Putting an end to Wall Street’s ‘I’ll be gone, you’ll be gone’ bonuses
By Barry Ritholtz
Washington Post
Saturday, March 12, 2011; 6:08 PM

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Want to reform Wall Street bonuses? Try clawbacks.

That’s right. We need to make executives personally liable for their reckless bets if we want to remove the risk for taxpayers. That means giving shareholders, boards of directors and regulators the ability to “clawback” past gains when new speculations go horribly wrong.

The Federal Deposit Insurance Corp. and the Securities and Exchange Commission have floated proposals on performance-based compensation for traders and bankers. Firms that have more than $1 billion in assets would have to disclose incentive-based bonuses. The largest firms (those with more than $50 billion in assets) would have to pay at least half of their bonuses in compensation that is deferred for three years. The SEC could, in theory, deny plans that encourage excessive risk-taking or outrageous bonuses.

While this approach is well-intentioned, Wall Street has proven itself especially adept at circumventing compensation laws. Rules that seek to limit bonuses will likely shift compensation more to salary and commissions.

Private profit, public risk

Understand this: I do not care what shareholders and their boards pay the people who create enormous value. Whether it’s a chief executive such as Steve Jobs of Apple or a hedge-fund manager such as Steve Cohen of SAC Capital, the people who are paid handsomely for creating incredible profit are not the problem.

On the other hand, many others received huge bonuses for bankrupting their firms and driving the economy into recession. Their job performance should be the subject of your ire and of regulators. They brought the world to the abyss of economic collapse because they had incentives to do so.

If that sounds unbelievable, consider:

• Subprime mortgage brokers who were paid based on the quantity – not the quality – of their mortgage writing. The loans lenders sold to Wall Street to be securitized carried a 90-day warranty. Hence, the brokers’ jobs were to find people who would make the first three monthly payments of a 30-year loan. After that, it was no longer their concern.

• Derivative traders who knew that what they were buying was going to blow up. In 2007, I published an e-mail from one such trader who wrote, “We knew we were buying time bombs.” The motivation was deal fees and bonuses. Once the derivative machinery was in motion, they had to “keep buying collateral, in order to keep issuing these transactions.”

• Collateralized debt obligation managers whose job it was to assemble pools of mortgages, yet had little or no understanding of the underlying loans. The salespeople, traders and managers working in the mortgage sector had incentives that were upside down. The greater the risk they took, the more they were paid. But brunt of those risks was on third parties, never themselves. It was shareholders and taxpayers who shouldered them.

This is backward. The people who should bear the downside are the ones who have the upside. Instead, the system was perversely one of private profit but public risk.

Note that it wasn’t merely the staff that engaged in this reckless risk-taking. At investment banks, senior managements were so reckless that they managed to destroy their firms. For this act of gross incompetency, they were rewarded with vast bonuses in cash and stock options. By the time their firms collapsed, they had cashed out hundreds of millions of dollars in legal booty.

Consider:

• Lehman Brothers Chairman and CEO Richard Fuld Jr. made nearly a half-billion – $490 million – from selling Lehman stock in the years before it filed for Chapter 11 bankruptcy.

• Countrywide Financial (now owned by Bank of America) founder and CEO Angelo Mozilo cashed in $122 million in stock options in 2007; His total take is estimated at more than $400 million dollars.

• Stanley O’Neal, who steered Merrill Lynch into financial collapse before it was taken over in a shotgun wedding with Bank of America in 2008, was given a package of $160 million when he retired.

• Bear Stearns former chairman Jimmy Cayne, rescued by a $29 billion Fed shotgun wedding to JPMorgan Chase, received $60 million when he was replaced;

• Fannie Mae CEO Daniel Mudd received $11.6 million in 2007. His counterpart at Freddie Mac, Richard Syron, brought in $18 million. In 2008, the two were forced into government conservatorship.

Add to this list Washington Mutual, Wachovia, IndyMac and other bankrupted firms whose senior management took a boatload of money and ran.

Nice work if you can get it – and still live with yourself.

