Posted tagged ‘compensation’

Another “Holy Shit!” Moment in Compensation: The P.A.F.

December 19, 2008

Wow. Seriously, wow

This year, up to 80% of the stock portion will come via what Credit Suisse is formally calling a “Partner Asset Facility,” of the illiquid assets, largely corporate loans.

Bankers won’t receive a return on the PAF program for eight years, although they can start to collect some of the principal in 2013. If the firm finds outside buyers for the assets, it will pay the proceeds to itself first, then provide the rest to employees.

The PAF applies only to senior bankers within the firm’s investment bank, which includes merger advisory, capital markets and leveraged finance. Those in Credit Suisse’s private bank and asset-management division aren’t subject to the PAF.

I’m going to play both sides of this one… But, how do you know it’s a good move? Hiede Moore’s post, in the next line, offers the proof:

The announcement elicited livid reactions from senior bankers, many of whom questioned whether it was legal. Many said they believed they were being unfairly punished for risky assets bought by colleagues in distant parts of the firm.

I’m not crying for these bankers, exactly, but they missed the point. To be honest, it’s a tremendous incentive for everyone to work together for the good of the firm. These same “livid” investment bankers, I’m sure, have been pushing transactions onto their counterparts in capital markets and trading for years. I know this, specifically of C.S.F.B. Their investment bankers would constantly use the “relationship” reason for doing a given transaction that resulted in real estate exposure for their firm (or leveraged finance commitments). So bankers, as a whole, shouldn’t say they are being unfairly punished for their colleagues decisions to make loans that they asked them to make. Now those bankers will not push loans they think might make it into their compensation! (There was a rumor that something like this happened a long time ago at Salomon Brothers.)

Now, why might this be a bad ideas? Honestly, all the reasons are highly technical. First, the investment is much longer dated than normal equity: first principal distributions come in 2013 and the investment will be zero-return for 8 years. This is a bit unfair, as the vesting and return of cash should be similar to normal equity plans if employees are given no notice. It’s only polite as it concerns things like paying college tuition. That being said, this is a program for senior employees and, thus, they should have planned for bad times and not gambled with their entire lifestyle. The two largest issues, though, are where the firm is using this to their advantage instead of being “just” about it. First, Credit Suisse pays itself before employees. That seems tacky.. pro-rata, maybe? Even pro-rata withe the firm counted more… Second, this makes C.S.F.B. employees much less mobile. When a bank is trying to figure out how to make the bankers being recruited from C.S.F.B. whole on what they lose when they depart their current firm (standard practice), it’s likely that their P.A.F. holdings will be valued at, or near, zero.

Now, despite the problems, I think this is a great lesson and a fair mechanism. And, unlike the clawback, if the firm loses money on the investment, so are the people getting paid in P.A.F. units… So you don’t have to worry about going after an employee, they get reduced along with shareholders.

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Semblance of Rationality in Compensation Structure, Finally

December 9, 2008

It’s finally occurred. As I just read on Clusterstock, there is officially some sort rationality creeping into Wall St. payment structures. Claw-backs are here, as I suggested previously (I was hardly alone). Now, I wonder what the real impetus behind this sort of decision really is. Is it public officials railing against bonuses? Traders who were paid millions to put on the positions that are now sinking their (former) employers? Or, perhaps it’s the fact the C.E.O.’s and executives who are used to taking no risk whatsoever, as Felix also intuits, and are used to being compensated in the ponzi scheme that has the slogan, “in line with our peers.” This sort of groupthink, parading as transparency (that only pertains to rising compensation, obviously) has been championed by familiar names. But, other familiar names have been railing against exactly this sort of thing (yes, all of those links are to distinct posts on the Icahn Report …). I wonder if some of those executives are angry at having to give up theirs and not being able to inflict the same on their minions… Not totally unjustifiable, after all it wasn’t John Mack who persoanlly took the positions that have caused writedowns at his firm, just like it wasn’t Vikram at Citi. Still, when the kings get stung you know the subjects will feel it.

This relates to some other topics on anti-competitive behavior, but I’ll leave those for the time being.

On Executives and Risk

July 31, 2008

Okay, I read the NYT Dealbook post on Alan Schwartz, and I have to admit, it completely destroys the entire notion of executives at firms, especially like Bear, as having any real personal risk. Let me quote…

Mr. Schwartz, Bear Stearns’s chief executive during the firm’s near-collapse, has been talking with Goldman Sachs, Citigroup, private equity firm Kohlberg Kravis Roberts and boutique advisory firm Centerview Partners, among others, people briefed on the matter told DealBook.

(emphasis theirs).

