Wall Street Is Having Our Cake And Eating It Too: A Call To (Pragmatic) Action

The past few weeks have seen a spate of
announcements detailing upward surges in U.S.
investment banking compensation expenditures. Goldman Sachs began by boosting
compensation and benefits by 33%, Morgan Stanley recently
set aside 72% of second quarter revenues for compensation, Citibank
and UBS have each increased pay by 50%, and two days ago JPMorgan followed shrewdly
by announcing
increased salaries to be implemented in 2010. These announcements generally follow
on the heels of initial decisions to boost base salary and benefits in exchange
for bonus refinement.

Of course, some of these pay raises are predicated
on a more concentrated industry and Fed measures to prop up the financial
sector (i.e., Fed discount window, AIG ATM mechanism, etc). The rest of the pay raises are, as loyal Zero
Intelligence readers know, due to notorious high frequency trading platforms
(scamming retail/institutional investors). Unfortunately, in a de-leveraging
economy supported precariously by government/Fed handouts to opining Wall
Street professionals, all of these factors are transitory and short-lived.

High Frequency Trading will soon yield 0
economic profit when it becomes illegal, destroys the stock market or sufficient
players enter the game to arbitrage all profit away. Being in a concentrated
industry won’t help when a long and drawn out economic recovery ensues and puts
a damper on investment banking and underwriting/lending/securitization profits.
Soon enough, the Fed and Government’s kleptomaniac hands will become
politically tied down and the free money train will stop.

And since the only Fed strategy is to
re-inflate prior bubbles, we can assume such earnings streams will violently
come crashing down in the short or mid-term.

So why is the bailed out financial industry
able to brazenly raise pay in the faces of tax payers who indirectly funded it
and even as the real economy suffers
dramatically and will suffer for many years to come?

Well, suffice it to say, this is not the
first time in history shareholders have been left holding the short end of the
stick as an entire market collapses. The CEO’s of the 70’s were widely regarded
as ‘empire-builders.’ Under the guise of ‘diversification,’ managers would
gobble up useless company after useless company, enlarging their balance sheet
and then boosting their salaries accordingly even as they failed to properly
run the behemoth conglomerates they had created. Needless to say, shareholders
had been duped by managers.

In a landmark study, Jenson argued that
there was a cost to wasted free cash flows for any firm and that firms pursuing
‘diversification’ strategies were needlessly fritting away shareholder value.
The solution was corporate restructuring and the 80’s saw the rise of the LBO.
Poorly performing firms were taken over, leveraged and thoroughly controlled to
make sure managers didn’t do anything stupid.

Of course, as investors approached
‘irrationally exuberance,’ too many firms were taken over and over-leveraged
leading into the 90’s and shareholder value was destroyed due to ‘too much of a
good thing,’ and the decline of cheap credit markets led to the fall from grace
of the LBO.

Again, the solution was corporate
restructuring. Instead of debt and interest payments representing control, we
saw the rise of the executive stock option grant, share grant and
compensation/bonus packages more closely aligned to share price performance.
Everything looked good for a while.

But then management realized they could
game the system by boosting short term earnings through accounting massage, low
transparency and over-leveraging. The Kings of Wall Street realized that the
creation of bubbles (tech, real estate, commodities) allowed them to reap
disproportional benefits in the good times as stock prices surged irrationally,
and then profit even more during the bad times when their ‘bubblicious’
(Krugman) policies forced the Fed and Feds to hand over further power and
opportunity to them.

And now, even though their game has been
unmasked and the economy lies in ruins, Wall Street titans have the cahonas to
double-down, pat themselves on the back and grudgingly raise their compensation
to unprecedented levels.

Lest there be any lone voice arguing that
these levels of compensation are required to produce shareholder value, let’s
all take a look at this graph depicting Lehman Brothers compensation versus employee
compensation. And this is before we
knew we were in deep recession.

 

Clearly, such behaviour is far from
shareholder profit maximizing.

