What you reward: Part 1, is what I’ll believe in

December 23, 2008 | Capital markets, Regulation, Subprime, Theory, US News

What you reward gets increased.  So be very, very careful what you choose to reward.


For years I ran my for-profit consulting company with cash-oriented compensation.  For any contingent transaction – and most of our work involved contingencies – we never counted fees until we had them in hand.  At year-end, we’d examine all the receivables, one by one, to decide if they were good enough to count, and we had a hard standard.  We needed to have issued the invoice, the deal needed to be closed, the work done, and the client a reliable pay.  Otherwise we counted it at zero for bonus purposes.



Everything other than cash, baby, counted zero


Now we’ve moved to measuring EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), and I feel at sea.  So we produce a cash schedule, just so I can feel grounded. 



I sail on EBITDA and ground on the shoals of cash


Now, as the globe suffers through massive deleveraging and cash dehydration, we see that a healthier respect for cash, and greater skepticism over EBITDA, would have served lots of folks well.


But now the senior executives at certain Wall Street firms, starting with this smug quote from former Merrill Lynch CEO Stan O’Neil featured in an article from the New York Times:


December 18, 2008

On Wall Street, Bonuses, Not Profits, Were Real


“As a result of the extraordinary growth at Merrill during my tenure as C.E.O., the board saw fit to increase my compensation each year.”

E. Stanley O’Neal, the former chief executive of Merrill Lynch, March 2008



E. Stanley O’Neal, the former chief executive of Merrill Lynch, was paid $46 million in 2006, $18.5 million of it in cash.


‘Saw fit’



I’m fit to be tied


Doubtless Mr. O’Neil would hasten to point this out (buried late in the Times article):


About 57% of their pay was in stock, which would lose much of its value over the next two years –


Cynics would point out that $18,000,000 of it was in cash.


– but even the cash portions of their bonus were generous: $18.5 million for Mr. O’Neal, and $14.5 million for Mr. Kim, according to Equilar.




For Dow Kim, 2006 was a very good year. While his salary at Merrill Lynch was $350,000, his total compensation was 100 times that — $35 million.


The difference between the two amounts was his bonus, a rich reward for the robust earnings made by the traders he oversaw in Merrill’s mortgage business.



From the NYT: very helpful  graphic on bonuses relative to salary


Very large compensation is sometimes – often? – justified, if people took risks, or produced unique or extraordinary results.  Normally, however, such extraordinary compensation flows from something longer-term than just one year’s results, particularly if those results are expressed as earnings


Mr. Kim’s colleagues, not only at his level, but far down the ranks, also pocketed large paychecks. In all, Merrill handed out $5 billion to $6 billion in bonuses that year. A 20-something analyst with a base salary of $130,000 collected a bonus of $250,000. And a 30-something trader with a $180,000 salary got $5 million.


By itself, the age isn’t important – talent should be rewarded regardless of gerontocracy.  The Times is trying to evoke outrage at the compensation amount, when it should be focused on how the compensation was calculated.


Critics say bonuses never should have been so big in the first place, because they were based on ephemeral earnings.


Even when the Times has it partly right, it cannot resist the loaded word.  The earnings aren’t ‘ephemeral,’ they’re non-cash, based on expected value.  But they are predicated on EBITDA projections that themselves derived from a fistful of optimistic assumptions about the performance of the securities sliced into all those little pieces parts.



We’re confident they’ll grow up to perform well


But Merrill’s record earnings in 2006 — $7.5 billion — turned out to be a mirage. The company has since lost three times that amount, largely because the mortgage investments that supposedly had powered some of those profits plunged in value.


The mortgages plunged in value for two reasons: (1) some underlying loans defaulted, and (2) Wall Street woke up to panic, realizing that the previous ratings were illusory. 


Unlike the earnings, however, the bonuses have not been reversed.


In privately owned firms, you carry your bonus in equity, and you can’t cash it in.  That’s a good model because it aligns incentives and keeps decision-making private.  The people you account to are your partners, and they know the business as well as you do. 


As regulators and shareholders sift through the rubble of the financial crisis, questions are being asked about what role lavish bonuses played in the debacle.


What role do you think they played?  They goaded people into taking risks – with other people’s money – and convincing themselves the risks weren’t risky.



Our whole business unit is sure this is safe


Scrutiny over pay is intensifying as banks like Merrill prepare to dole out [wrong word – Ed.] bonuses even after they have had to be propped up with billions of dollars of taxpayers’ money. While bonuses are expected to be half of what they were a year ago, some bankers could still collect millions of dollars.


At issue – which the Times doesn’t mention – is whether the bonuses are contractual obligations, and whether the TARP money precluded them. 


“Compensation was flawed top to bottom,” said Lucian A. Bebchuk, a professor at Harvard Law School and an expert on compensation. “The whole organization was responding to distorted incentives.”


What you reward gets increased.  Reward EBITDA without cash, you get more EBITDA without more cash; in fact, you use cash to create EBITDA, a decision you will rue.



I thought EBITDA was just fine


Even Wall Streeters concede they were dazzled by the money. To earn bigger bonuses, many traders ignored or played down the risks they took until their bonuses were paid.


Traders are risk-takers.  Caution is for wimps.  I don’t blame them any more than I blame vampire bats or chum-addled sharks.



We’re not frenzied yet, chum


Who should be blamed?



As a result of your catastrophic performance, the blogger ‘saw fit’ to blame the CEO


Their bosses often turned a blind eye because it was in their interest as well.


Well, duh.


I’ve always had my worries about large financial institutions that are publicly owned, because the principal-agent risks are so extreme.  Shareholders pay cash bonuses to employees who own small amounts of stock.  Gordon Gekko had it right:


The Carnegies, the Mellons, the men that built this great industrial empire, made sure of it because it was their money at stake. Today, management has no stake in the company! All together, these men sitting up here own less than three percent of the company. And where does Mr. Cromwell put his million-dollar salary? Not in Teldar stock; he owns less than one percent. You own the company. That’s right, you, the stockholder. And you are all being royally screwed over by these, these bureaucrats, with their luncheons, their hunting and fishing trips, their corporate jets and golden parachutes.



You are being royally screwed …

Cromwell: This is an outrage! You’re out of line Gekko!
Gordon Gekko: Teldar Paper, Mr. Cromwell, Teldar Paper has 33 different vice presidents each earning over 200 thousand dollars a year. Now, I have spent the last two months analyzing what all these guys do, and I still can’t figure it out. One thing I do know is that our paper company lost 110 million dollars last year, and I’ll bet that half of that was spent in all the paperwork going back and forth between all these vice presidents. The new law of evolution in corporate America seems to be survival of the unfittest. Well, in my book you either do it right or you get eliminated.


Management has a duty to be skeptical, tough, and restraining.  Many in these conglomerates failed their duty, in part because they genuflected before EBITDA, and EBITDA was controlled by accounting wizards who themselves fed at the same trough.


“That’s a call that senior management or risk management should question, but of course their pay was tied to it too,” said Brian Lin, a former mortgage trader at Merrill Lynch.



Our pay is tied to our beliefs


Everybody in management had a shared interest in believing in EBITDA.



Keep believing in me and you’ll get paid



[Continued tomorrow in Part 2.]