Monday, December 03, 2007

Wall Street bonuses- skewed against shareholders?

Goldman Sachs will be handing out huge bonuses even in what is a miserable year for Wall Street. No question, Goldman has done well. It has hedged subprime risks, has reported healthy profit for the third quarter and is expected to do well in the last quarter as well. Enough reason for its CEO to walk away with something in excess of the $54 mn he earned last year.

But people at the top at Goldman know that huge payouts in times such as these are bound to attract hostility. They have sought to preempt it by announcing the creation of a charity, Goldman Gives., to which senior executives will contribute a part of their compensation. Each contributing partner will have his or her own account in the charity and will have say in determining beneficiaries.

In this, Goldman people are doing what the Narayana Murthys and Aziz Premjis have done long back as also Bill Gates and Warren Buffet (although both Gates and Buffet seemed to need some prodding). It helps if you are seen to give back to worthy causes; it also helps if you are seen to have a not very flamboyant lifestyle.

The problem arises with bonuses at firms that have not done well. How do you justify bonuses at firms that have seen an erosion in shareholder value? I address this in my latest ET column, Sorry, you can't touch my bonus.

There are two reasons why Wall Street might think this is justified. The first is that variable pay is a big piece of compensation on Wall Street - and this has to do with individual, not firm performance. If you don't have variable pay, then base pay will have to go up - and Wall Street firms would like to avoid that. The second reason is that performance is easilly measurable unlike in non-financial firms.

Fair enough. However, in financial firms, including banks, there is an issue of rewards not taking into account losses to the firm down the road. Firms pay when the individual performs but don't expect him to pay back when he inflicts losses on the firm. This does seem to be a problem given the scale of bonuses.

True, stock options that vest over a longish period go some way towards addressing the problem. But several problems remain. What if options vest in the third year and the individual
causes a loss in the fourth? What about payments that are made in cash? And what about rival firms taking care of options that are yet to vest when they poach a high performer?

Banks and investment banks are highly leveraged and banks enjoy a security net at the expense of the taxpayer. High leverage can result in high returns to equity and high bonuses when the going is good. It can result in bankruptcies when the going is bad. Incentives in financial firms seem to be skewed in favour of the individual and against the shareholder. The problem needs to be addressed.

27 comments:

Ludwig said...

Ram

Have been a silent reader of this blog for some time now. Thanks for many interesting posts. This current one was thought-provoking enough to provoke a comment!

In the ET article, you say at the beginning:

"But Wall Street’s top five firms are set to distribute $38 billion in bonuses this year, up from $36 billion last year. Bonuses in a year as bad as this one?"

I'm not sure I understand. If the top 5 firms have $2 billion more to distribute this year than last, doesn't that mean they've had a better year (i.e. made more money) than the last one? In which case the second sentence ("...year as bad as this one...") seems out of place.

If the firms made less money this year than last year, then where are they finding the extra $2 billion?

Also, while your explanation about the internal variation in bonuses makes sense (i.e. high performing individuals in badly performing firms getting high bonuses), shouldn't it all cancel out at an aggregate level? I mean, if the firms as a whole made less money this year than last year, wouldn't it make sense that they paid less bonuses this year than last, at an aggregate level?

Or did I misunderstand the "...year as bad as this one..." reference. Was the year bad for the economy as a whole, but good for the top 5, and so explaining the increased bonus?

Caveat: I'm not a finance/business type person by any stretch of the imagination, so I've probably missed something blindingly obvious! And any explanations will have to be made from Farex and spoon-fed!!

T T Ram Mohan said...

Ludwig, Thanks,first, for your kind sentiments!

When we say that firms have done better, we mean they have produced higher profits than expected or better profits than the previous year. We also mean that the stock prices of the firms have gone up. This not true of many Wall Street firms in the current year.

But this does not mean they do not have cash surpluses which they can distribute to employees. Bear Stearns is sitting on a pile of billions of dollars of cash inspite of huge losses it has incurred this year. When that cash is handed out to employees, to that extent shareholders are losers. Cash that is not handed out would sit in the firm and would belong to shareholders.

So, the firm as a whole may do badly, that is, it may run up a loss. But individuals and particular divisions may have generated profit. They are rewarded - and the reward comes out of cash surpluses with the firm, which could be the result of previous years' performance.

Trust this clarifies.

-TTR

Ludwig said...

TTR

Thanks for the clarification. Makes sense. If Bear Stearns had a worse year this time than the last one, and they gave out more in bonuses this year than they did last year, then what to say? Some skulduggery at work, is what springs to mind.

Anyway, the machinations of the Wall Street intellect are beyond the mental fabric of the biryani eating birdwatchers of Hyderabad.

Thanks again for your time and patience.

Raj said...

Raj Patel, ex-world Bank and now an activist has an interesting comment on the bonus earned by Goldman

Raj said...

Sorry, here's the link :

http://stuffedandstarved.org/drupal/node/256

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