwind these complex deals, which is supposedly why you are getting the big bonus.
3) You analogize that your plumbing work was ruined by an electrician that burned the house down. The plumber should still get paid. Not if they work for the same company.

I wish the government just let them fail, and we could avoid this. A capitalist can't whine about government messing with the free market when he is getting a bail out. Further, the AIG contagion effect is based on a domino theory that I do not buy. If you take out a bookie, don't be scared by notional obligations because the cancel out.

Is the Market Better than Regulation?

Someone asked if the market also would fail Geithner's objectives for new regulations. Surely not, if we define 'to serve, protect and reward' sufficiently. But the key point is regulation is rarely effective at what it supposedly does, just think about NYSE floor traders who screwed investors for years via their monopoly control of stock market trading for decades, and the lack of competition on commission until the 1970's, all while there were these 1930's era regulations that supposedly protect the investor (the SEC acts of 1934 and 1941). Public regulation enhances the ability of insiders to fleece the public because that's what happens to regulation, insiders use the regulations as barriers to entry, and write them for that purpose. Rahm Emmanuel types, the kind who make $13MM in 3 years while out of government, make regulation work for them. Those who merely try to innovate and compete, are an annoyance for the elites who hypocritically always talk about helping the poor stiff while making sure they are lining up patronage jobs for their cronies. Fannie Mae and Freddie Mac made a fortune for political hacks for decades, always for the pretext of helping the poor and historically under served.

The Market is filled with self interested people who have to convince people their service is actually better than its alternatives and is worth the cost. Regulation is filled with self interested people who simply tell people what to do. The most uncompetitive market is nothing compared to a legal mandate.

The chief difference between the market and regulation is that under the former a man pursues his own advantage openly, frankly and honestly, whereas under the latter he does so hypocritically and under false pretenses.

All this hullabaloo about mortgages ignores the fact that this mistake will not made again in our lifetimes. It will be a different mistake. Thus, we are now hiring thousands, and writing pages of regulations, specifically targeting spilled milk. This is just a waste of time.

Geithner Calls for Better Regulation

A bold stand, up there with a call for better health care and education.
Timmy's spreech contained this nugget:

To address this [crisis] will require comprehensive reform. Not modest repairs at the margin, but new rules of the game. The new rules must be simpler and more effectively enforced and produce a more stable system, that protects consumers and investors, that rewards innovation and that is able to adapt and evolve with changes in the financial market.

When was the last time government implemented regulations that met these criteria?

Is 'Experienced Mortgage Expert' an Oxymoron?

This week's Treasury plan notes 5 criteria for new investors in the PPIF, including this one:

2) Demonstrated experience investing in Elgible Assets, including through[sic] performance track records

Now, if there were investors with experience in mortgage backed securities (the Elgible Assets) with a thorough track record, what are the odds they were drinking the Kool-Aid about mortgage innovations? No money down, 'outdated' underwriting criteria, record increases in housing prices, etc., and nothing sounded an alarm. These are the guys we want to save us?

Most of us can comfort ourselves that we weren't in the business of looking at mortgages. The mortgage crisis caught us by surprise but we had no reason to really examine mortgages or housing price data carefully, other than to note anecdotally stories about housing prices. I think it is wrong to assume, with hindsight, this was an easy bubble to call. More likely, savvy people looking at this figured something did not seem right, so merely choose a different field because in general it does not pay well to be short, either as an investor, or attitudinally within an long-oriented organization or group. I imagine most who thoughtfully examined the trends merely weren't in the business of buying MBS as opposed to shorting them. But if this was your full time job, you have demonstrated a very large error in your analytics, because you were almost certainly a bull throughout. Surely a small portion got out, or went short, but of those who match the other Treasury Criteria (eg, you have $10B under management, and can fill out paperwork by April 10) and whose stock rose dramatically anticipating a huge government subsidy (eg, FIG, BKCC, JNS, EPHC, BX), they were the guys who screwed up!

Like a Sovietologist circa 1990, a Y2K expert in 2001, or an Internet Fund in 2003, there are times when your profession showed a complete lack of ability to capture the Most Important Thing in the subject of their expertise. If you were not considered a screwball renegade before events made things obvious, you are a fool, fraud or dup whose experience is damning. An expert would more likely be someone in a related asset class, not the class in question.

