ECONOMY SEPTEMBER 17, 2009
Few issues since the collapse of venerable Lehman Brothers one year ago have caused as much consternation as performance bonuses for bailed-out bankers. Yet, even among sophisticated observers, there is confusion about what really happened. So, with the benefit of a year's perspective, how should we think about banker compensation in the context of bank bailouts?
Here's a hint: The bonus outrage has distracted attention from the more important way that taxpayers underwrote the wealth of profligate bankers, which was to preserve the extensive equity holdings that senior personnel at these institutions had accumulated prior to the debacle of 2008. And this diversion, in turn, has delayed effective action that might inject a bit of moral culture into the money culture of Wall Street.
Setting aside the debate about the culprits of the crisis, we can acknowledge that every major commercial and investment bank in the United States faced a direct threat to its solvency arising from (a) its level of leverage, which ascended to new heights in the credit bubble, (b) its interrelationships with other leveraged institutions--"counterparties"--and (c) its reliance on short-term funding from those counterparties. These facts are undeniable, even if certain conservatives prefer to attribute the genesis of this predicament to a political desire to foster homeownership among lower-income families.
Now, it is true that every insolvent bank arrived in extremis in a slightly different way. Bear Stearns, which had never reported an unprofitable quarter in its history as a public company, suffered a loss of confidence that prevented it from rolling over its short-term funding--but only after having taken its debt ratio to a level of 30 to 1 or higher. Meanwhile, a friend at Lehman confided to me, "We woke up one morning and, instead of an investment bank, we were a real-estate company." That was a week before his firm spiraled into bankruptcy. Merrill Lynch raised its exposure to subprime securitization late in the cycle and, when the music stopped in 2007, got stuck with many more assets--and, hence, much more risk--than it could syndicate.
Bear, Lehman, and Merrill were the three U.S. investment banks that were forced out of existence. But just because other banks might have been better positioned going into the crisis does not mean they would have been safe once the crisis unfolded. Some might have avoided distress in a theoretical world where there were no chain reactions, no credit default swaps, and no panics. But, in the real world, every major bank had used structured finance techniques and wholesale funding markets to ratchet up its leverage. Which meant that, once those markets seized up, every bank was exposed to disaster in the absence of government intervention. And there can be no gainsaying just how aggressive that intervention was. To protect the financial system, the range of actions taken by the Federal Reserve, the Treasury Department, other regulatory bodies, and their international counterparts has been breathtaking. Each surviving bank is the beneficiary not just of one bailout but of multiple bailouts.
Most directly, of course, there were the capital infusions provided under the Troubled Asset Relief Program (TARP). Then there was the fact that the money under TARP was provided on terms far more generous than available in private markets. There were the backstops fashioned to draw a perimeter around toxic-asset exposure. There were the guarantees from the Fed that enabled financial institutions to obtain funding when wholesale markets dried up. There were the efforts to unclog the commercial paper markets.
Nor was this all. There were the counterparty bailouts: The Bear Stearns and Fannie Mae/Freddie Mac bondholders were protected to buy time for other financial institutions to enhance their balance sheets and buttress confidence. AIG was used as a conduit to facilitate contractual repayments at par (thus avoiding the need for AIG's counterparties to suffer haircuts on those derivatives). There were also the unusual accommodations: targeted short-selling bans, expedited bank-holding company conversions, fdic-assisted consolidation activity, implicit and explicit "too big to fail" pronouncements
To enumerate these actions is not necessarily to criticize them. To adapt Napoleon's phrase about taking Vienna: If you want to save the system, save the system. In financial crisis management, mistakes and unpalatable side effects are inevitable. The failures that led to this extraordinary situation were hardly confined to the major banks. There is plenty of blame to go around. But it will not do to absolve banks of their errors because they were responding to easy money or new international accounting standards or modern risk models or investor pressure. They weren't compelled to take leverage above prudent levels or to misread the downside of excessive reliance on securitization.
Regardless of the systemic impact of any uncontrolled solvency crisis, we do not need much imagination to know what would happen to institutions and their employees if they had all been permitted to enter bankruptcy. We can look at what happens to car companies or telecommunications carriers or airlines or, indeed, to Lehman and its predecessors, like Drexel Burnham Lambert, in financial services. Then we can understand the magnitude of the favor provided to the banks, courtesy of the taxpayers.
What happens to senior employees in a conventional bankruptcy? First and foremost, their equity is almost always wiped out. If they have accumulated stock or options, that source of wealth evaporates. At this stage, fiduciary obligations of directors and managers shift from maximization of shareholder value to protecting enterprise value on behalf of all stakeholders--notably, the creditors such as banks, bondholders, and vendors who can no longer count on their loans being repaid.
As part of these court-supervised restructurings, new decision-makers now enter into compensation decisions. Creditors have the right to form committees that review all major corporate decisions, and judges must approve important expenditures. Creditors in bankruptcies, as such, can be harsh taskmasters. Any management-compensation plan for those lucky enough to retain their jobs must meet strict third-party review standards. And the senior talent that has spent many years building equity value faces evisceration of personal balance sheets.
