Hedging Your Bonus

I had to stop and think about this one for a few minutes. Eric Dash wrote this piece for Dealbook outlining how partners at Goldman Sachs (among other banks) have been hedging the non-cash portions of their bonuses since 2007. On the surface, it looks like an attempt to circumvent the "safeguards" put in place to keep top bankers focused on the long-term health of the bank and not just taking huge risks to juice a year-end bonus.

Basically what's going on is that top bankers whose bonuses include a hefty portion of illiquid stock are buying puts on their own bank's stock to offset the risk of their bonus stock dropping before they can sell it. Smart, right? But think about the implications for a moment. If you have a bunch of stock you can't sell for two or three years, but you've effectively hedged it with downside protection, do you really care if the company's stock drops?

Employees who hedge their holdings are less concerned about a falling share price. That’s why the government barred top executives at banks that received multiple bailouts from using the strategies until they paid back the funds.

“Many of these hedging activities can create situations when the executives’ interests run counter to the company,’’ said Patrick McGurn, a governance adviser at RiskMetrics.

More broadly, critics say, the practice represents another end run around financial reform.

“Wall Street is saying it is reforming itself by granting stock to executives and exposing them to the long-term risk of that investment,’’ said Lynn E. Turner, a former chief accountant at the Securities and Exchange Commission. “Hedging the risk can substantially undo that reform.’’

So I ask you guys: Is hedging your bonus stock a good idea, or just another way to get around regulations?

Comments (26)

Feb 10, 2011 - 8:18am

Edmundo Braverman:
Buying puts isn't exactly shorting, per se. In fact, for anyone else it would be a bona fide hedge.

Eddie, most firms have a policy against buying naked puts on your own firm as well- or taking any financial interest contrary to the firm. I am not sure how they are allowed to do this at GS, but at the two BBs I've worked for, naked puts are explicitly prohibited, in addition to CDS products, even a $50 bet with your friend that the company misses earnings technically violates my current personal investment policy.

Whether or not it's explicitly prohibited, placing bets against your own firm is a good way to get yourself in trouble- especially if your bank has a strong team/loyalty to the firm culture.

The problem with deferred comp is that it only vests at the same time you can sell it. Most people who work for a company might be willing to own its stock for five years, but won't want to wait at the same firm five years for it to vest.

Feb 10, 2011 - 7:06am

The Law of Unintended Results...the free market is always smarter than government. Watch out if government ever starts paying incentive bonuses to it's employees!

A good friend will come and bail you out of jail...but a true friend will be sitting next to you saying, "Damn...that was fun!"
Feb 10, 2011 - 12:36pm

Juwanna Mann:
Obvious noob question, I'm sure, but wouldn't it be prohibitively expensive to buy 2-3 year puts?

One way of getting around the cost of those premiums is to sell calls. It effectively locks you in at a certain price. It's what Mark Cuban did when his company sold at the height of the dot com boom.

As for the buying of the puts - that's just smart.

Feb 10, 2011 - 9:29am

^^^ Why would anyone own unrestricted stock in their own firm? You have enough exposure as it is as an employee, and if you're getting RSUs as bonuses, perhaps another 30% of your net worth is tied up in the firm. A diversified portfolio is tough enough with RSUs- I think a lot of smart financiers are going to be very careful when it comes to having unrestricted company stock in their PAs.

Feb 10, 2011 - 12:23pm

If I am not mistaken, I think that John Arnold wanted to buy some puts when Enron was teetering. He asked ones of his colleagues in an e-mail about the legality, costs, etc.

Enriching yourself at the firm's demise would be fucking awesome.

Perhaps at the moment, but in the long run, there is always the legal process and in the very long run, there's the final judgment. Best to enrich yourself in ways that are more reasonable.

Feb 10, 2011 - 1:44pm

Dot com entrepreneurs did a lot of that, mostly through equity swaps to get around the shorting regulations. That caused a scandal, and now most avenues are explicitly prohibited either by law and/or employment contracts (like Illini's).

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