Okay, now, here’s the issue I have: Alan Schwartz is the reason Bear doesn’t exist today. Remember the three part WSJ article about Bear going under? Remember what I noted about the first part? Alan Schwartz, who is not a trader, vetoed the very trade(s) that would have saved Bear and was proposed by his senior traders. What happened from that decision was that thousands of people lost their jobs, the firm went out of business, and a lot of other, very bad, things. That’s fine that he made the decision. I almost don’t care that he was wrong. However, it’s a huge moral hazard/slippery slope/perverse incentive/etc. Alan Schwartz should be toxic right now.

One can argue about Stan O’Neil, Chuck Prince, or any of the other C.E.O.’s that lost their jobs but got large payouts. (I don’t support that either, by the way–if you were at the helm, you should take what you’ve already been given and neither ask for nor accept any more. You retire/leave rich nevertheless–but boards were incompetent, stupid, or in league on promising these things, so taking them isn’t the fault of the ex-C.E.O.’s.) However, these C.E.O.’s firms didn’t die and go away and they certainly didn’t veto the proposed lifeline with nothing but a body of irrelevant experience to guide them arguing from a place of no authority. These same kinds of hedges worked at other firms.

The common argument says, “C.E.O.’s get paid more because they have more risk.” Well the other people at Bear Stearns got less money, are out of a job, and, in this market, certainly are finding it difficult to get a new job. These people probably don’t have millions of dollars. Alan Schwartz does have millions of dollars, is out of a job as a result of something he could control, and can land on his feet as a senior deal maker making millions of dollars? Unacceptable and unthinkable. If this situation defines the rule then C.E.O.’s should get paid much less than they currently do and realize that even if they roll the dice and lose when betting with an entire company they will still get a job that pays exceptionally well.

You’ll notice your paycheck is lower. We have reformed it!

March 6, 2008

The F.T. had an article yesterday about  an organization (that I’ve never heard of) coming up with “code of best practice” to establish banker’s pay (note that the F.T. mentions rules would be geared toward traders, so much like most of the financial media, they think everyone at an investment bank is a banker). Obviously it’s a disadvantage for whichever institution institutes these things on their own–if you’re going to be paid less and be at a long-term risk for something you do at one institution, but not at another, then you’ll avoid working there. So, here’s my question: At what point is a bunch of bank’s, getting together to talk about a new code for pay, establishing a “code of best practice” versus being anti-competitive?  Just a thought.

Banking Risk

February 28, 2008

It’s funny to me that all of these problems are coming to light and, while there are clearly themes as to how these various products all became so prevelent, as well as why, there are some things that still need explaining. What do leveraged loans have to do with all this? Indeed Goldman could be asking itself why it got involved in that market–one in which it had become a major player, unlike some other businesses it was lucky enough to have been unsuccessful in entering. How did C.D.O.’s, a product generally managed off of trading floors where many market-sensitive businesses didn’t lose money, seem to be a categorical loser for banks? The answer seems pretty plain to me: These were products driven by “bankers.”

A “banker” is a person, as I think of them, whose job is to pitch a transaction to an entity/person/institution/group and get the fees involved in said transaction. They don’t manage risk, that is generally outsourced–but they do worry about it insofar as one can dimension the risk. Bankers make assumptions. Bankers LOVE assumptions. “Assume that trend continues.” “Assume defaults come in at 80% of the model for this collateral.” “Assume that debt gets taken out.” “Assume rates rally.” “Assume a static L.I.B.O.R.” “Assume this rate scenario and no losses.” It’s simply amazing. Why would one stress losses and not interest rates? Wouldn’t it be a better assumption that if 10% losses are occurring when 2.5% are projected that it’s because interest rates are higher than expected and people can’t get new loans? Well, the bonds don’t perform under those scenarios and showing that would make them harder to sell. Merely an example, I digress.

Bankers run the process on C.D.O.’s and  on leveraged loan deals. Their job is to put together scads and scads of powerpoint presentations detailing all kinds of details. Bankers show nice graphs like supply (amount of bonds issued) versus spreads (yield premium required for a bond’s incremental) to show some trend. Bankers trot out the all-knowing league tables for their product. (As we now know, the most accurate thing predicted by the C.D.O. league tables turned out to be writedowns–but bankers were judged on their standing in these league tables!) So, what if a banker was so successful at pitching these transactions that they were able to sign up dozens, creating a pipeline, and lock up the fees? They were a superstar! Imagine the fees on billions of dollars of C.D.O.’s? If their bank provided the financing for the C.D.O. issuer to acquire the assets? Higher fees! If the bank agreed in advance to buy the bonds and take them onto is own balance sheet if the market wouldn’t buy them? Higher fees! If these arrangement were made, 10-15 C.D.O.’s could earn $100 million in fees. Was there more risk? Of course, how do you think bankers would justify higher fees for these incremental commitments?! But, when your job is to spend months courting C.D.O. issuers, and you spend countless hours on conference calls telling them what a good deal issuing a C.D.O. is, and when you repeat, over and over, how strong the market is, citing many datapoints, then you’ll probably convince yourself too. Indeed, when told a deal you got a client to agree to commit to is too risky, by a risk manager or other independant person, then you will probably fight back… hard! (And, feel free to substitute C.D.O. with leveraged loan transaction in every instance.)

