December 18, 2008
On Wall Street, Bonuses, Not Profits, Were Real
Daniel Acker/Bloomberg News
E. Stanley O’Neal, the former
chief executive of Merrill Lynch, was paid $46 million in
2006, $18.5 million of it in cash.
For Dow Kim, 2006 was a very
good year. While his salary at Merrill Lynch was $350,000, his total
compensation was 100 times that — $35 million.
The difference between the
two amounts was his bonus, a rich reward for the robust earnings made by the
traders he oversaw in Merrill’s mortgage business.
Mr. Kim’s colleagues, not
only at his level, but far down the ranks, also pocketed large paychecks. In
all, Merrill handed out $5 billion to $6 billion in bonuses that year. A
20-something analyst with a base salary of $130,000 collected a bonus of
$250,000. And a 30-something trader with a $180,000 salary got $5 million.
But Merrill’s record
earnings in 2006 — $7.5 billion — turned out to be a mirage. The company has
since lost three times that amount, largely because the mortgage investments
that supposedly had powered some of those profits plunged in value.
Unlike the earnings,
however, the bonuses have not been reversed.
As regulators and
shareholders sift through the rubble of the financial crisis, questions are
being asked about what role lavish bonuses played in the debacle. Scrutiny
over pay is intensifying as banks like Merrill prepare to dole out bonuses
even after they have had to be propped up with billions of dollars of
taxpayers’ money. While bonuses are expected to be half of what they were a
year ago, some bankers could still collect millions of dollars.
Critics say bonuses never
should have been so big in the first place, because they were based on
ephemeral earnings. These people contend that Wall Street’s pay structure,
in which bonuses are based on short-term profits, encouraged employees to
act like gamblers at a casino — and let them collect their winnings while
the roulette wheel was still spinning.
“Compensation was flawed top
to bottom,” said Lucian A. Bebchuk, a professor at
Harvard Law School and an expert on compensation. “The whole
organization was responding to distorted incentives.”
Even Wall Streeters concede
they were dazzled by the money. To earn bigger bonuses, many traders ignored
or played down the risks they took until their bonuses were paid. Their
bosses often turned a blind eye because it was in their interest as well.
“That’s a call that senior
management or risk management should question, but of course their pay was
tied to it too,” said Brian Lin, a former mortgage trader at Merrill Lynch.
executives at four firms have agreed under pressure to go without their
John A. Thain, who initially wanted a bonus this year since he joined
Merrill Lynch as chief executive after its ill-fated mortgage bets were
made. And four former executives at one hard-hit bank,
UBS of Switzerland, recently volunteered to return some of the bonuses
they were paid before the financial crisis. But few think others on Wall
Street will follow that lead.
For now, most banks are
looking forward rather than backward.
Morgan Stanley and UBS are attaching new strings to bonuses, allowing
them to pull back part of workers’ payouts if they turn out to have been
based on illusory profits. Those policies, had they been in place in recent
years, might have clawed back hundreds of millions of dollars of
compensation paid out in 2006 to employees at all levels, including senior
executives who are still at those banks.
A Bonus Bonanza
For Wall Street, much of
this decade represented a new Gilded Age. Salaries were merely play money —
a pittance compared to bonuses. Bonus season became an annual celebration of
the riches to be had in the markets. That was especially so in the New York
area, where nearly $1 out of every $4 that companies paid employees last
year went to someone in the financial industry. Bankers celebrated with
five-figure dinners, vied to outspend each other at charity auctions and
spent their newfound fortunes on new homes, cars and art.
The bonanza redefined
success for an entire generation. Graduates of top universities sought their
fortunes in banking, rather than in careers like medicine, engineering or
teaching. Wall Street worked its rookies hard, but it held out the promise
of rich rewards. In college dorms, tales of 30-year-olds pulling down $5
million a year were legion.