Blame game

How did this happen? Some people blame excessive greed; others say crony capitalism is at fault. I believe we can sum it up in one word: liability.

In recent years, there was no legal liability for extreme recklessness. Take a healthy company, roll the dice and if it comes up snake eyes, all you lose are your unvested stock options. Most management does not have significant capital at risk.

The cost for pushing a healthy firm into insolvency by excessive risk-taking is some snickering at the golf course. In terms of lost monies, it is minimal.

You might be surprised to learn that it was not always this way. Before these firms went public in the 1970s and 1980s, bank management had full liability for their firm’s losses. During the era of Wall Street partnerships, if employees were so reckless as to lose billions of dollars, the partners were on the hook for the full amount. This meant that after the firm was liquidated to pay its debts, the partners’ personal assets were next on the auction block: Houses, cars, boats, even watches were sold to satisfy the debt.

Not surprisingly, partnership liability worked wonders in focusing attention on taking appropriate risks.

Once a bank or investment firm went public, this liability shifted from management to the company’s stockholders and creditors (namely, the bond holders). Add to this the rise of stock-option compensation, and you have a recipe for extreme short-termism.

In his book “The Accidental Investment Banker,” Jonathan Knee described this mercenary attitude with the phrase “IBGYBG.” As bankers signed off on increasingly risky deals, IBGYBG meant “I’ll be gone, you’ll be gone” by the time the really messy stuff hit the fan. Call it what you will – smash and grab, take the money and run. Without partnership liability or clawback terms, IBGYBG was perfectly legal.

The simple solution to IBGYBG is legal liability.

How this works: There must be a civil liability for recklessness that caused a collapse or loss. Liability for loss accrues when a trader knew and disregarded the risk or, failing that, should have been aware of the risks they were taking.

The ability to clawback past gains in the event of a subsequent collapse should accrue to the board of directors, the shareholders and the SEC.

