>Bonus or Derivatives – Misplaced Timing

>Yes, I know my title makes no sense, that is the point.

In a previous post I blasted the record 2009 bonuses about to be paid out on Wall Street, bonuses which are based upon revenue that could only have been generated thanks to taxpayer funded bailouts. The government is focusing on executive compensation though and has just stripped Ken Lewis of his 2009 income (don’t cry for him just yet, he’ll retire with about a $50 million package). It bothers me though that the government is involved in compensation, if it weren’t for the fact that I believe the financial system is simply just a ward of the state at the moment I would be more bothered.

What really is irritating though is the fact that Derivatives, specifically Credit Default Swaps are not garnering more attention. Buffet once called derivatives “financial weapons of mass destruction” and 2008 proved him correct. However, instead of waging war on the enemy (derivatives) we are waging it on executive compensation (which is miniscule in terms of risk).

I don’t want derivatives banned, instead I want them regulated in a manner that makes sense. Making sense means that the issuance of a derivative product cannot make your company a systemic threat to the financial system. It means that if you issue an insurance policy you better have reserves to pay for it (Credit Default Swaps are nothing more than a life insurance policy on a company, if the company dies (goes bankrupt) it pays out). CDS should not be allowed to be used for speculation, only hedging (there is more to this as I do understand that in order to be offered a hedge someone must take the opposite side of the trade, which is usually a speculator, but I’m trying to keep things simple here).

What I’m trying to get at is that we shouldn’t have a dozen companies owning CDS on another company and in the position to profit if that company goes bankrupt, it provides an incentive for that company to go bankrupt. This is why there is a concept in life insurance called “insurable interest,” which basically means that you can’t buy insurance on just anybody. If you could buy life insurance on anyone there would be severe moral hazard as you could profit if that person dies (which leads to a big mafia business in ensuring the policy is collected on, if ya know what I mean).

Our four largest banks are the biggest issuers of these derivatives and are so interconnected into our financial system that one failure would collapse them all. We must extricate these banks from these types of transactions and only allow non-systemic companies to issue such derivatives. We must make our banking system smaller and our banks should not be acting as investment banks – Glass-Steagall 2.0 needs to be imposed.

Finally, we need to do something about the top bank, The Federal Reserve. It has accumulated to much power and used it in non-transparent ways, accomplishing the exact opposite of its founders intentions (actually its accomplishing everything its founders intended, just not what they sold it as). The Fed has not stopped the formation of bubbles or lessened the boom-bust cycle, in fact it has made it worse and devalued our currency in the process.

Bonuses and executive compensation are important, but they are shareholder issues and thus the best way to address them is to address the bigger issues and get the government out of owning the financial system (but regulating it….which they haven’t proved able to do) and give the power over executive compensation back to shareholders (where it hasn’t been….partially due to mutual fund ownership).

We continue to spend our time and outrage over bonuses that seem huge (and they are) but are pennies compared to the larger issue of derivative time bombs (we are talking billions versus trillions).

Scott Dauenhauer CFP, MSFP, AIF

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