Mod note: Best of Eddie, this was originally posted on 10/9/12.
Sheila Bair has been making the rounds promoting her new book lately and, by and large, she hasn't said anything that she hasn't been saying for five years now. But one thing she said recently stuck out in my mind and got me thinking about incentives, especially those incentives that relate to banker pay.
There's no longer any question that the compensation structure was largely at fault for some of the ridiculous risks taken during the run up to the subprime crisis. And that's at all levels: from loan originators in strip malls all the way up to Wall Street CEO's. Everyone is talking about banker comp these days (Morgan Stanley's James Gorman even says it's still too high) because everyone is afraid of the next major crisis.
So an idea Bair came up with made some sense to me. Right now (post Dodd-Frank) the compensation structure has been changed to reflect a more sober environment: where bonuses used to be mostly cash now they're cash and stock - some bonuses are even majority stock at this point. The thinking is that the bankers will be more interested in the long term success of the bank (and by extension the bank's stock price) if they have some skin in the game. But maybe there's a way to skew it even further toward cautious stewardship.
What if bankers were paid in bonds instead of stock? There's an argument to be made that even a three-year lock-up on selling bonus shares could be circumvented by juicing the stock price temporarily (i.e. taking outsized risk and hoping it works out over 36 months). But if bankers were paid in bonds they'd have an even greater incentive to keep the ship upright and water tight.
I have to say there's some good logic there. While I don't think it's an easy feat to manipulate a stock price higher over the course of three years, I have to admit that paying guys in bonds would remove the temptation altogether.
Obviously this applies more to senior guys, and not much would change at the junior levels. But it makes pretty good sense to me. I'd like to hear an argument against it anyway.
What say you WSO?
Interesting. But wouldn't the amount of bonds awarded still be based on annual performance? And with the competition found on Wall St, you will still have people gambling for redemption.
What's more, the need to "keep the ship upright" is only as credible as the likelihood of a bank failure. Post-Lehman, is anybody going to let a BB fail? While clawbacks are possible, it still seems like the same incentives exist.
For all the talk about excessive risk taking, most executives are simply not aware of risks that may be hiding within the company. As Rumsfeld might say, it's the "unknown unknowns" that pose a threat. Outside of rogue traders, banks didn't blow themselves up prop trading because they knew it was risky. On the other hand, supposedly AAA securities nearly collapsed the financial system. And the London Whale came out of a risk management function.
That would be a risk-averting approach, and would stop shareholder equity dilution.
All good points, and you pointed out something I neglected to mention: in order for the bond compensation system to work there has to be no more corporate welfare. All the players have to know that if they fuck up they go under, no questions asked. The assumption of an unlimited government backstop is destroying the market right now.
Eddie, glad you mentioned the point about making firms accountable. Without that the whole point is pretty much moot.
Actually, that would be pretty interesting because you could include specific call provisions in the bonds relative to performance. How cool would it be to give a manager a 10 million bond callable after 5 years at 50% of par, if a certain set of benchmarks isn't met or the performance of the company falls below a certain level. Same can be said to give them guaranteed upside after a number of years should they hit all their metrics and exceed them. Granted, I would hate to be paid this way but it would certainly incentivize managers. I mean, suddenly the options are almost limitless on how you could structure your pay packages (not that they weren't before).
On a side note, think of how cool it would be to trade these types of bonds. You could create an entirely new market with all kinds of crazy bonds with different features and subtleties.
This would certainly make management guidance more meaningful. If some CEO promises to achieve a 15% ROE within 3 years, and has 50% of his deferred comp riding on it...I'll actually assume he is going to reach that target.
But it would create some very strange incentives. In the above example,if they are at 13% ROE 2 years in...well, guess it's time to take out a loan for a buyback!
I hope you mean if the EXECUTIVE'S performance falls below a certain level, his/her pay would be reduced. It's difficult to pin the blame for bad quarterly earnings onto one guy since there are so many factors that come into play.
Also, now that I think about it the only real reason that you need to pay guys in bonds is because there is the spectre of having to bail them out and thus curbing risk. Thus, if you take away the safety net, you can pay people however the hell you want. Microsoft, as said below, can pay anyone however they want because if they get blown up and fail it's just part of life.
@bTbanker, Yes, I am referencing the executive's performance but I think that a 5 year period is a decent reflection of the effect an executive has had on an organization. Obviously there are things far beyond your control and even the greatest CEO can't save some businesses, but after a certain point I think it is fair to lay the blame on an executive because they are being paid extraordinary amounts for that exact reason. They are the stewards of an organization and they will get both way too much credit and way too much blame.
