Equity compensation is the root of all Corporate evil

What Obama and Barney Frank need to focus on is the nefarious practice of Bankers being compensated through restricted stock or stock options. The basic premise of equity compensation is that Manager interests are aligned with shareholder interests through this practice. This theory is flawed for the following reasons

1. The actual cash value of payments in shares are never recognised in the Financials of the company. Share payments are recognised as part of the capital account and not in the operational earnings, as a cost.

2. The amount paid is not a fixed expense amount. Instead, it is a share of the company.

3. You cannot give away the farm to align a managers interest with the owner. To provide an analogy, if I pay my housekeeper, a share in my property so as he does not damage my property, eventually he will own my house and I will be the housekeeper.This is the same concept.

Are we there yet ?

It is time to buy. But not yet. We must wait for the market to hit the bottom. Till then we need to bide our time and drink to it. Bottoms up!

Capitalism has run out of capital. Ich machst nixt Das Kapital! (no it is not really German I just made something up from my Rosetta stone).

However note the profoundity of the statement - Capitalism has indeed run out of Capital! We need a new system. We need communism from China to provide us Capital. What happened to all our capital? Did someone madoff with it ?

We probably spent all our capital on Christmas gifts that nobody wants. We need to figure out a way to grow more capital. Capital does not grow on trees. It needs to be harnessed and managed so that it grows into more capital.

So it is not really a liquidity problem. We just need more money. Stop burning cash and conserve. Only way to build capital is by not wasting it.

Kerviel and the Back office control environment

SocGen had one of the best risk management systems. Yet there was such a major failure of controls. No one knows how he was able to pick the locks. He had a perverse understanding of the "complex" control systems because of his experience in the middle office.

That is really hogwash. The Middle office teaches you how to book trades and how to calculate P&L. The Middle office does not teach you anything about the control system, as the controls are mostly in the Back-Office.

This is how derivative trades are actually controlled. Trader does a trade, presses a button and the system books it and sends it through to the Back-Office. Back-office calls the counterparty and confirms the details of the trade. At settlement, Back-office moves cash with the counter-party's Back-office. Trader estimates his Profit or loss, Middle-office confirms his profit or loss, and Back-office counts the cash. Its all very simple really, when you are counting just one widget.

In reality it works this way. Trader does a million trades. Sytem processes everything"STP' - straight through processing. Trader has no way to track the beans, so he relies on the system to calculate his Profit or loss. Very rough estimates are made based on the "risk". But as the complexity and volume increases, these estimates become less and less reliable. Middle Office has the same problem. Middle Office uses the very same systems to re-estiamte the P&L, and generally would like to agree with the Trader. Back-Office pays out the cash. All the outsourcing has resulted in the Back-office being in India, Buffalo, Singapore or some other unreachable place. Most of the time they are just paying out the cash as fast as the orders come in to settle. If something is missing they might track it, or they might let it go, depending on their situation. So cash is no longer counted, one major control does not really work.

The other control is the confirmation with the counterparty. Again, this is a Back-office function that has systematically been reduced to bare bones. Most places are back-logged on confirmations for atleast a few months. There are millions of trades with internal counterparties that are not tracked at all. There are old portfolis that no-one looks at, new ones that were opened without everyone knowing about it, dummy portfolio that should not have live trades and so on.

The point here is that we are not manufacturing cars, or making small loans out of the local credit Union. There the beans are generally counted and Accounted for at a higher level of accuracy. The derivative business is a lot of smoke and mirrors, filled with charlatans.

The kid fresh out of Ivy league schoool with a few sound bytes about how the market "thinks" gets to play with millions of dollars as a Trader. The CEO does not know the Trader's positions, the head of the desk may not know the extent of all the Trader's positions, the middle office person that does his P&L does not know a whole lto more, and the Back-office processor that pays out on these transactions does not know either. The truth is that no-one really knows or asks questions. As long as the numbers are positive, everyone gets paid. "Them that ask no questions, are'nt told no lies- so watch the wall my darling, as the gentlemen go by" - Smuggler's song. So it is really surprising that there are so few of these blow-ups.