Friday, May 22, 2009
The primary problem with Wall Street compensation, in aggregate, is not the quantum of it. As far as I'm concerned, that is for the Board, the management and shareholders to sort out. For many, many years (even decades), Wall Street compensation in aggregate has ranged between 45% and 60% of revenues, depending on the Firm and its capital and risk intensity.
Secretary Geithner was recently quoted as saying he was more concerned as well about the structure of that pay than the amount. At a high level, he is right.
The fact is, between 2003 and 2007, bankers and traders (but especially traders) saw levels of current cash compensation which were inordinately high relative to their long term incentive compensation. Their (traders) pay structure encouraged capital use and risk maximization for their companies because they made so much in current compensation ($3mm to $20mm was not unusual) with no at risk component. Wall Street was overcapitalized, and encouraged its traders to put that capital at risk by paying a lot in current money to do it.
The perception at places like Lehman and Bear Stearns, however, was that the stewards of the place nonetheless had such large stock positions (i.e. long term value at risk) that they would manage risk taking carefully. In turn, these stewards build large fixed income and real estate portfolios perceiving these asset classes to be lower risk. They then levered these asset classes to the max, blowing up their balance sheets to grow earnings higher and faster, and thus propel their shares higher.
From 2003 to 2007, it worked magically. Until it exploded and collapsed.
What to do?
1) Reduce annual cash compensation to minimum levels. Yes, New York has a high cost of living (lower now!) and people need to live here and make mortgage payments and experience the communist New York tax regime. But don't let Wall Street employees build wealth with their annual cash comp.
2) Create incentive compensation which is essentially a capital account whereby wealth builds within the financial institution for a long term partner at book value. Their net after tax incentive compensation should remain within the Company for most if not all of their career there - especially if the firm is a capital user and risk taker (i.e. not a merger advisory boutique, but a firm with lending and trading operations).
3) Be very cautious about stock as a long term incentive compensation tool. It's good, but it has limits. When it trades at book value of at an excellent firm, it has great perceived value as a store of money. When it trades to an inflated multiple of book or earnings, financial people no longer take it seriously as a compensation vehicle and demand more cash. In effect, they become sellers. Not good.
4) Let stars leave if they threaten your risk management systems through compensation demands. Traders were brilliant at levering hedge fund compensation levels to demand more money from their employers, threatening them (legitimately) with departure for greener pastures. Management did let some stars go, but caved far too often to mediocre guys who really didn't deserve the compensation they got; and certainly not in the structure they got it - i.e. too much current cash. Most sensible hedge fund managers tie up 95% of their money inside their funds as I'm suggesting for the larger financial institutions. In the 2003-2007 period, Wall Street traders were paid hedge fund money in cash and got most of it out annually, rather than having it tied up. The truth is, most financial institutions overvalue a given individual versus their Firm's franchise. It's natural, because we all like to believe we are irreplaceable. Truthfully? That's bullshit. Very few traders, bankers or investors truly merit what I'll call entrepreneurial wealth creation-type capital. And if you're a good financial institution, you'll survive the stars departure.
As we know, this ended in tears. The surviving firms had compensation models which were closer to the traditional private partnership, and that is what you need to replicate to manage risk carefully. If traders are risking their money for long term wealth creation, rather than using "funny money" to maximize a call option, they will invariably manage risk more prudently and so will their bosses. But in both cases, they are being rational. Just remember that. These are mostly smart, rational people; and they respond to the incentive you as a manager create for them.
I just hope the government doesn't destroy Wall Street. There is a reason we have had the most vibrant capital markets the world has ever seen.
In the greater scheme of economy destroying actions from the Obamanation this one is going to get little attention and yet potentially have big effect. Henry Waxman may do more damage to the economy writ large, but this one is serious too.