I agree, it would create some very odd incentives but I would think you could reasonably make the case that deferred comp could end up being higher anyway because it isn't an initial cash outlay for the company. I could be totally and horrifically wrong, but I can imagine that you'd see compensation end up higher because of this.
This,though, is probably the only way for managers to get a meaningful stake in the company that is similar to an illiquid equity stake in a private company. You really can't get someone to care about a company that he has no stake in. I don't count giving someone a bunch of stock an 'equity stake' simply because it doesn't mean all that much really at the end of the day. They can still dump it on the market and I don't think that it still provides a mentality of being paid rather than taking ownership of it. That is the most important part IMO is the taking ownership in a company. That is as much a mentality as it is a pay structure.
Not sure if any measure will be able to circumvent the 'gambling' aspect of any business. High fliers in any industry will inherently take more risk. If you're going to pay bankers in bonds, why not pay the guys at Microsoft in bonds? Upper management at Microsoft is making a MASSIVE gamble with Windows 8.
I suppose I do understand this in the short term, but not in the long term.
MSFT doesn't pay out 45% of annual revenues as comp, so there's that.
As a point of curiosity, who does?
So I sell the bond to myself and reap both sides of the transaction? Brilliant!
Bankers should be paid a relatively high salary with no bonus like all other government employees.
At its core, this idea serves to neuter banks, and also makes the problem worse. Here's why:
The value of that bond will not go up. The incentive to increase the value of the company isn't tied to the payout. With this compensation structure, people are encouraged only to break even. It's literally encouraging mediocrity.
I think that bond or stock compensation will net out to the same effect and that putting restrictions on when they can monetize holdings is more pertinent. Five years or longer will be annoying to millionaires, but will guarantee they don't burn down the house for some short term gain. Ultimately, the equity partner model has been replaced by the publicly traded model, and people look at this as a JOB and not a CAREER....no compensation structure will change the fact that the most powerful dealmakers at publicly traded companies ultimately answer to a bunch of shareholders who can sell the stock of the company five minutes later: why should they be so much more invested in a company than the other owners? It breeds frustration -> apathy -> people rape the system or jump out and start their own...or both. Why the hell should anyone want a career at these banks? The money may come back, but the psychological motivators and freedom these platforms offered is gone.
ALSO: creditors are paid first in bankruptcy. With stock compensation, they can shoot for a big payout and hope to at least continue to boost the company value over time. With bonds, they KNOW that their comp won't increase in value over time beyond the predetermined amount. That might not even be a dealbreaker. But there is now the perverse structure where someone can see the benefit of taking a massive gamble that gets them a payout, say, this year, but kills the company in three years....and if the bank goes bankrupt, they know that bondholders have to be paid before everyone else and the value of that payout is GUARANTEED.
This is worded very clumsily, but I'm busy right now, so sorry about that. Honestly, this is a really bad idea put forth by someone who does not understand the industry or the mindset of the people who come here.
UFO,
You're showing your youth a bit here, which is understandable because you came of age in a post-Glass-Steagall world (at least I think you did). Banks are not supposed to grow. Banking is supposed to be the most staid and boring profession on the planet. Mediocrity=success in banking. There was an old axiom in banking known as the 3-6-3 business model: you take in money at 3 percent, you lend it out at 6 percent, and you're on the golf course by 3. This worked for bankers for nearly a century before everyone started getting cute with securitization and derivatives and whatnot.
This is a good point, and it's clear that compensation bonds would have to be subordinated (to just about everything else) to discourage this type of moral hazard.
It's unfortunate that she ever had to learn the investment banking side of the business, but Wall Street came to her with hat in hand begging for a handout. It's a pretty popular theme here on WSO: if you're gonna take welfare you gotta be willing to do what the fuck your benefactor tells you.
Cash, Equity or Bonds... None of these will work.
Why would getting paid in bonds make you take less risks? How many TBTF Bank bondholders lost money in the crisis? Very few. Most did quite well. Even those that did lose money (Lehman), were far better off than their respective equity holders. None of this is surprising.
This tinkering doesn't address the moral hazard of TBTF government guarantees, the successive public bailouts of financial institutions/bondholders since LTCM, regulatory capture and the other systemic issues that actually led to the crisis. The compensation issue is a symptom of those deeper institutional problems and not the cause of the crisis on its own, rather a contributing factor/enabling process.
