First, Let’s Fix the Bonuses
So asked Representative Barney Frank, chairman of the House Financial Services Committee, of John J. Mack, the chief executive of Morgan Stanley. The tongue-in-cheek question was posed last week, when the C.E.O.’s of the eight largest financial institutions in the country — all of whom had taken billions in government bailout money to shore up their balance sheets — testified before the committee in a widely publicized hearing.
Mr. Mack didn’t miss a beat. “We love what we do,” he replied smoothly. “If we had no bonuses, we would still love it.”
To which I remember thinking: yeah, right.
Ever since it was revealed that John A. Thain had paid out $3.6 billion in bonuses two days before Merrill Lynch was acquired by Bank of America — and just weeks before it posted a staggering fourth-quarter loss of $15.3 billion — the country has been up in arms about Wall Street bonuses. According to the New York State comptroller’s office, total 2008 Wall Street bonuses were $18.4 billion, a number that seemed so blatantly outrageous that President Obama condemned them. How can it be, people fume, that companies that have brought themselves down with their poor decision making and short-term greed, and have very nearly brought the country’s financial system to its knees — how can the employees of these companies still feel entitled to multimillion-dollar bonuses? How can they be so callous, so tone-deaf, so arrogant?
“When I’m trying to explain to my constituents why we are doing this stuff to help the financial system, they just want to talk about the bonuses,” said Senator Christopher J. Dodd, the chairman of the Senate Banking Committee. “I can’t ever get to the big picture because this keeps getting in the way.”
Mr. Dodd added testily, “I would like to see one of these Wall Street guys go to a Caterpillar factory, where 20,000 people have lost their jobs, and explain why they need their bonus.”
Late last week, Mr. Dodd did something about Wall Street bonuses: he inserted an amendment into the stimulus package that pretty much chokes them off for the five top executives — and, far more horrifying for Wall Street — for the top 20 earners as well. The antibonus amendment applies to any company that has received bailout money (it gets tougher the more money a company has received) — and the only sure way a company can get out from under these new strictures is to give back the taxpayers’ money.
With the signing of the Dodd amendment into law this week, it’s now Wall Street’s turn to sputter in anger. Don’t the politicians understand that the best performers will be most hurt by these new strictures? Wall Street executives mutter to themselves. Don’t they realize that some of those companies didn’t even want the bailout money—and only took it to because former Treasury Secretary Henry M. Paulson Jr. forced them to? Don’t people realize that this is just political pandering on Mr. Dodd’s part?
“Dodd wants to pay people like congressmen,” said Brian Foley, an independent executive compensation consultant, “all up front and without regard to performance.”
I agree that the Dodd amendment is a poorly conceived piece of legislation that will have unintended consequences. But that doesn’t mean the Wall Street bonus system isn’t a problem. It is. Until the bonus system undergoes a long-term fix, Wall Street won’t be fixed either.
It may seem hard to believe now, but Wall Street pay wasn’t always in the stratosphere. “When I became a partner at Lazard in 1961, my salary was $51,000,” recalled Felix G. Rohatyn, perhaps the best-known investment banker of his era. “And until I left the firm in 1997,” he added, “my compensation was always based on what percentage interest I had in the firm. Everybody was working for the greater interest of the firm.”
And why wouldn’t they? Like all Wall Street firms in those days, Lazard Frères was a private partnership. Every year the partners drew a percentage of the annual profits as their compensation — but they also had to keep most of their capital in the firm until they retired. They had a keen interest in ensuring that the firm had a healthy, long-term future.
Today’s bonus system is a warped legacy of those old partnerships. Starting in the 1970s, Wall Street firms began going public, which meant that the partners’ capital was replaced by shareholder equity. But the firms never abandoned the idea that salary was only a small portion of employee pay — and that the big payoff came at the end of the year at bonus time.
In addition, trading began to overshadow advising as an investment bank’s primary way of making money. Valuable traders whose operation made hundreds of millions of dollars for their firms demanded a significant piece of those profits for themselves — or they took their services elsewhere. So that quaint notion that the firm’s long-term health came first slowly gave way to a more cutthroat ethos. Whereas the incentives during the partnership era fostered loyalty to the firm, the new incentives turned everyone into a greedy free agent like, say, Alex Rodriguez.
By the time the late, great housing bubble was in full throttle, the compensation incentives were moving the financial system toward disaster. Firms made short-term underwriting fees for packaging mortgage-backed securities that have since become known as “toxic assets.” Traders booked short-term profits trading them (or simply marking them up). Executives pushed their subordinates to take more risk because that would yield more profits, and bigger bonuses. Nobody had any incentive to worry about whether those securities would someday “blow up.” Too much bonus money was at stake.
Is this the problem Mr. Dodd is trying to solve with his amendment? Alas, no. He seems mainly trying to send a message that people who take money from taxpayers need to show restraint. And surely they do.
But as Mr. Foley pointed out to me, the Dodd rules won’t force the ones most responsible for the current problems to give back the tens of millions they made as they led their firms off the cliff Secondly, Wall Street is actually right that the best performers will be hurt the most, and they’ll jump ship. (It’s already happening. Just recently, a group of Merrill Lynch bankers, shortly after getting their share of the Merrill booty, split for Deutsche Bank, which does not have any American bailout money.)
Perversely, under the Dodd rules, the merely above-average performers have a better chance of making the big bucks than the true superstars at the top. And finally, the new rules encourage firms to give back the bailout money to avoid the pay restrictions. Given the still-fragile state of the financial system, that’s not a very smart idea.
What Wall Street really needs is smart pay incentives instead of dumb ones. Bonuses are not inherently evil — indeed, they are probably a sensible way to encourage risk-taking — so long as the bonuses reward genuine performance and calculated risk-taking, rather than the smoke-and-mirrors lunacy of the past few years. (The sheer size of bonuses, still based on the glory years, also needs to drop, though the market is likely to cure that problem as Wall Street’s business continues to deteriorate. After all, you can’t pay out money you don’t have.)
Thus, instead of the Dodd amendment, wouldn’t we be better of with an approach that requires everyone who gets a bonus to have a large chunk of it deferred? “You can have a pool of cash and common equity that would comprise the compensation that is being deferred,” said Jaidev R. Iyer, a managing director at the Global Association of Risk Professionals. “That way everyone would have skin in the game in terms of the ongoing health of the firm.” Traders would get the deferred portion of their bonus paid out over a number of years, as the profitability of their trades were assured. And if the trades went sour, traders would have to give some, or all, of their bonus back. That way, traders would have an incentive to act for the long term, instead of churning out short-term, often illusory, profits.
As it turns out, the one big Wall Street financial institution that comes closest to this approach is Mr. Mack’s firm, Morgan Stanley. Last year, it instituted new bonus rules that say the more senior you are, the more of your bonus you get in stock. What’s more, 65 percent of a trader’s bonus is deferred, and it vests over three years. If deals or trades you worked on later go bad, that portion of the bonus can be clawed back by the firm. It’s a step in the right direction.
During his testimony last week, Mr. Mack told the committee that he took no bonus in 2007 or 2008. He also likes to point out that in 2006, his bonus was all in stock.
I did a little checking. That 2006 bonus? It was worth $40 million at the time, making it, at least for a while, the largest bonus ever given to a Wall Street executive. No wonder he loves coming to work.