Not the Time to Own Good Junk

Currently, high yield bonds (aka junk bonds) have spreads of around 1200 basis points to Treasuries, though that is a rather unfair benchmark given that AA rated bonds trade at about 300 basis points to Treasuries. The graph is from Markit's B-rated bond index. Note spreads are 17%, which is insane. In today's crazy markets, everything is suspect.

But these securities trade with very large bid-ask spreads, many at 10 points. With a median price of around 68, that's a 15% loss if you buy Monday and sell Tuesday. This kind of bid-ask spread makes relative value trading impossible, because it is simply too expensive to go long and short a large number of securities and make money off any edge in forecasting future performance (even ignoring the difficulties of shorting many HYBs). Any reasonable relative value edge simply cannot overcome the costs here, because while if you pick and choose one bond, you can be patient, if you have to go long 30 and short 30, you will have to cross that spread a lot.

The only reason to be long a high yield bond is thus either 1) if they have a really good feeling about one particular company or 2) it is part of a basket of long HY Bonds. In the second case, going long HYBs as a sector, it is probably cheaper to simply buy a junk bond ETF (eg, JNK or HYG). Any edge in relative value would probably be eaten up in the idiosyncratic costs of overhead, bonus, and transaction costs. The only ones putting relative prices in place are those taking one-off bets, or the effect of tilts with large long-only portfolios. But here's a problem. If you are long a portfolio of HYBs, or a particular HYB, you are bullish. If you are bullish, you are expecting spreads to contract, prices to rise. The crappiest HYBs will rise faster than the better ones, because they are most distressed. In 2003, the best performing HYBs were the worst as measured by most objective models (eg, Merton Model, defprob). Similarly, one could have noted that in 2003 those bonds with the lowest prices rose the most proportionately--they have really high betas. This was a situation I was monitoring very closely at the time because I was contemplating a HYB strategy (luckily for me, I didn't implement it for reasons outside my control).

So, currently, as spreads are at a historic max, I think it would be imprudent to be long the better credits. Only in good times or the beginning of a recession, is it good to be long the cream of the crop.

I Love My Commenters

... but only in the way I love hot dogs. Ann Althouse recently got engaged to one of her longtime commenters.

Shiller Did Not Call the Bubble

In Shiller's Irrational Exubrance, 2nd edition, there is a section on the housing prices, and a graph showing housing prices rising. But there are literally pages of qualifications, about how this price rise cannot continue, but not much about housing prices falling much in nominal terms. I was struck by this graph from a blog that seems spot on. Unfortunately, the book had a picture that did not have anything after 2004 (see below), the prices just go up, so there's a healthy bit of photoshopping going on. I've seen him introduced various times as calling the housing bubble. If you actually read the book, you read about how “In cities where prices have gotten so high that many people cannot afford to live there, the price increases may start to slowdown, and then to fall. At the same time, it is likely the boom will continue for quite a while in other cities [page 206].” That's economese for prices are expected to fluctuate.

Bad Assumption More Than Bad Intentions

I listened to a bloggingheads by Bill Cohen, a former investment banker who wrote House of Cards. He seems to blame this on hubris, not understanding risk, taking too much risk. All true, but that's with hindsight, and there is little one can learn from that diagnosis because I doubt hubris, ignorance, and short-sightedness are in any company's mission statement. Many commentators note that there was significant 'moral hazard' caused by short term bonuses, as basically bankers were putting on trades that had zero or negative net present value, but paid a positive return over long periods. Think of a high yield bond that pays +1, +1, +1, +1, +1, -5. If you get in on that early, and lever up, by the time it tanks you have banked several healthy bonuses and shareholders and taxpayers are on the hook.

The problem with this line of thinking is that I have worked in banks and hedge funds, and never have I known those making the ultimate decision to ignore the over-the-cycle present value. They are often wrong, but even if a lower-level guy is trying to game the system this way, when the strategy or trade is pitched and discussed, it is over the cycle. When every bank is in on the same trade, it's not like everyone is being duped, rather, its a really subtle, powerful intellectual error. Some people were cynical opportunists--those pushing NINJA loans, turning the knob to 11--but generally I think people were just sincerely incorrect.

