Summary
In the Wall Street Journal opinion, paying off the $18 billion in bonus pool is just good sense. The only real problem was that some bankers exercised poor timing. “John Thain's year-end bonuses to Merrill Lynch executives, whatever their rationale, reflected an acute case of political tin ear.” The Journal also feels that the compensation is mislabel: it is not bonuses at all, but rather like tips, constituting the majority of the employees compensations and it has the bonus pool in way has fallen to the insignificant level of about $112,000 person, and paying them will help the NYC. The Opinion Page opposes any limits on employee compensation for fear of harm to the business motivation.
Analysis
The Journal makes a rookie mistake here, conflating the Sandy Weill business model, with proper compensation for risk and effort, neither of which the management teams demonstrated during the crisis.
Wall Street is a revenue rather than asset driven industry: it does not follow a bottom line model, but rather top line with high variable expenses many of which are tied to performance based compensation. First we have brokers who work on direct, negotiated commission for the business they produce. They are just salesmen and money is not a bonus. Other revenue generators get bonuses such as deal makers, traders and analysts. Their bonuses are based in part on the revenue they generate and how their area does in contributing to firm overall profitability. A good analyst not only contributes to sales, but also the banks standing in many different areas such as corporate finance. A trader would commonly expect to see about 30% of portfolio generated profit. For others, less directly tied to producing business, it varies. Lastly there are support people, not in revenue generating areas, and they receive some money from the pool. There salaries are competitive and the bonus is an extra. It must be noted that even such things as internal audit or compliance are important to success because they prevent bad things, even if they generate no revenue, they save it.
Only brokers and traders are compensated directly on how much money they make for the firm, and their money is mostly derived from their own efforts. The others do not, but receive their bonus money on sufferance. In that manner both the top management and the maintenance crew have something in common.
The foregoing describes the classic model of the bank, based on mark-to-market accounting, that is, what the assets can be easily liquidated in a broad liquid market, that is there would be no future surprises hidden in any asset balance. There are a number of things that have changed. As we can see from the subprime problem that was not the case, but bonuses and firm earnings were calculated as if those assets had a value, which in fact they did not when the bonuses were calculated. I suggest anyone interested in how events developed read the following:
Senior Supervisors Group of the Bank of International Settlements Observations on Risk Management Practices during the Recent Market Turbulence March 6, 2008.
There a number of things that must be remembered. The banks apparently had no exit strategy and in a sense couldn’t, based on the nature of the product. If they left the market, the product would have no value, and some had actually placed the full faith and credit of the firm behind support of a market for the product. Of more concern, management had no feeling on how big the market might be or at what level of activity in the mortgage business might indicate a bubble in the making. It seems that they had no idea that such research was either possible or necessary. In the mortgage market, the information was available and the estimates could easily have been made, and weren’t.
More to the point, the market for these securities was in serious trouble by the end of 2007, but those problems had no effect on the bonus pool: top management had made no note of the problems in the area or reflected those problems in the financial statements.
More damning is what management did once it became obvious in 2007 and 2008 that there was a problem both in marketability, liquidity and quality with CDOs (Collateralized Debt Obligations): precisely nothing. Management swapped CDO components and made every effort to make them marketable but did not make any attempt to dismantle them and deal with the individual mortgages for which there was both value and a market. That step will be left to the Treasury to try and liquidate these assets to recoup part of the bailout. Though the whole process, management has offered little guidance or other value added, to the people directly involved.
The ultimate problem is that management compensation was seen to have no relation to potential future risks. Put another way, no one had an interest in the long-term viability of the bank. Before public ownership, partners had a very real interest in the firm’s survival because that was where their wealth was stored. With public ownership, no one cared because the compensation horizon was radically shortened, to the year.
No matter what the partisans say, simple justice requires adjustment of the bonus pool. First though it cannot be stated to strongly that risk-takers will not die-off if bonuses are adjusted, it will just make them more cognizant of total risks.
Probably the best place to start adjusting is with the bonuses and compensation to the leadership. In every instance they failed in their fiduciary duty to the bank, and the reasons are clear. They saw no personal risks involved in backing any line of business and any degree of risk because they were compensated year to year so could overlook anything beyond that time horizon, and they did. Simple justice demands that all of them involved in should get no bonuses whatsoever, and the government should demand return of earlier bonuses (claw-back) from when these lines of business were taken on. It can be seen almost as a fraud on the bank because the decision makers entered into lines of business which very easily be seen as having no long term potential, just to improve their bonuses and win investor support by inflating the share price, with no thought for the morrow. Never forget that institutional investors that cover this industry and attracted to volatility and the new regimes gave it to them.
A lot of people did their jobs and made money for the banks, and should see their bonuses depending on how directly their efforts helped the firms, and of course the real condition of the firms themselves For others, well, there have been years when there were very small bonus pools and others when whole lines of work disappeared, like municipal bonds did for a while. Such risks are part of the business.
None of the people whose decisions directly in these failed business ventures should profit from their failure to do otherwise would show a social indifference to anti-social activity. Increasing accountability will improve risk management rather than harm it.
The Sandy Weill and Hank Greenberg business model is dead: financial conglomerates are not too big to fail, but rather too big to manage. Further the incentives to manage are not their. Compensation is determined divorced from performance in those models and perhaps cannot not even be managed at all. The rewards were paid based on circumstance and a empty chair might have done better. Now with this model hopefully permanently in the grave, real managers and real entrepreneurs will fill the gap.
