Monday, February 9, 2009

Five Pound Box of Money

Hey Santa Claus,
You want to make me happy this year?
Listen to me, honey:
Give Pearl something that'd be of some use to me, like a ...
Like a five pound box of money.

Now, now there’s a little gift
That’s loaded with
Lots of sentiment.
See, when uh ever I get blue, Santa,
I’m gonna think of you,
But at the same time have a little change to pay my rent, you see?

— Pearl Bailey, Five Pound Box of Money

Compensation, O Dearly Beloved, is a complicated thing.

I say this without fear of contradiction, because I have been thinking carefully about this subject for quite some time. In particular, I have been thinking and writing about compensation in the investment banking industry on this site for many moons, ever since a rag-tag collection of highly-credentialed yet woefully uninformed pundits began taking potshots at the source of my livelihood early last year. However, whenever I think I have the broad outlines of the conundrum clearly in my sights, I find that concentrating my attention on any one aspect of it tends to make the problem skitter away like mercury on a mirror. At other times, I feel like I am trying to nail jello to a wall.

In other words, Dear Friends, figuring out compensation is a bitch.

* * *

I should know this, of course, from my many years in the industry, both as a junior investment banker hanging breathlessly on some pompous Managing Director's pronouncement of the one number which represented the culmination of a year's worth of difficult, demeaning, and exhausting work and as one of those aforementioned MDs watching the frightened eyes of my junior bankers as I delivered the news. It is indicative of the tension and emotions boiling beneath the surface of the annual bonus discussion that the firms I worked for discovered they should separate the announcement of a banker's annual compensation from his or her year-end performance review. They soon figured out that once a banker heard The Number, all prior and subsequent conversation might as well have been conducted in Swahili.

People who do not work in investment banking simply cannot relate to this process. That is because, for most workers in most other industries, an annual bonus is a purely discretionary award, given to acknowledge good or exceptional performance, and one which they learn not to expect as an entitlement. Furthermore, a normal bonus outside the investment banking echo chamber is something like 10% or 20% of an employee's annual salary. For the big cheeses, sometimes you will even see a bonus of 100% or more of salary, for a year in which senior management really knocks the cover off the ball.

In banking, by contrast, bonuses—except for the most junior footsoldiers—can range from 200% up to 100 times or more of base salary. This is because bankers' base pay is a comparatively tiny proportion of their expected annual compensation. No matter how senior or how well-compensated a banker expects to be at the end of any year, it would be hard to find anyone in the industry who makes a salary in excess of $650,000 per year, including my favorite balding squintillionaire, Goldman Sachs CEO Lloyd Blankfein. This system is an historical artifact, dating back to the annual "draw" members would take from the equity of the original investment banking partnerships to pay personal expenses until they could divy up actual profits at the end of the year. (It is also a dusty relic of a time when $200,000 was a lot of money, even in New York City.)

While this legacy plays havoc with the personal finances of all but the most wealthy of investment bankers, it actually makes a good deal of sense. By paying even the most senior investment banker a relatively small percentage of his or her expected earnings as salary, the bank not only keeps the banker honed to a keen, aggressive, business-getting edge but also maintains a call on revenues the banker expects to bring in with a relatively low-cost option. If the banker doesn't deliver, poof!: he is fired, or paid a pittance as an option on next year's revenues, and told to pound sand if he doesn't like it. It is about as draconian a system of pay-for-performance as can be found anywhere.

It also makes sense because many business lines and forms of revenue at an investment bank are highly lumpy and extremely volatile. In any one year, a highly effective client-facing MD in traditional M&A or corporate finance can bring in anywhere from a few million to $100 million or more in revenue (net of direct expenses), depending on luck, fate, timing, and a million other circumstances beyond his or her control. It makes good economic sense to keep people like this on a small retainer, in the expectation that sooner or later they will hit the cover off the ball.

In contrast, what is an outstanding performance at a typical consumer goods company, selling another 500,000 units of Huggies to WalMart? Not to denigrate Huggies, or WalMart—God forbid—but you can see why a run-of-the-mill banker without management responsibilities can earn a $10 million bonus, while a consumer goods product manager is happy with a 20% bump to his salary.

* * *

Now this venerable system of paying your revenue-generating partners just enough to keep them solvent until the end of the year, when the bank's net profits after expenses were divvied up and distributed, began to change when investment banks began taking corporate form and retaining equity to fund their growth. Participation in growing global capital markets became a necessity, according to the heads of most of the leading investment banks, and funding that balance sheet and income statement growth was increasing leverage that required a growing cushion of equity. Eventually, of course, most of the old partnerships went public, and got public shareholders to fund their growth. But before that, and afterwards as well, they accumulated substantial equity by deferring a substantial portion of their bankers' annual pay in the form of restricted stock and options (or, as cynics like me like to think of them, interest-free loans).