Thus, I do not see moral hazard as the main driver of the disastrous risks taken, rather, a collective, economy-wide underappreciation of the credit risk in residential mortgages. You had 200 full time regulators looking at Freddie Mac and Fannie Mae who never wrote about credit risk prior to 2007, and regulators had no big bonuses. Further, most of the investment banks retained significant exposure to the AAA rated pieces, so they weren't playing those they sold to--they believed it. It wasn't bad intentions, it was an honest error that seemed to hit almost everyone.

Kids think everything happens because of will. Bullies bully, storms rain, and rocks fall because they are like cartoons where everything is alive and has intentions. Unfortunately, bad things are usually the result of ignorance, though with hindsight every bubble has hubris almost by definition.

Prospect Theory Explains Everything, Nothing

I was reading this quote from Kahneman and Tversky, and found this part very revealing:

Low probabilities, however, are overweighted, and very low probabilities are either overweighted quite grossly or neglected altogether, making the decision weights highly unstable in that region.[page 8, Choices, Values and Frames]

Given this definition, I don't see why this theory is considered useful. If a disaster happens that seems to cause a lot of angst, one can say it was underweighted. If someone is paying a lot for insurance that seems to generate a positive return, one can say people are overestimating this risk. Ex post, the theory explains everything, and nothing. Looking a small probability event before the fact, it predicts everything, and nothing.

Geithner's Plan Not Bad

I really disliked Tim Geithner's 'stress test'. Taking over companies that could be insolvent in the future is a horrible precedent, setting a vague standard for solvency, because if you are insolvent in the future under the government's opinion, you are insolvent today. Thus, insolvency is not the exit criteria, rather one has to plan for future 'future' insolvency as defined by the government. This is a political football, meaning, it's all lobbying and appeasing regulators to maintain market power and beat down new entrants. I noted in his WSJ editorial, Geithner mentioned that people will be more confident in banks after having passed this vetting process, and that may have been the motivation, but passing a politically infused stress test is not reassuring.

On the other hand, his new plan is to basically match fund private investors in buying distressed securities, with over $500B set aside. This mitigates poor incentives, because they are not providing the first loss or senior piece, just sharing parri-passu. They are not giving purchasers leverage, even. An investor who thinks it is a bad risk-return investment will not be incented to invest, because this government involvement does not change the payoff space. This is just adding liquidity, and is not a subsidy, because the expected value of this is zero if we assume market prices are expected values of future payoffs. The cost is actually negative if we think the markets are in a panic, but costs are quite high if we think this is the mid point in a massive financial cataclysm.

Thus, Krugman thinks this is a huge subsidy because he thinks market prices are way too high for CMBS and RMBS securities, though I think this is really because he believes anything that would justify greater government control of economic activity. He has presented absolutely zero data on the prices and corresponding historical loss curves for the various vintage-product types (eg, Alt-A mortgages, 2006, average current price and losses). He doesn't have the data, he wouldn't know how to set it up. It's the kind of detail he is ignorant about but does not think is important. Details matter. Subprime, Alt-A, conforming,vintage, seasoning all matter. AAA 2007 subprime tranches trades at around 25% via the Markit ABX index. Is that really reasonable? What are the losses on the collateral? He just wants to take over the banks asap because asymmetries and imperfect information prove markets are inefficient (heh).

I found 94 subprime mortgage tranches, and some referred to the same underlying mortgage pool. You can find these by going to the Markit ABX index page, looking at the constituents, and see they refer to 20 tranches that vary by seniority for the various grades (eg, CWALT 2007-21CB M Mtge, BSABS 2007-AQ1 A1) . Anyway, the average cumulative 90+ delinquency is about 25%. That's pretty high historically, but after seasoning 21 months, this means a conservative estimate of total 90+ delinquency is going to be around 50%, and losses on those delinquencies no more than 50% (housing prices did not fall more than 50% in most places, on average). Thats for all of subprime in 2007. The market price for AAA rated assets (better than average) is a mere 25 cents on the dollar, suggesting the average subprime mortgage is priced below that, say 10 cents on the dollar. This is way too low.

