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AIG Financial Services = “Capital Decimation Partners”

March 19, 2009
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In a book last year (and in a very complicated, fairly obscure paper in 2001, downloadable here), MIT Professor Andrew Lo, one of the most quoted and respected of the quantitative analysts who have lately transformed the financial universe, imagined a hedge fund he called Capital Decimation Partners.

Lo described a simple investment strategy that was very likely to return big profits in the short term, and almost guaranteed to crater in the medium-to-long term. Lo posited that the outsized pay and strange compensation schedule for hedge-fund managers–typically, every year they keep 2 percent of the assets they manage plus 20 percent of their reported investment gains–could lead to their taking outsized risks with other people’s money.

“I propose a research agenda for developing a new set of risk analytics specifically designed for hedge-fund investments, with the ultimate goal of creating risk transparency without compromising the proprietary nature of hedge-fund investment strategies,” Lo wrote then.

Alas, Lo’s proposal was not implemented. It appears that AIG’s now infamous Financial Products Division was CDP incarnate. Only worse.

According to the compensation contracts released yesterday by U.S. House Banking Committee Chairman Barney Frank, the AIG folks got a full 30 percent of all the cash they claimed to have made. And as the New York Times’ Steven M. Davidoff explains on his blog, the AIG people had less skin in the game than the typical hedgie.

In A.I.G.’s case, however, employees got 30 percent with very little personal risk (we don’t know how much of their compensation was in stock) and their overhead covered. The arrangement shows the cavalier attitude of A.I.G. management and the power the financial products division had.

Ironically (though perhaps not surprisingly), AIG’s one-time profit center did not actually hedge its bets. They just assumed that what has come to pass could never happen.

Or, perhaps, they just didn’t care.

And why should they? With rare exception, the architects of the collapse have each squirreled away millions of dollars.

Picture a typical failed hedge fund genius with five years’ experience during the boom times. At the market’s peak, he was worth maybe $200 million. After the crash, he’s got maybe $30 million in hard assets. At a congressional hearing, he could say he’s suffered more than the average investor–having lost 85 percent of his net worth as compared to the typical 40 or 50 percent. But even with only 15 percent of his former wealth, the guy’s still got a five-bedroom home in Greenwich, CT, a good sized boat, a one-fifth share in a small jet, a villa in Spain or Italy, and maybe $20 million in conservative, liquid investments that yields about $800,000 per year income.

Guys like this, lots of them in their 40s or even mid-30s, are a dime a dozen on Wall Street.

They could retire (obviously). But they probably won’t. They’re eager to get back in the game. They think they’re more valuable than the money they have today. They know that, given another chance, they can make a lot more (for themselves, at least).

At their level (and, again, these are mid-level people in the Wall Street hierarchy), under today’s rules, the worst that can happen is they’ll end up where they are now–as run-of-the-mill multi-multi-millionaires.

Consider the case of John Meriwether. Those with long memories might recall him as the third brain behind Long Term Capital Management, the curiously short-sighted hedge fund that imploded in 1998, requiring a $3.6 billion private bailout arranged by the New York Fed. Meriwether & Co’s investors lost billions on that deal. Naturally, he started another hedge fund, reportedly losing $250 million or so of his fund’s value as of last March.

Does anyone expect to see John Meriwether in a soup line? Does anyone think he won’t keep soliciting new investors whose money he will manage, for a huge fee?

Almost every so-called innovation in financial engineering made over the past 30 years has aimed to shift the risk to you and me while capturing the upside for John Meriwether and friends. The outsiders–hedge fund investors, pension funds, bond holders–share in the profits in the good years, but are on the hook for the losses when the system inevitably fails.

Until now. Now taxpayers are on the hook. We’re told we have to “save the financial system.”

And here is where the government’s bailout system appears to fail. On the one hand, the TARP, the TALF, and other federal cash infusions are designed to buoy those outside investors–the counterparties to AIG’s fraudulent insurance. But aside from a bit of foot-stamping, there has as yet been no attempt to attack the system of compensation and misaligned incentives that inevitably create these Capital Decimation Partners.

Indeed, the bailout seems designed in part to preserve this system of crazy-pay-and-no-risk for compulsive gamblers.

Bills allegedly to be introduced would tax bonuses at AIG and other bailout recipients at 90 percent. Well, how about taxing all these guys’ compensation over $1 million at 90 percent? It worked in our fathers’ time; perhaps it’s no coincidence that all this financial engineering and 2/20 compensation has happened since the top marginal rates came down to the 30s.

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