It is too late to force the big banks and investment houses to go private and become partnerships again. However, we can return the liability for their recklessness back to where it belongs – on the traders, fund managers and executives who profited from extreme risk-taking.

~~~

Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, The Big Picture.

Originally published in the Sunday Washington Post, March 13, 2011

Category: Bailouts, Legal, Wages & Income

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

25 Responses to “Putting an end to Wall Street’s ‘I’ll be gone, you’ll be gone’ bonuses”

  1. Clawbacks are a great idea, Barry. Or, we could utilize stock option rewards where the options don’t vest for 5 years (all or nothing) or tiered over a 7 year period. This forces a longer term approach as well. You are right that we can’t get the partnership structure back, but we can re-enact Glass-Steagall. That would be a great start.

    Also, bankers were legally liable and faced possible prison time before the Great Depression. Not sure that would be the best idea, but it would certainly influence behavior.

  2. MayorQuimby says:

    HOW DO I APPLAUD LOUDLY ON THE INTERNET?!

  3. klynchit says:

    Stealing computer code from Goldman Sachs: 8 years in prison. Goldman Sachs unleashing financial weapons of mass destruction: Priceless.

  4. Clay says:

    Nice article Barry. Hope it helps get the ball rolling with your suggestions.

  5. BusSchDean says:

    Terrific Post — Applauding Loudly!!

    When I talk with alumni and other business professionals personal accountability ranks at the top of the qualities they seek in a business school graduate (up there with communication skills, a willingness to learn, quant skills, etc.). Time for business leaders and regulators to walk the talk. Publicly “out” and get rid of those who seek to delink risk from reward and compensation from performance accountability. Publicly cherish those who are smart enough to make profits by identifying quality business practices and opportunities.

  6. Hausse says:

    As logical, sound and downright common sense as this suggestion is, as unlikely it is to actually happen. That’s the tragedy of how corporate and political ethics have degraded. And it’s a global phenomenon – we have the exact same problem in Sweden where I live.

  7. advsys says:

    I got another word for you. Accountability!

  8. crutcher says:

    The fact that someone with integrity and intellectual firepower can still be published in the Wa Post is encouraging – great article BR

    Chances that your proposals come to pass…….?

  9. mathman says:

    i wish we could put an end to the Republican Party (in its current, bat-shit crazy form):

    http://crooksandliars.com/karoli/hr-3-requires-irs-perform-abortion-audits

  10. newton says:

    great stuff, didn’t catch it in WaPo. thanks for posting.

  11. rallip3 says:

    On the question of limited liability and bosses’ pay, it does not make sense to single out the banks. Taking the rough with the smooth, I’d back less rules rather than more. We certainly don’t want to give lawyers new ammunition to sue! I would say also that financial employee bonuses should be skewed in favor of agency commissions like brokerage or M&A fees; if someone is paid to trade the bank’s proprietary book or to allocate credit, those profits should be kept by the shareholders who are bearing the downside. If traders want to make it big, they should trade their own money or launch a hedge fund.

    I agree that there is a problem with moral hazard when the sovereign feels forced to underwrite liabilities of failed financial intermediaries. This is being mitigated by increased capital requirements and greater oversight. But I would like in addition to see Central Banks in growth years targeting domestic credit expansion and leaning against overshoots. Piling on total debt too fast has to increase systemic fragility, even if it is impossible to know in advance where or when the hits will come. In the US, I would like to see the SEC create a ‘Securitization Act’ which codifies the rules for packaging loans to be sold to investors (eg only the top tranche of a securitization can be called ‘debt’. All the junior tranches should be labelled as equity since they depend on the difference between assets and liabilities).

    Make banking more boring and market forces will quickly bring down excessive remuneration.

  12. Petey Wheatstraw says:

    SwimUpstreamToWealth Says:

    “Also, bankers were legally liable and faced possible prison time before the Great Depression. Not sure that would be the best idea, but it would certainly influence behavior.”
    ______________

    Can’t see why it isn’t the best idea ever. Prison time, clawbacks, and punitive fines that exceed the value of the crimes by several orders of magnitude. Decimation of their ranks is in order (literally). Any punishment short of that, no matter how harsh, should be considered a bonus.

  13. BusSchDean says:

    Can we possibly have a world where a talented and responsible plumber is valued more than an untalented and irresponsible banker?

  14. DL says:

    Clawbacks?

    BR is “preaching to the choir” on this one.

    I’m more of a free market-type person than most people who post here, but when it comes to institutions that are deemed “TBTF”, I’m an enthusiastic advocate of clawbacks.

    ~~~~~~~~~~~~~~

    In search of a bit of controversy, I would say that clawback provisions should be extended to other industries, particularly the automobile industry, that receive bailouts.

  15. carleric says:

    DL….I agree about the other industries even if it wasn’t malfeasance but stupidty and greed…..and as for Barry’s article, I only sigh and say “if only”, “If only”

  16. b_thunder says:

    Clawbacks? Yes, it’s a good idea, but really, Barry, did you just came back to Earth from a 2-year mission to Mars?