As this practice spread, there was at first some lip service paid to the notion that bankers holding stock in their own firm aligned their interests with those of the public shareholders. Certain firms—most notably (and sadly for their employees) Bear Stearns and Lehman Brothers—developed very strong employee ownership cultures, and thousands of employees ended up retaining large holdings in their firms even after they vested. But no matter how much stock a banker might have, if he or she isn't in a position to make decisions which directly affect the management and direction of the firm, this "alignment" is mere window dressing, a canard. (You tell me: would you really feel like an owner if you held $10 million of unvested equity in a firm with a $50 billion market cap? Would you feel that almost anything you did or didn't do would have any noticeable effect whatsoever on such a behemoth? I wouldn't.)

Later, banks began imposing more and more onerous vesting schedules and restrictions on bankers' deferred pay, typically preventing them from taking delivery of deferred stock for up to three years (or even more) from the year it was granted, and forcing any banker who resigned to join a competitor to forfeit unvested awards. Management's nominal argument for these practices was that they encouraged employee retention, making it difficult for bankers to job hop around the Street.

But if this was indeed the reason, it was a very blunt and usually ineffective instrument in practice. It certainly did little to prevent other banks from hiring your star performers, since all they had to do was "buy out" a banker's unvested pay with an equivalent amount of unvested stock and options of their own. The only people these practices really encouraged to stay put were the average and even poor performers, who could not dream of getting bought out by a competitor. There was no clawback option in these plans, either, other than the nuclear option of confiscating an employee's unvested pay if he or she was fired for "cause," usually criminal. On the positive side, a bank which lost a star performer to a competitor could take some consolation by canceling the departing employee's deferred pay—thereby reducing past and future compensation expense—or, more commonly, turn around and use the freed-up stock to poach some other bank's rainmaker.

* * *

The thing which really broke the old Wall Street compensation system beyond repair, however, was the rise of proprietary trading at investment banks. As these banks bulked up their balance sheets to take advantage of larger and larger trading opportunities, traders on the prop desks began making bigger and bigger bets with more and more borrowed capital. Investment banks began emulating hedge funds, albeit highly leveraged ones, and the traders who placed these bets began pulling down enormous paychecks, even by the jaded standards of the dusty old i-bankers in corporate finance and M&A. Twenty-five, fifty, even sixty million dollar paydays became regular occurrences, and caused no end of envy and hate among the traditional investment bankers who used to rule the roost on the Street.

Of course, based on the old system of eating what you kill, those paychecks did make some crazy kind of sense. If a prop desk booked a billion dollars of net profit in a year—as the Salomon Brothers traders who later founded Long Term Capital Management were reputed to have done—why shouldn't they share a $75 or even $100 million bonus pool? Top management of investment banks, who increasingly came from the capital markets side of the house themselves as profits from that division ballooned, began to rely heavily on the supercharged profits successful proprietary trading generated to meet growth targets and satisfy shareholders. They did all they could to keep prop traders fat and happy, which became increasingly difficult as the independent hedge fund industry blossomed and any trader worth his salt could get a better bid away just by picking up the phone.

In addition to corrosive pay envy from bankers on the other side of the wall, this system also exacerbated the age-old tensions between the agency side of the business and the principal side. Client bankers may have groused when a successful prop trader took home a $25 million windfall in a good year, but they screamed bloody murder when he lost $300 million the following year. The injury that an M&A banker with a blowout year could see his bonus halved because some knucklehead on the govvie desk blew a half a billion dollars was only compounded by the insult that his unvested stock got slaughtered when the news hit the tape. It was no consolation that the offending trader was usually fired without a bonus.

Agency business—advising companies on mergers, underwriting stocks and bonds, and trading securities for clients' accounts—generates very little downside risk: whether you think it's right or not, the M&A advisors on the AOL Time Warner merger were not held liable when that deal went down the toilet. Similarly, an investment bank is usually only on the hook for its commission and incidental losses if an IPO tanks immediately after the offering. In contrast, principal activity can generate enormous losses, as we have all seen. This problem was compounded by the traditional Wall Street practice of paying bankers each year for the results they generated that year. When proprietary profits begin to act like insurance premiums, and a $100 million "profit" in year one carries a substantial risk of a $1 billion loss in year three, traditional pay-as-you-go comp practices—even with heavy emphasis on deferred pay—simply break down.

In fact, one could easily accuse the old system of making the reckless risk taking which has landed us in our current soup even worse. A clever trader who built up a $50 million position in unvested stock at Lehman Brothers on the back of risky long-tailed mortgage trades and who saw trouble coming had every incentive to jump ship and get another bank to buy him out. That way, when Lehman blew up, he was sitting pretty with stock in a firm not subject to those risks. One wonders whether some of these job-hopping superstars would have been quite so cavalier with their own bank's balance sheet if they knew that their net worth would remain exposed even if they swapped employers.