I suspect most banks will be unwilling to sell off assets at market prices, because the market prices are so low. In that case the plan 'fails', but it would also then cost us nothing, and in the meantime not screw anything up (in contrast to the stress test).

Economic Inference With Little Data

Interest rates fell sharply last week as news came out about the Fed's new program of buying long term bonds. 10 year yields went from 3.0% to 2.5% last Wednesday.

Bonds are a funny asset. Looking at a time series of long term interest rates from 1950, we see a simple pattern: it rises to 1980, and falls to today. How the heck do you extrapolate from that?! In a sense, it looks like we have two observations, the increasing regime from 1950 to 1980, and then a decreasing regime from 1980. Under that interpretation, you don't really have enough data to really draw any conclusions.

I've noted many bond strategies that people simulate generate nice Sharpe ratios if they are implicitly long, going back 30 years seems like a large data set. Clearly, this then begs the bigger question, about whether the secular decline in interest rates will continue. Thus, like housing derivatives, many sophisticated bond strategies can make mistaken assumptions, but even a non-quant can ask the simple question: what is the effect of the sample time trend on your trading strategy?

I would just say that given our government is bent on doing everything possible to inflate asset prices again--government borrowing and spending, monetary expansion--it seems likely that inflation, and thus interest rates, will rise. We are like people who drink hard alcohol to get drunk, where the first sensation of inebriation is well past the point of moderation. Plus, there's a lower bound on interest rates, and we are pretty close to it.

Experimenting with Classes

I read the following story, probably apocryphal:

An economics professor at Texas Tech said he had never failed a single student before but had, once, failed an entire class.

The class had insisted that socialism worked and that no one would be poor and no one would be rich, a great equalizer. The professor then said, "OK, we will have an experiment in this class on socialism."

All grades would be averaged and everyone would receive the same grade so no one would fail and no one would receive an A. After the first test the grades were averaged and everyone got a B. The students who studied hard were upset and the students who studied little were happy.

But, as the second test rolled around, the students who studied little had studied even less and the ones who studied hard decided that since they could not make an A, they studied less. The second Test average was a D! No one was happy.

When the 3rd test rolled around the average was an F.

Students remember very little from specific classes. Even though this experiment is obviously going to generate horrible incentives, the lesson learned probably would be more long lasting and profound than any mastery of problem sets with indifference curves and linear programming.

2009 NCAA Wrestling Results

The big result was that dominating Brent Metcalf was defeated by Darion Caldwell in the finals at 147 pounds. Caldwell had pinned Metcalf back in 2007 in a freak move called a 'spladle', and it is really fun to watch on YouTube. But this was considered a lucky accident. Metcalf went on to win 69 matches in a row, including a national championship in 2008, and a dominating performance in the qualifying tournament. Caldwell was still very good, but no one thought he could beat Metcalf again. In the finals Caldwell was clearly the better athlete, with greater natural quickness and flexibility. He threw a headlock, and actually got a takedown out of it, a move that clearly shows no fear (usually throwing a headlock against a really good wrestler opens one up to a counter, it's a high risk, high reward move). It was a shock, and Caldwell won Outstanding wrestler of the tournament. See match here.

Unfortunately, as much as I would have liked to cheer for Caldwell's greater ability, he was a classic 'poor sport'. He took extended injury time to catch his breath. He ran away at the end of the match and did a back flip. As Caldwell was celebrating, the TV announcer said 'he's got to get off the mat', as the announcer was clearly anxious about the fact that he was potentially going to ruin a great moment. We know you are happy, but winning a competition should not just be about you, because the competitor and his supporters are all there. To celebrate excessively assumes the competitor does not exist.


There was the case of Anthony Robles, a one-legged wrestler from Arizona, which is rather amazing. He was born without a leg, and so clearly has a disadvantage. On the other hand, he gets another 10-15 pounds of weight for his upper body. One would think this is insufficent, yet he placed 3rd in the NCAAs. That's not charity.

