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
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.