While top executives
received the biggest bonuses, what is striking is how many employees
throughout the ranks took home large paychecks. On Wall Street, the first
goal was to make “a buck” — a million dollars. More than 100 people in
Merrill’s bond unit alone broke the million-dollar mark in 2006.
Goldman Sachs paid more than $20 million apiece to more than 50 people
that year, according to a person familiar with the matter. Goldman declined
Pay was tied to profit, and
profit to the easy, borrowed money that could be invested in markets like
mortgage securities. As the financial industry’s role in the economy grew,
workers’ pay ballooned, leaping sixfold since 1975, nearly twice as much as
the increase in pay for the average American worker.
“The financial services
industry was in a bubble," said Mark Zandi, chief economist at
Moody’s Economy.com. “The
industry got a bigger share of the economic pie.”
A Money Machine
Dow Kim stepped into this
milieu in the mid-1980s, fresh from the Wharton School at the
University of Pennsylvania. Born in Seoul and raised there and in
Singapore, Mr. Kim moved to the United States at 16 to attend Phillips
Academy in Andover, Mass. A quiet workaholic in an industry of workaholics,
he seemed to rise through the ranks by sheer will. After a stint trading
bonds in Tokyo, he moved to New York to oversee Merrill’s fixed-income
business in 2001. Two years later, he became co-president.
Even as tremors began to
reverberate through the housing market and his own company, Mr. Kim exuded
After several of his key
deputies left the firm in the summer of 2006, he appointed a former
colleague from Asia, Osman Semerci, as his deputy, and beneath Mr. Semerci
he installed Dale M. Lattanzio and Douglas J. Mallach. Mr. Lattanzio
promptly purchased a $5 million home, as well as oceanfront property in
Mantoloking, a wealthy enclave in New Jersey, according to county records.
Merrill and the executives
in this article declined to comment or say whether they would return past
bonuses. Mr. Mallach did not return telephone calls.
Mr. Semerci, Mr. Lattanzio
and Mr. Mallach joined Mr. Kim as Merrill entered a new phase in its
mortgage buildup. That September, the bank spent $1.3 billion to buy the
First Franklin Financial Corporation, a mortgage lender in California,
in part so it could bundle its mortgages into lucrative bonds.
Yet Mr. Kim was growing
restless. That same month, he told E. Stanley O’Neal, Merrill’s chief
executive, that he was considering starting his own hedge fund. His traders
were stunned. But Mr. O’Neal persuaded Mr. Kim to stay, assuring him that
the future was bright for Merrill’s mortgage business, and, by extension,
for Mr. Kim.
Mr. Kim stepped to the
lectern on the bond trading floor and told his anxious traders that he was
not going anywhere, and that business was looking up, according to four
former employees who were there. The traders erupted in applause.
“No one wanted to stop this
thing,” said former mortgage analyst at Merrill. “It was a machine, and we
all knew it was going to be a very, very good year.”
Merrill Lynch celebrated its
success even before the year was over. In November, the company hosted a
three-day golf tournament at Pebble Beach, Calif.
Mr. Kim, an avid golfer,
William H. Gross, a founder of Pimco, the big bond house; and Ralph R.
Cioffi, who oversaw two
Bear Stearns hedge funds whose subsequent collapse in 2007 would send
shock waves through the financial world.
“There didn’t seem to be an
end in sight,” said a person who attended the tournament.
Back in New York, Mr. Kim’s
team was eagerly bundling risky home mortgages into bonds. One of the last
deals they put together that year was called “Costa Bella,” or beautiful
coast — a name that recalls Pebble Beach. The $500 million bundle of loans,
a type of investment known as a collateralized debt obligation, was managed
by Mr. Gross’s Pimco.
Merrill Lynch collected
about $5 million in fees for concocting Costa Bella, which included
mortgages originated by First Franklin.
But Costa Bella, like so
many other C.D.O.’s, was filled with loans that borrowers could not repay.
Initially part of it was rated AAA, but Costa Bella is now deeply troubled.