Then there was Paul Donahoe, who won the championship in 2007, but was dismissed from Nebraska because he was in some naked pics with another wrestler for some gay magazine (he's not gay himself). It sounds at first like homophobia, but I think the issue was that he was exposing himself while wearing school uniform. I think it's a reasonable request that a school require its athletes not to pose naked with school colors on, because its a PR nightmare. He went to Edinboro, and lost a close match in the finals.

How to Cature Rents Without Seeming To

In many cases, one has something of value, but it is considered impolitic to seize this value. Over on Offsetting Behaviour, Eric Crampton notes that bands face a quandry in that front row seats sell for $1000 for top bands, yet bands do not want to appear to charge this much. Trent Reznor of the band Nine Inch Nails, explains that in practice the ticketing agents have already made a deal with the scalpers to split the surplus without appearing like jerks by having high posted ticket prices. The band, meanwhile, negotiates with the ticketing agents, and this ticket agent revenue is factored in the negotiations. (He then goes on to note his particular band is willing to give up this money to get real crazed fans in the front row, a logical reason to let the front row keep the consumer surplus).

This method of capturing value without seeming to reminds me of how investment banks capture the value from initial public offerings (IPOs). The IPO game is basically a way for brokers to capture the one-day pop in IPO prices. IPO’s predictably generate 12% return on their first day of trading, and most IPO investors sell in the first couple of days (though, of course, their broker discourages this to little avail).

For the broker issuing the IPO, by giving these only to clients who pay extra commissions, that first-day return is all capturable. Generally, in 2001 a hedge fund might pay 0.1 cents a share for bare bones trading, and 3 cents a share for trading bundled with ‘research’ and ‘trade ideas’. Of course, this research is worthless on average and the hedge fund knows it, but it leads to getting on the IPO list. Thus, the investment bank capture the one-day pop via the implicit overcharge on commissions to get access to the IPO.

To summarize: the investment bank captures the 12% one-day spike in the IPO price via overpriced research sold to a fund, which is known worthless. This quid pro quo is needed because the equity issuing firm would not appreciate paying the broker an 8% fee plus giving them the benefit of the first-day pop. The hedge fund trades commission dollars for the one-day return from IPOs because it is a basically even trade, and generally helps the portfolio manager point to 'great trades' useful for narratives about their savvy investing prowess, whereas the commissions are spread like string beans on a kid's dinner plate.

There are lots of trades like this, and often, like in the IPO trade, a key to participating is to never acknowledge to anyone in the chain the blatant logic at work. That is, a hedge fund would never ask explicitly for this quid pro quo, or if one did, one would not get a positive response. One merely recognizes the game and then smoothly joins, asking about IPOs say a couple months after paying for 'research'. As disgraced former Illinois governor Blagojevich found out, the first rule of trading favors to avoid explicit payment schemes is never to say or write this is what you are doing. It is a feasible equilibrium because as a repeated game, one can punish cheaters.

Fama on Taleb

From French and Fama's website:

Q: It would be very enlightening if you would comment on the Nassim Nicholas Taleb ("The Black Swan") attack on the use of Gaussian (normal bell curve) mathematics as the foundation of finance. As you may know, Taleb is a fan of Mandelbrot, whose mathematics account for fat tails. He argues that the bell curve doesn't reflect reality. He is also quite critical of academics who teach modern portfolio theory because it is based on the assumption that returns are normally distributed. Doesn't all this imply that academics should start doing reality-based research?

EFF[Eugene Fama]: Half of my 1964 Ph.D. thesis is tests of market efficiency, and the other half is a detailed examination of the distribution of stock returns. Mandelbrot is right. The distribution is fat-tailed relative to the normal distribution. In other words, extreme returns occur much more often than would be expected if returns were normal.

There was lots of interest in this issue for about ten years. Then academics lost interest. The reason is that most of what we do in terms of portfolio theory and models of risk and expected return works for Mandelbrot's stable distribution class, as well as for the normal distribution (which is in fact a member of the stable class). For passive investors, none of this matters, beyond being aware that outlier returns are more common than would be expected if return distributions were normal.

