What you reward: Part 2, be careful what you wish for
[Continued from yesterday's Part 1.]
Yesterday we focused on the weakness of compensation structures tied to annual EBITDA calculation, using as our text an article from the New York Times that opened with an infuriatingly smug quote from now—departed CEO Stanley O’Neil:
“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
– which reminded me of a particularly damning passage from Michael Lewis’s Conde Nast Portfolio article on the boom’s end. But first, I have to set it up:
In the spring of 2007, the market strengthened. But, says [Steve] Eisman [formerly of Oppenheimer], “credit quality always gets better in March and April. And the reason it always gets better in March and April is that people get their tax refunds. You would think people in the securitization world would know this. We just thought that was moronic.”
Tugg Speedman: In a weird way I had to sort of just free myself up to believe that it was okay to be stupid or dumb.
Kirk Lazarus: To be a moron.
Tugg Speedman: Yeah!
Kirk Lazarus: To be moronical.
Tugg Speedman: Exactly, to be a moron.
Kirk Lazarus: An imbecile.
Tugg Speedman: Yeah!
Kirk Lazarus: Like the dumbest mother fucker that ever lived.
Tugg Speedman: [pause] When I was playing the character.
Hintz wanted to know what Eisman was up to.
“We just shorted Merrill Lynch,” Eisman told him.
“Why?” asked Hintz.
“We have a simple thesis,” Eisman explained. “There is going to be a calamity, and whenever there is a calamity, Merrill is there.”
Everywhere you don’t want to be?
When it came time to bankrupt
When the internet went bust, Merrill was there.
Way back in the 1980s, when the first bond trader was let off his leash and lost hundreds of millions of dollars, Merrill was there to take the hit.
That was Eisman’s logic—the logic of Wall Street’s pecking order. Goldman Sachs was the big kid who ran the games in this neighborhood. Merrill Lynch was the little fat kid assigned the least pleasant roles, just happy to be a part of things. The game, as Eisman saw it, was Crack the Whip. He assumed Merrill Lynch had taken its assigned place at the end of the chain.
Well, the mornings after this global risk-taking hangover, those who got huge bonuses are now verbally penitent:
If not financially penitent:
The highest-ranking executives at four firms have agreed under pressure to go without their bonuses, including John A. Thain, who initially wanted a bonus this year since he joined Merrill Lynch as chief executive after its ill-fated mortgage bets were made.
Mr. Thain has an argument that looks good in micro: “You’re paying me to rescue the bank, don’t penalize me for the sinners of my predecessors.” It doesn’t look so good in macro: “The bank wasn’t making any money, I just prevented greater catastrophe.”
Clawing back the 2006 bonuses at Merrill would not come close to making up for the company’s losses, which exceed all the profits that the firm earned over the previous 20 years. This fall, the once-proud firm was sold to Bank of America, ending its 94-year history as an independent firm.
For now, most banks are looking forward rather than backward. Morgan Stanley and UBS are attaching new strings to bonuses, allowing them to pull back part of workers’ payouts if they turn out to have been based on illusory profits.
Barn, horse, stolen, lock.
Now that all the horses have been stolen …
For Wall Street, much of this decade represented a new Gilded Age. Salaries were merely play money — a pittance compared to bonuses. Bonus season became an annual celebration of the riches to be had in the markets. That was especially so in the
Personally, I care not that they spent it in wretched excess; if they had earned it the old fashioned way, spending it would have been their prerogative.
Did you make money the old fashioned way … by reporting EBITDA?
The bonanza redefined success for an entire generation.
I always thought it meant ‘Dan Blocker’
Graduates of top universities sought their fortunes in banking, rather than in careers like medicine, engineering or teaching.
Oh, for goodness’ sake! I remember people wanting to be in investment banking thirty-five years ago.
Even willing to cut our hair for money
Wall Street worked its rookies hard, but it held out the promise of rich rewards. In college dorms, tales of 30-year-olds pulling down $5 million a year were legion.
So were tales of getting laid. That didn’t make them true.
Oh yeah, like I believe that one
While top executives received the biggest bonuses, what is striking is how many employees throughout the ranks took home large paychecks. On Wall Street, the first goal was to make “a buck” — a million dollars. More than 100 people in Merrill’s bond unit alone broke the million-dollar mark in 2006.
You see, if everyone is getting rich, then we all think we are all geniuses. We’ve cracked the secret of wealth, and everyone else is stupid.
Pay was tied to profit, and profit to the easy, borrowed money that could be invested in markets like mortgage securities.