In the bankruptcies of financial institutions, this displacement is even more destructive. By their nature, financial intermediaries are more highly leveraged. Further, certain nuances in the bankruptcy code make an orderly reorganization of the business (rather than liquidation) nearly impossible. That is why the FDIC always orchestrates bank seizures and sales over the weekend, so disorderly panic can be avoided. For investment banks, as with the Lehman example, the inability to stay certain counterparty creditors--such as holders of derivative contracts--coupled with the inability to obtain ongoing financing mean that the firm effectively has to shut its doors overnight.
With the benefit of hindsight, we can argue about whether the actions taken to address the rolling crisis of confidence were wise. What is inarguable is the special treatment that bankers received. It wasn't just that jobs were preserved or that annual bonuses continued to be paid. It was that, unlike every employee of every company that goes bankrupt for reasons related to its own position or general industrial conditions, the bankers had their equity preserved by the government's rescue efforts--whereas, say, the bailouts of GM and Chrysler left nothing for their shareholders.
In practice, this meant that 1,000 or so senior employees in each of the institutions with major investment banking operations avoided the disappearance of their accumulated wealth, numbering in the millions of dollars per employee in the vast majority of cases--and in the tens of millions of dollars in many cases. In public corporations across most industries, only a handful of employees are compensated to this degree (the notable exception being the technology industry, where IPO stock can lead to riches but where companies do not get bailed out in the event of failure). But, in major banks, the extent of stock-based ownership awarded as a central component of bonuses and the run-up in equity values in the years preceding the crash led to hundreds upon hundreds of managing directors gaining expansive paper wealth.
In the case of Lehman, the managing directors lost all of their equity. Bear Stearns bankers salvaged less than 10 percent from the peak. And, indeed, the pressure on stock prices for financial institutions and the dilution associated with the huge losses have meant that, even among the surviving banks, paper wealth has compressed to 70 percent (or, in some cases, much less) of what it was in the heady days of 2007. Crucially, however, these companies lived to fight another day--and to enable a rebound of the personal balance sheets of these bankers who, in a normal insolvency context, would have lost it all.
It is in this respect that the decision to pay bonuses needs to be reviewed. Many CEOs and senior bankers last year eschewed bonuses (which constitute, by tradition, the vast majority of total pay for managing directors) and almost all managing directors took real pay cuts. But, among those thousands of bankers at bailed-out institutions whose wealth had been preserved, almost all wound up receiving a bonus at a level many multiples of the average annual income.
The main argument for continuing to award these bonuses, even in the face of government ownership, is that the banks risked losing top talent to competitors--hedge funds, private equity firms, boutique banks that did not require bailouts, and so on. But, even if you grant that debatable proposition, the form and structure of that compensation remain at issue. And it is here that policymakers and the boards of directors responsible for governing the banks must focus attention.
When the government put money into these institutions last year, the bankers who made the mistakes were not asked to help rebuild the bank's capital as a condition of their bailout. The cheapest form of private financing would have been for accrued managing-director bonus pools to have been channeled into deferred compensation subordinated to the taxpayer funds. In most businesses that lose money, owners have to put capital in rather than take money out--as banks well know, since their core function as lenders is telling borrowers how to protect their businesses' viability.
Despite last year's bonus reductions, many recipients of public support still allowed senior employees to take significant cash out. They also awarded new grants of restricted stock at historical stock-price troughs, which turbo-charges compensation when the market recovers (as it recently has--thanks, of course, to all those government interventions).
Private sources of capital, such as Warren Buffett, want to know that senior managers have interests aligned with theirs, which is why they often insist that key employees not be permitted to sell their stock or take any cash out of the business for a period of time. Among other things, this protects the position of the new-money investor in any business dependent on human capital. Bankers uncomfortable with that type of lock-up are probably not the best employees to continue to work for a troubled financial institution. If they are not willing to partner with the government--which, after all, has protected their historical accumulated stock compensation--on terms that any private investor would stipulate, then they should leave the firm, forfeit any unvested stock, and free up the funds. My guess is that few Wall Streeters would have refused those reasonable terms in the face of the economic maelstrom.
Similarly, institutional investors supplying capital for private equity funds routinely include the concept of a partial clawback of any gains taken out that are subsequently eclipsed by losses. Funds are required to escrow a certain percentage of their notional gains as well. This mitigates the problem of outsize compensation being taken in good years and, then, having only a downside of zero in bad years. Even now, months after the credit meltdown called into question the profits of the previous decade, banks have been slow to implement mechanisms like this that moderate risk to their own shareholders--and the system as a whole.
Another logical approach was taken by Credit Suisse, which gave its senior bankers an interest in the toxic assets remaining on its books--a way of making their managing directors eat their own cooking while helping reduce the exposure of other owners to the securitization debacle. An even simpler structure would be to pay bankers in subordinated equity-like securities that have low interest rates and take first losses in any future financial strain, thus enabling them to join the taxpayers in the pleasure of rebuilding the institution's balance-sheet capital position. Financier, fund thyself.
The point is that there are a wide variety of ways to structure compensation at financial institutions. It's not creativity that is required--just a dose of humility, gratitude, and a willingness to entertain risk-sharing constructs that are widely used already in the private sector. Oh, and public morality. After everything we've done as taxpayers, is that too much to ask?
Laurence Grafstein, chairman of The New Republic Advisory Board, has worked on Wall Street for 20 years. These are his personal views.