The losses on the investment far exceed the money Merrill collected for
putting the deal together.
So Much for So Few
By the time Costa Bella ran
into trouble, the Merrill bankers who had devised it had collected their
bonuses for 2006. Mr. Kim’s fixed-income unit generated more than half of
Merrill’s revenue that year, according to people with direct knowledge of
the matter. As a reward, Mr. O’Neal and Mr. Kim paid nearly a third of
Merrill’s $5 billion to $6 billion bonus pool to the 2,000 professionals in
Mr. O’Neal himself was paid
$46 million, according to Equilar, an
executive compensation research firm and data provider in California.
Mr. Kim received $35 million. About 57 percent of their pay was in stock,
which would lose much of its value over the next two years, but even the
cash portions of their bonus were generous: $18.5 million for Mr. O’Neal,
and $14.5 million for Mr. Kim, according to Equilar.
Mr. Kim and his deputies
were given wide discretion about how to dole out their pot of money. Mr.
Semerci was among the highest earners in 2006, at more than $20 million.
Below him, Mr. Mallach and Mr. Lattanzio each earned more than $10 million.
They were among just over 100 people who accounted for some $500 million of
the pool, according to people with direct knowledge of the matter.
After that blowout, Merrill
pushed even deeper into the mortgage business, despite growing signs that
the housing bubble was starting to burst. That decision proved disastrous.
As the problems in the subprime mortgage market exploded into a full-blown
crisis, the value of Merrill’s investments plummeted. The firm has since
written down its investments by more than $54 billion, selling some of them
for pennies on the dollar.
Mr. Lin, the former Merrill
trader, arrived late to the party. He was one of the last people hired onto
Merrill’s mortgage desk, in the summer of 2007. Even then, Merrill
guaranteed Mr. Lin a bonus if he joined the firm. Mr. Lin would not disclose
his bonus, but such payouts were often in the seven figures.
Mr. Lin said he quickly
noticed that traders across Wall Street were reluctant to admit what now
seems so obvious: Their mortgage investments were worth far less than they
“It’s always human nature,”
said Mr. Lin, who lost his job at Merrill last summer and now works at RRMS
Advisors, a consulting firm that advises investors in troubled mortgage
investments. “You want to pull for the market to do well because you’re
But critics question why
Wall Street embraced the risky deals even as the housing and mortgage
markets began to weaken.
“What happened to their
investments was of no interest to them, because they would already be paid,”
said Paul Hodgson, senior research associate at the Corporate Library, a
shareholder activist group. Some Wall Street executives argue that paying a
larger portion of bonuses in the form of stock, rather than in cash, might
keep employees from making short-sighted decision. But Mr. Hodgson contended
that would not go far enough, in part because the cash rewards alone were so
high. Mr. Kim, for example, was paid a total of $116.6 million in cash and
stock from 2001 to 2007. Of that, $55 million was in cash, according to
Leaving the Scene
As the damage at Merrill
became clear in 2007, Mr. Kim, his deputies and finally Mr. O’Neal left the
firm. Mr. Kim opened a hedge fund, but it quickly closed. Mr. Semerci and
Mr. Lattanzio landed at a hedge fund in London.
All three departed without
collecting bonuses in 2007. Mr. O’Neal, however, got even richer by leaving
Merrill Lynch. He was awarded an exit package worth $161 million.
Clawing back the 2006
bonuses at Merrill would not come close to making up for the company’s
losses, which exceed all the profits that the firm earned over the previous
20 years. This fall, the once-proud firm was sold to
Bank of America, ending its 94-year history as an independent firm.
Mr. Bebchuk of Harvard Law
School said investment banks like Merrill were brought to their knees
because their employees chased after the rich rewards that executives
“They were trying to get as
much of this or that paper, they were doing it with excitement and vigor,
and that was because they knew they would be making huge amounts of money by
the end of the year,” he said.
A version of this article
appeared in print on December 18, 2008, on page A1 of the New York edition.