The Times — following in AHI’s footsteps – then goes through a particular CDO security that Dow Kim’s team put together:
One of the last deals they put together that year [2006 – Ed.] was called “Costa Bella,” or beautiful coast — a name that recalls
Perhaps he wants to rethink his tag line: “the authority on bonds” TM
Merrill Lynch collected about $5 million in fees for concocting Costa Bella, which included mortgages originated by First
Concocting is a loaded, benefit-of-hindsight word.
But Costa Bella, like so many other CDO’s, was filled with loans that borrowers could not repay. Initially part of it was rated AAA, but Costa Bella is now deeply troubled.
I’ve previously excoriated the rating agencies for their willingness to rate the best part of a puree of bad assets as a good asset.
The losses on the investment far exceed the money Merrill collected for putting the deal together.
That’s always the case. Fees range from one to two points, whereas losses, when they hit, can be substantial.
So pay people to be careful
Don’t forget, nobody made people buy these things. Yield hunger drove pension and other investors to find higher returns and to suspend their doubts.
When the supply of money (that is, people who want to invest) exceeds its demand (quality investments to make), two things happen:
* Yields go down because money becomes cheaper.
* Investments increase as new products are invented and come into the marketplace.
If the world has more wine drinkers than vineyards, marginal soils are planted and plenty of plonk is sold and drunk.
Blend them together and call it rose? How to securitize wine
That, in essence, is how Wolf sees our current credit mess – as the inevitable consequence of enormous global money supply over global financial demand.
Too much money chased too few quality goods.
By the time Costa Bella ran into trouble, the Merrill bankers who had devised it had collected their bonuses for 2006.
Many firms I know compel bonuses to be escrowed for 2-3-4 years, or issued in restricted stock; either way, the money is paper, not real, until the portfolio is seasoned.
I have more confidence now that they’re seasoned
Mr. Kim’s fixed-income unit generated more than half of Merrill’s revenue that year, according to people with direct knowledge of the matter. As a reward, Mr. O’Neal and Mr. Kim paid nearly a third of Merrill’s $5 billion to $6 billion bonus pool to the 2,000 professionals in the division.
They can’t ‘just tell the story,’ they have to spin it.
After that blowout, Merrill pushed even deeper into the mortgage business, despite growing signs that the housing bubble was starting to burst. That decision proved disastrous.
Repeating the quote from the cynical (and prophetic) Mr. Eisman:
“Whenever there is a calamity, Merrill is there.”
And Merrill was there:
As the problems in the subprime mortgage market exploded into a full-blown crisis, the value of Merrill’s investments plummeted. The firm has since written down its investments by more than $54 billion, selling some of them for pennies on the dollar.
Which isn’t the traders’ problem:
“What happened to their investments was of no interest to them, because they would already be paid,” said Paul Hodgson, senior research associate at the Corporate Library, a shareholder activist group.
When things go really badly, those who led the effort leave:
As the damage at Merrill became clear in 2007, Mr. Kim, his deputies and finally Mr. O’Neal left the firm. Mr. Kim opened a hedge fund, but it quickly closed.
[Mr. Kim] departed without collecting a bonus in 2007. Mr. O’Neal, however, got even richer by leaving Merrill Lynch. He was awarded an exit package worth $161 million.
That Mr. O’Neil’s exit package was likely specified by his employment contract is of little consolation:
I’ve brought you this far, don’t I deserve a reward?
Mr. Bebchuk of
“They were trying to get as much of this or that paper, they were doing it with excitement and vigor, and that was because they knew they would be making huge amounts of money by the end of the year,” he said.
What you reward gets increased. So be very, very careful what you choose to reward.
Especially bonus and compensation systems
Comments
Comment from G Caldwell
Date: December 24, 2008, 12:52 pm
Similar things happened at Enron, at least as reported in “The Smartest Guys in the Room.” During the 1980 and 1990’s, Enron paid fanstatic bonuses to employees who made various long-range contracts, such as construction and operation of the notorious Dabhol Power Plant. The bonuses were based on the expected revenues from the deals. In fact, these expected revenues were nothing more than wild-eyed guesses, grossly inflated to justify the huge bonuses. These revenue-guesses were booked as present operating income when the deals were made, even though they were not going to generate revenue for a long time, if ever. The deals often made no economic sense except so far as a justification for inflating income statements and bonuses. That is, the employees were paid spectacular amounts to make deals that were terrible for the company.
As time passed, these bad deals created huge losses in the late 1990’s and into 2000 and 2001, although they were covered up by the creative accounting of Enron’s new CFO, Andy Fastow. Although Fastow, Jeffrey Skilling, and others were ultimately convicted of crimes, many of the dealmakers (Lou Pai, Rebecca Mark) walked away with huge amounts of money.
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