Shouldn't there be some delineation made between those in S&T and those in IBD? Why would someone in M&A need to be tied up in the firm's performance for 3 years or anywhere near as long as someone who trades in structured products?
No.
I think a combination of bonds and options/stock would be good.
Eddie, what do you think of paying a portion of their comp in a bull spread instead of just a call option. Then they'll still have exposure to the stock upside, but it will have ceiling on it. I think if comp was going to be $5mm in bonds, plus a (restricted) call option bull spread that will be worth another $2mm maximum or something if the stock reaches a reasonable level in a few years might be a good way to get the incentives, if not perfect, at least less bad than the past systems.
In a perverse way I can actually see that making matters worse. Think about it: if you knew your bonus was capped at a maximum level, wouldn't you do anything and everything to ensure that you got every last penny? I can actually see where a cap on equity appreciation could lead to even greater moral hazard.
Or maybe I'm just a dick.
THis would never work in my opinion because the amount of structural changes that would have to happen would be enormous. You said that there would have to be no corporate welfare anymore (bailouts, toxic asset buys, etc.) but the fact is that the U.S. political system will never venture away from bailouts. Sure, people now say that bailouts are terrible, but in the heat of the moment politicians are more scared for their reputation and job than their moral qualms. Maybe a few people like Ron Paul or his son would stand up. But look at LTCM, GS 1993, TARP. After each one they said "no more!" but the next time a crisis rolls around they are on the front lines promoting it.
Because of this, paying with bonds will be essentially paying with cash (although IR changes can impact it). The CEO has no incentive to do anything different, except the fact that he now has a ton of bonds that he can use as loan collateral. (a la McClendon)
Personally I think that investment banks should grow, commercial banks not so much. That is the main problem with the repeal of Glass-Steagall. While I generally think less regulation is better, I think that we would either need to re-separate banks or make it more segregated. (Umbrella corporation rather than unified one)
Honestly compensation will be messed up as long as the government continues to involve itself in bailouts. Options at least incentivize the CEOs to maximize equity while making sure that it doesn't collapse and reduce the options to 0. If only the U.S. government has the balls of Iceland then we could get everything right.
I'm not sure repeal of Glass-Steagall actually was the reason of the crisis. I mean Lehman brothers wasn't affiliated to any commercial banks when it failed.
One of my friends saw the title of this thread and suggested it be rename to... "Should bankers be paid?"
Haha... She kinda has a point though... I mean, they are doing God's work...
Hahahahahaha I'm with you bro
If Gorman still thinks comp is too high, why doesn't he take a $0 bonus and $1 salary?
was it really the guys at the top that caused the crisis? i saw it more as a lack of oversight as noone cared since money was flowing in.
In the case of Magnetar, it was everyone at the firm, and how their entire business was structured, so......
While there is the juicing the stock thing to worry about, shares have an advantage over bonds in the mitigating risk department. In normal bankruptcy cases the bond holders would see money before the stock holders. Maybe its just me but if I knew that my company bonus was higher in seniority than the share holders of the company I would be taking more risks to increase my bonus pay.
Isn't Credit Suisse (or maybe it was Deutsche Bank) already paying some of their bankers in bonds? I'm pretty sure they off-loaded some of their securitized products on to their employees back in 2010, 2011...
http://www.bloomberg.com/news/2012-01-23/credit-suisse-bonuses-to-inclu…
Hey dawg, I put your bonus in a derivative of a derivative
How about Europe focus on how fucked every other part of their economy is instead of trying to control the payscale of one group of people. The problems stem from the government not having the will, power, or desire to enforce their own shitty rules. If insider trading, LIBOR manipulation, and other issues are as bad as we're told (they are) then actually make good rules and enforce them in those areas.
Good idea but it might hurt bankers in the long run.
Yeah, ha, "you created this shit, now we'll pay you with it!" Seems like a legit idea... However, when I first heard about it a few years back, and given the "optimistic" outlook on the economy, I thought to myself, "damn, these guys will probably make a killing on this even though it's supposed to be somewhat of a punishment!"...
And who says they haven't bought a put option on it?
Think about it: the gov't isn't allowing bankers to take what the g'vt creats and controls: cash. SO.....somehow......the solution is to make bankers take as payment something the bankers create and understand. It's like telling a drug dealer they will be paid ONLY in gold bullion and untraceable small bills from this day forward.
It's almost like a gift.
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