Charles Murray at the AEI

Charles Murray was honored by the AEI last week, and gave a talk on happiness in the context of modern America. His talk hit on an interesting paradox of welfare programs aimed at the poor, that it negatively affects the satisfaction of life for those who are most likely to gain life satisfaction via non-vocational activities. Most liberals see faith as authoritarian delusions, and family and community needs as the responsibility of the government. That's not horrible if you have an great job and are good at it  because you can bask in the status from that job, but if you are merely a hard working mensch your path to a meaningful and satisfying life is diminished:

To become a source of deep satisfaction, a human activity has to meet some stringent requirements. It has to have been important (we don't get deep satisfaction from trivial things). You have to have put a lot of effort into it (hence the cliché "nothing worth having comes easily"). And you have to have been responsible for the consequences.

There aren't many activities in life that can satisfy those three requirements. Having been a good parent. That qualifies. A good marriage. That qualifies. Having been a good neighbor and good friend to those whose lives intersected with yours. That qualifies. And having been really good at something--good at something that drew the most from your abilities. That qualifies. Let me put it formally: If we ask what are the institutions through which human beings achieve deep satisfactions in life, the answer is that there are just four: family, community, vocation, and faith.
...
the sources of deep satisfactions are the same for janitors as for CEOs, and I also said that people needed to do important things with their lives. When the government takes the trouble out of being a spouse and parent, it doesn't affect the sources of deep satisfaction for the CEO. Rather, it makes life difficult for the janitor. A man who is holding down a menial job and thereby supporting a wife and children is doing something authentically important with his life. He should take deep satisfaction from that, and be praised by his community for doing so. Think of all the phrases we used to have for it: "He is a man who pulls his own weight." "He's a good provider." If that same man lives under a system that says that the children of the woman he sleeps with will be taken care of whether or not he contributes, then that status goes away. I am not describing some theoretical outcome. I am describing American neighborhoods where, once, working at a menial job to provide for his family made a man proud and gave him status in his community, and where now it doesn't. I could give a half dozen other examples. Taking the trouble out of the stuff of life strips people--already has stripped people--of major ways in which human beings look back on their lives and say, "I made a difference."

Just as you can't give someone respect, you can't give them security, shelter and clothing, without taking away much more. Sure one can imagine situations where a helping hand is appropriate--pathologies, temporary crises--but these are exceptions, perhaps one tenth of what the modern state addresses.

Retention Bonus in Cash?

AIG paid 22 people over $2MM each as retention bonuses, even though they worked in the Financial Products Division that basically sets the standard for bad investing. If you want a key employee to stay, your pay is in exchange for future services. If they have the option to leave right after the bonus, this is not a retention bonus, but rather, a bonus for performance, such as a percent of commissions or revenues generated.

Thus, it makes zero sense to pay someone cash as a retention bonus. You should pay them in restricted stock, or call it something else. As part of a unit that basically bankrupted the company, I do not see any reason why one should pay a premium for these people, because when a unit like that fails so massively, the option to cherry pick trades that made money and lobby for a piece of those profits is worthless. The Financial Products group is so worthless, such tendentious pleading should fall on deaf ears. Further, paying them cash makes no sense for shareholders. It seems like an "agency problem" is at work.

This just highlights the ability of corporate insiders to appropriate value from shareholders. I wouldn't give them a special tax, as a government agent I would just liquidate the company, unless they can pay back my investment immediately. The franchise value should go to zero, and debt holders may bear some losses. If this happens, perhaps insiders will not try this as much in the future, because capital providers would care about such things. In this market there are a lot of smart people, knowledgeable about derivatives and financial products, looking for work. The notional amounts are scary, but it is straightforward, and the current management is clearly not operating in 'good faith', and once you know that, you need to excise them asap. Breaking promises is warranted because basically this company is bankrupt, and employees are unsecured creditors. In the same way I think Ford and GM need to abrogate their old UAW contracts, AIG should abrogate million dollar cash retention bonuses. Both are not in the capital provider's best interest, and as these people need capital, it should present such firms with a choice: adjust your contracts or get in line with everyone else to pick over the company's assets.