* * *

Anyone with half a brain realizes that Wall Street, with few exceptions, is badly broken. Its compensation practices either contributed to the mess or did nothing to prevent it. So where do we go from here?

First, I think we must realize that putting arbitrary pay caps on investment bankers and traders will be counterproductive. Our financial system is in a deep and muddy hole, and I, for one, have no interest in demotivating M&A advisors, capital markets bankers, and prop traders from making lots and lots of money for the US government and the banks' shareholders to fill in the hole. I don't think the Treasury does either, which is why the plan it proposed last week governing pay for senior executives at financial institutions suckling at the taxpayer's teat imposes no explicit limitations on total compensation for CEOs or anyone else. Sure, the plan imposes a $500,000 limit on annual cash compensation for "senior executives," but it makes provision for potentially unlimited amounts of deferred compensation for them and non-senior execs.

Believe it or not, my friends, half a million in cash, before taxes, is a pretty skimpy wage to support a CEO-type lifestyle in New York City. Nevertheless, most of the people who will be looking for these jobs are rich already, and I am sure their personal fleet of accountants, compensation experts, and tax advisors will be able to find them enough of the folding to keep the wife and mistress in Prada. As long as they can margin the Degas to pay the rent, I can think of a hundred guys who would love to book $25 to $50 million in deferred stock every year for three to six years, especially at the ridiculously depressed levels at which the banks in question currently trade.

As long as they repay the Treasury, and repair their institutions, I see no reason why we shouldn't wish them Godspeed. Furthermore, deferring the bulk of every banker's pay in like fashion makes eminent sense, too. M&A bankers, corporate security underwriters, and other investment bankers whose revenues carry no long-tail risk might legitimately complain that they are being tarred with the same brush as proprietary traders, and deferring the bulk of their pay constitutes an unfair hardship. But there are two reasons to disregard their complaints. First, one of the first things the walking wounded banks subject to these rules must do is re-equitize their balance sheets, and what better captive source of interest-free loans common equity is there than your employees? Second, while bankers like these on the agency side of the business contribute little risk to the overall organization, they definitely draw a substantial portion of their legitimacy, stature, and revenue-generating capabilities from their firm's franchise. Locking them up with long-term deferred comp seems a modest price to pay for renting Goldman Sachs' or JPMorgan's good name, in my humble opinion, especially since the bid away is practically nonexistent.

Prop traders, of course, should be locked up until Kingdom come, or at least until the cows come home. The ideal solution, actually, would be to set up internal hedge fund accounting at each bank. Track prop traders on their individual results, and pay them with long-vesting "shares" in their own trading book, just like real hedge fund managers. That'd align those little buggers, alright. Unfortunately, this solution is probably administratively unworkable, even if it is theoretically very neat. As a distant second best, pay them in restricted shares of the parent bank that vest on a schedule which matches as closely as possible the long-term risk profile of their trading activities. Effectively structured, such a program would render bonus "clawbacks"—and all such similar proposals being floated in the court of public opinion right now—effectively moot. (Given their position at the top of the food chain, and their responsibility for using proprietary trading to dig their banks out of the holes they have put themselves in, senior executive management pay should be structured in the same way.)

Of course, pushing the entire industry to deferred compensation will work much better if bankers can take their stock with them when they move. Let a banker jump ship to a competitor, if he or she wants to. Let them keep their currently unvested stock, with all restrictions and required holding periods intact, and the incentive to jump off a sinking platform onto a new one will be replaced by a clear self-interest in helping right the ship. Competitors who want to poach a rainmaker from another bank won't have to buy out his lifetime earnings from the previous employer, and the pressure to make big guarantees will moderate at the margin, too. The additional fact that no-one is hiring, and any bankers still employed will feel lucky just to have a seat, won't hurt either.

Finally, if the Treasury really wants to align incentives for banks under the TARP umbrella, they should stipulate that each bank's Chief Risk Officer should be compensated no less than the CEO for the duration of the restrictions. Some meaningful portion of the CRO's pay should be tied to the maintenance of low volatility and low net losses at the bank.

* * *

Does all this sound excessively simple, or naïve to you? It probably is. If there is one truism we can take to the bank, it is that well-designed and well-managed compensation systems are never simple. There are unintended consequences from every decision on pay, and comp systems must be constantly tweaked and adjusted to achieve their primary objective of motivating employees to effect the company's goals. The involvement of the government as regulator, lender, and shareholder only complicates a muddied picture even further.

But there is a simple solution for this, too. Employ executive compensation expert and gadfly Graef Crystal to review every compensation plan drafted by a bank receiving TARP funds. Bill his services at a rate of $500,000 per hour, and deduct his charges from the aggregate bonus pool available to senior executive management.

I bet you will see some of the shortest compensation plans ever drafted come out of Wall Street then.

© 2009 The Epicurean Dealmaker. All rights reserved.