But luckily, there is a solution. A timely
and well thought out proposition and simulation done by Bhagat &
Romano suggests that the optimal corporate restructuring and incentivizing
involves largely a mix of restricted
stock and stock options (to be released some years hence, when the extent of
their policies should be more wholly reflected in the stock price).

Of course, there is the risk that policies
following the executives’ termination result in unfair stock price depression.
But, as recent history has shown, the risk that executive policy culminates in
disastrous effects years later is far too prevalent and systematically
compromising to ignore.

Although it would be best for shareholders
to enforce and stimulate the creation of such policy, the government should not
stand idly by and wait forever for shareholders to act. The systemic risks
posed by high-flying High Frequency Traders, sleazy lending and securitization,
corrupt hedge funds and ratings agencies must not be ignored by bodies politic
charged with safeguarding the public interest.

If the Fed is going to keep the bailout money
a-flowin’, we must at least pressure politicians and engage in shareholder
activism to restrict the compensation of executives (which enforces dependence on
future stock price/events). Such a modus operandi would at least be more
politically palatable and easier to handle than wrestling power away from Voldemort (the Fed).

 ‘Too-Big-To-Fail?’ Okay… Aside from staging a coup on the Powers-That-Be, we are stuck with this label for now...

‘Too-Big-To-Restrict-Bloated-Compensation?’ Hopefully not.

Comments

[Anonymous]

These mega banks should have been required to pay the AIG money back before they were allowed to give bonuses or raises!!! Goldman Sux alone got $13 billion in the back door when AIG was bailed out and the tax payers got reamed. Profitable my azz...we need to get GOldman out of our government and out of market manipulation...

[Anonymous]

You might like my blog, reactivated after 22 years at NY Observer and more recently Forbes.com and Daily Beast.
http://midaswatch1.blogspot.com

[Anonymous]

First, it's eat your cake and have it too...

Second, incentive structures are so bad in corporate america that any managerial accounting student (MBA Course) worth his salt could develop more effective programs... the research is out there.

Third, once you have let tarp recipients repay the loan and buy back their warrants, how the hell do you get to tell them what to do? Until we ban systemic risk or incentivize against it, from a fundamental perspective, our hands are tied... I realize there are some equities involved with GS for example, who got 100% on the dollar from AIG, but I say let em fail... if CIT can fail, then let them take all the compensation they want and give the bailout money to more, smaller firms to pick up the slack... let the buzzards have their feast.

[PragmaticIdealist]

http://en.wikipedia.org/wiki/Have_one's_cake_and_eat_it_too

1) "Have your cake and eat it too" is apparently more common, my good sir.

2) As I mentioned in the article, shareholder activism as well as regulations spurred by anger from 'Main Street' could well provide the impetus for compensation restructuring. Both factors have proven successful in the past. The Rise of the Institutional Shareholder has been historically associated with changes in corporate structure and there is no reason to assume that such power is unable to be revived henceforth. Of course, since there is a lot of systemic risk associated with financial management (as you rightfully point out) there is likely a need for government/regulatory intervention as well. But as in the case of Lehman's et al., we clearly see the damage such compensation initiatives can cause shareholders as well.

[trader1]

thanks for the post.  i think the whole issue of executive compensation (purely cash bonuses based on annual performance) is a crucial element in resolving what has led up to this financial crisis.  the whole bonus-seeking culture within the most-aggressive financial institutions, to include that of the traders and m&a bankers, has reinforced a systemic culture of taking risk only to boost short-term gains while often sacrificing strategic, long-term thinking and sound, sustainable investment that creates or unlocks added value to the overall economy.  the attempts so far to control how much executives are being paid haven't done anything to resolve the issue.  salary caps and/or bonus caps are a bit draconian.  there are more innovative ways to align incentives for management and the profit-generating positions within these institutions as outlined in this article.  in addition, it would be nice to see some severe penalties (of course, one can always lose his job - but, i'm talking more about financial penalties, i.e. forfeiting portion of base salary or no bonus similar to what credit suisse has done) when an executive or trader makes a poor risk management decision and costs the firm and its shareholders significant losses.