    Didn’t you hear that banks are back to business as usual, with all the stock buybacks and dividends as if the bailouts never happened? Do you really believe that after literally stealing money from all the prudent mom&pop savers and funneling it to the banks so that they can pay dividends (that mostly go to the top 0.01%) and stock buybacks (mostly from present and past executives and other insiders) the same bank execs will be forced to give back those “hard stolen” dividends? Would you try to claw back money from the ex-Goldman execs who now work for US Treasury? Would you try to claw back bonuses from the ex-bank lawyer who now runs enforcement division of the SEC? Would you claw back from PIMCO clients and Bill Gross who, in September 2008, was appearing on TV more frequently than Bush, Paulson and Bernanke combined, and who relentlessly lobbied for the “government” purchasing the very same junk paper that he was holding in PIMCO? Would you clawback from “good old’” Uncle Warren who, like Gross, aggressively lobbied the government to bailout the banks and who currently is the single biggest beneficiary of those bailouts? (he just happens to be the largest shareholder of wells fargo, axp and goldman!)

    But seriously, you’re talking about investigating tens (if not hundreds) of thousands of people just on Wall Street, and additional hundreds of thousands when it comes to the entire mortgage chain. And this is when SEC’s is understaffed, run by ex-bankers, employs bankers-in-waiting, and is equipped with computers so old that they’re incapable of even displaying quality internet porn!

  17. hammerandtong2001 says:

    As b_thunder says…

    I guess it’s a good idea to close the barn door. But we do know those horses are long gone.

    .

  18. wngoju says:

    The clawback idea is good, but apply it generally. Ie, what about “private equity” aka leveraged (that word again) buyouts.

    Private Equity for fun and profit:
    1. Buy a healthy company which has a bunch of cash. Use some of the “private equity” but mostly borrow to do it.
    2. Now you own the cash. Pay yourself a “fee” with the cash. Now you can’t loose. You be gone. But wait; there’s more.
    3. Restructure the financing. Now the loans are collateralized by the company’s assets, not the “private equity”. Oh. You get a fee for this.
    4. Tell the former managers of the company to work their rear’s off for two years to “streamline” the company and show some “profit”. If they do that they’ll be rich when the IPO happens.
    5. If you are lucky the economy limps along for a while, and indeed you can IPO the company. Again, you get paid a big fee, you own 50% of the company and make zillions, the management makes a few mill.
    6. If the economy waivers, the company crashes – it has probably negative margin for error – and becomes another hulk – out in the midwest somewhere. Former employees wandering around like refugees from the Japanese Tsunami. But you be gone.

    NB – you can get out at any point after step one with tons of cash. But you are streamlining the company – making it efficient! Ya.

  19. bman says:

    I still think that they should be Taxed, vigorously. A clawback law is a nice idea, but like any newfangled toy, it comes in all shiny then a little while later it gets put on the shelf and forgotten. The IRS has a long tradition of good public service. Put them to work. By taxing the corporations at 50% you will force them to invest, one way or another. Yes they will find loopholes, in fact that is what you want, loopholes that encourage them to invest in this country. Even if they refuse to invest and waste their money on bonuses at least 50% will go to the common weal.

  20. lalaland says:

    What kind of ‘capture’ is it when the regulators are straight jacketed by congress, which has been ‘captured’ instead of the regulators? Republicans are all ginned up to start ‘cutting red tape’ again…

  21. MP32 says:

    On the very week that Lehman collapsed (September 2008), my wise old friend, Al Wojnilower, said:
    “The way to stop Wall Street firms gambling with ‘Other Peoples Money’ is simple: Require that ALL financial companies, except stringently regulated Banks authorized to take deposits from the Public, be private partnerships with UNLIMITED PERSONAL LIABILITY.

    “With this Rule: Banks, Trading Houses, Hedge Funds, et al, could no longer play their self-enriching game: ‘Heads we win; Tails, the Taxpayer loses.’” (Technically: 30X Leverage would no longer be sought by or available to Wall Street gamblers or its dubious ‘innovations’, like securitization of CDOs, CMOs, etc.)

    But don’t expect this Rule to become law, or even discussed. The USA is a Plutocracy. The Financial Industry is the largest provider – by far – of campaign funds to Politicians at all levels of Government.
    And Wall Street is still the favored destination for millions of Americans hoping to “make money” more easily than gambling in Las Vegas; and for thousands of University graduates determined to gain employment in the Financial Industry as croupiers…

    To expose the Emperor’s (Wall Street) New Clothes, to show the Goose’s Golden Eggs to be Fool’s Gold, requires American voters to relinquish their “Impossible Dream”: We can all get rich quick.

  22. Theba says:

    BR – An island of sanity in a sea of stupidity.

  23. blackjaquekerouac says:

    More like “I’ll be LONG gone buddy while you’ll just be friggin GONE, man, gone…as in “blown away” by me and “what i can do to those who claim to represent you.” I’m just bummed out I wasn’t in on the scam to begin with. What else CAN you say?

  24. Mickey Z. says:

    I can already see the response to this one…”It’s not fair to threaten our compensation when we have to deal with so much regulation and government interference!”.