The point is the mentality. Bankers weren’t paid to manage risk day-to-day, watch the market, and hedge. Bankers became salespeople with some analytical and technical expertise. They weren’t thinking about hedging–they might not even have assets to hedge, they hadn’t created bonds yet. Market fluctuations didn’t affect the revenues from fee income. Although, a commitment to buy unsold bonds if the market has lost liquidity and values are plummeting is a risk, it’s not one bankers would have assumed, and definitely not hedged. Indeed these bankers, at some firms, even had separate reporting lines than the traders and risk management professionals. Their division was generating lots of revenue, so their senior layers of management gained a lot of power. A perfect storm? Seems like it was.

In fairness, the perfect storm that occurred was due to a fundamental problem–the disappearance of liquidity. In the heyday it wouldn’t have seemed rational to consider scenarios that correspond to what the market has actually experienced. But the methods of accounting for and cataloging the risk of, for example, derivative contracts exposed to tail events or highly illiquid investments clearly wasn’t used (When a P.E. firm makes a highly illiquid equity investment, I would bet bankruptcy risk is discussed!). Indeed most of the C.D.O. bankers were ex-lawyers, ex-structurers, or converted salespeople who didn’t have the background in these views on risk either. As for leveraged loans, the leveraged finance professionals were also mainly investment bankers and refugees from other relationship-driven fee-based businesses. I even know of people that jumped between the two (C.D.O.’s and leveraged loans)!

Another point, that seems obvious, is the scheme of compensation. Roger Ehrenberg had a recent post that discusses some of these issues. My personal belief is that the mentality was much more of an issue than the structure of the compensation scheme–but the perils of compensation, as it currently stands in the financial world, are well discussed and documented.

Maybe I just have the benefit of 20/20 hindsight, but maybe the traders and other people who poke fun at bankers (see Monkey Business  and, of course, DealBreaker) for not seeing the forest through the trees were on to something.

This is compensation, it is also a game.

February 6, 2008

I wonder how compensation would be a different process if it was more strategic. The way it currently works is a number is handed down to someone senior. “Your division’s bonus pool is X, it is [up/down] Y%.” For this year, for example, securitized products might have had a bonus pool that was down 50-70%. So the person who gets this news then allocates two layers–the bonus pools for the groups that report to them are then allocated as well as the bonuses of the people who directly report to him/her are decided (as their bonus was most likely decided by the person who delivered the new size of the bonus pool).

There is an interesting subtlety. One doesn’t have any say in one’s own bonus–it comes from above. Common sense tells us that this is the correct and accurate way to do it, no? Well, let’s think about this for a second. What if a group of revenue generating employees was  grouped together, and given a bonus pool size. They were then told they had to agree and that someone above them would veto completely ridiculous allocations (“I’ll get all of it next year and none this year.” “I won’t agree to anything except 90% of the bonus pool.”).  What should happen? As with anything in finance, let’s make some assumptions:

  • Dollars to allocate: $1,000,000
  • Revenue generated: $10,000,000
  • Number of people: 4
  • Revenue generated by person: Person 1 (P1) generated $2,000,000 in revenue, Person 2 (P2) generated $1,000,000 in revenue, Person 3 (P3) generated $5,000,000 in revenue, Person 4 (P4) generated $2,000,000 in revenue.

Taking a simple approach, one might say that the correct way is to give each person the same percentage of the bonus as their percentage of the revenue they generated (e.g., P3 gets $500,000 bonus dollars because P3 generated 50% [5,000,000/10,000,000] of the revenue).  If someone were to force an inequitable allocation then the person who was given less than their fair share could simply leave and get another job (it’s not uncommon for a bad pay year to drive a senior person to another firm). Also, the subtlety here is that the people deciding the bonus allocation here understand, fully, what each other’s true contributions are. If P1 and P4 work together then how they account for their respective contributions will most likely show a more nuanced understanding of their actual contributions versus their perceived contributions. Perhaps P1 and P4 had an arrangement where extra work will be shared, or perhaps P1 did 90% of the work on something and then handed it to P4, where the credit was then given to P4 for the entire amount of revenue generated. Is this more fair? Perhaps. I find it quite common that very senior people will set bonuses for people they interact with very little.

Obviously a solution like this is rife with issues, and I would never claim something like this should be implemented. It is, however, definitely instructive to think about the situation and wonder how it differs from the status quo. What extra infromation comes into play that doesn’t in the current system? What would the difference be in someone’s pay if this system was adopted? Why? Just a thought.