Semblance of Rationality in Compensation Structure, Finally

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.

The Real Problem with the Citi Bailout

We all know that Citi was “bailed out” last week. However, as far as I can see, Citi’s is a unique situation for several reasons:

1. The company was not taken over, and
2. Management was allowed to stay on, and
3. The government is shouldering losses coming from securities that are already identified.

Taken together, these leave a huge hole in this “living bailout” (I call it that because, obviously, Citi was in dire straights but was allowed to survive, essentially, as it existed before) that, obviously, Treasury never thought out (setting aside my prior concerns). I’ll put the problem into a single statement…

When taxpayers agree to pay for losses of a company that is continuing to operate, but the losses being referenced pertain only to specific assets, there are a huge amount of games that can played and the government has no way to stop or monitor what is truly going on.

As a matter of fact, as I write this the news of the G.A.O. report (PDF) on T.A.R.P. is making the rounds. One of the main criticisms is the lack of monitoring of bailed-out institutions. And those institutions don’t have explicit guarantees like Citi does. It is extremely surprising to me that, for example, there aren’t auditors or officials from Treasury meeting with traders and executives of Citi’s mortgage groups regularly. As a matter of fact, I would station some people on the trading desks where these assets are being managed to give status reports and monitor the situation. Further, Hank Paulson’s and Vikram Pandit’s interests are aligned here. Vikram shouldn’t want these assets languishing or Citi being accused of sitting on assets that might lead to a taxpayer loss in the future and Hank Paulson should want to know Citi still feels some obligation to minimize taxpayer’s exposure to losses.

Now, the question of what “games” can be played is the next natural question. Well, if I’m a trader, I mark my own position every day. In mortgages, there is little to no verification of these prices–the markets are so illiquid that only the people that trade the product know the actual value of a given instrument. This conflict, in general, is controlled for by the organizational structure: the person most likely to know the product as well as, if not better than, the trader is the trader’s boss. Obviously, the trader’s boss has little incentive to allow his employees to incorrectly mark the trading book because he can be held accountable. With this “living bailout” though, what incentive does Citi have to sell assets in a liquidity-challenged environment? If no pressure is applied from Treasury, and how can they apply pressure without being deflected if they aren’t “on the ground,” then why wouldn’t Citi just hold assets they currently view as having positive value? Citi likely has assets that are obviously going to go bad, in which case there is likely no way they can offload those assets (perhaps around, oh, say… $29 billion worth…), and assets they view as merely undervalued due to liquidity concerns. Why would I seek out a guarantee on further losses for assets I can sell today? If losses are guaranteed then what’s my downside in just holding illiquid assets?

Because Citi won’t absorb all the losses on the assets viewed as undervalued, those assets are worth more to Citi than others. And, as a trader that gets paid based on his/her personal P&L, I have every incentive to avoid losses that I view as not being inevitable and I have a defensible reason to not mark my position merely to the price I can sell it today. Another nuance comes from how traders actually mark their books…

1. A trader buys mortgage bonds, loans, or any other security. The current profit or loss of that trade (we’ll call it “the bonds” or “the position”) is the purchase price and there is no net P&L.
2. The trader then enters into another transaction that is considered a hedge for the position. This transaction could be buying credit protection, shorting treasury bonds, or any number of other possibilities. We’ll refer to these transactions as “the hedges.” This trade generates no net P&L.
3. On an ongoing basis the position is marked “flat” to the hedges. This means that, dollar for dollar, any loss or gain in the hedges is added or subtracted from the original position so as to generate no net P&L. This isn’t perfect, but it’s theoretically very clean since the point of the hedges is to eliminate the risk in the position.
4. Generally, a price movement in the position that isn’t reflected in similar price movements in hedges is marked manually–usually this takes place at month-end. However, if the original position is sold then the difference between the most recent marked price and the sale price will generate positive or negative P&L as well.

So here’s a good question: Why does a trader, now, have any incentives to hedge? A better question, though, is why would I mark my positions accurately versus hedges? Can’t I make the claim that all the gains in the position, as evidenced by losses in the hedges, should be taken as P&L but only 10% of the losses, as reflected by gains in the hedges, should be taken as P&L? Because the positions hedging the guaranteed mortgage positions are either derivatives or other products that likely aren’t also guaranteed this asymmetry becomes problematic. It’s not even clear that whatever scheme generates the most profits for Citi isn’t the correct way to account for the gains and losses of a typical hedged mortgage position in this atypical arrangement. I know that traders are asking these very questions. However, the possibility that taxpayers could shoulder costs while Citi also books profits whose existence depends on taxpayer-funded guarantees is troubling.

I don’t think anyone would disagree that this arrangement is complicated enough that a higher degree of oversight is required (and should be desired by all parties) to ensure that nothing improper is going on for the sake of taxpayers and Citi’s reputation. One thing we’ve learned from A.I.G. is that even if billions of dollars are at stake expenditures on the order of one hundred thousand dollars can become P.R. nightmares. Treasury should be auditing all of Citi’s mark-to-market procedures and setting standards to protect taxpayers (more so than non-“living” bailouts). Also, as I stated before, there is no reason that there shouldn’t be some sort of watchdog presence on the trading floors to ensure Treasury is keeping watch and being kept in the loop.

The Discord in Similarity

here’s an interesting Alphaville post that ran recently that pointed to an article in the FT. From FT’s Alphaville:

Recently installed chief executives at Merrill Lynch and Citigroup are raiding the ranks of their former employers, Goldman Sachs and Morgan Stanley, as they seek to transform the culture and management of banks shaken by the credit crisis.

The article actually has a bit of a glaring error, Vikram didn’t raid Morgan Stanley for the people they mention (John Havens, Don Callahan, and Brian Leach), but rather they came with Old Lane (except for Callahan, who came over from Credit Suisse). Other than this, there are some differences that should be highlighted.

1. At Citi, the team was brought in and given jobs for which they were ill suited. These people had all run businesses, but none had been focused on or solely in the alternative asset management business. That’s why the Old Lane acquisition has been such a disaster in the context of adding to the alternative asset management platform. One need look no further than the man that was heavily involved in the deal:

But the point, [Lewis] Kaden told Fortune this past March, was not for Citi to secure a hedge fund business but rather to capture the talent of Pandit and his team. That was like acquiring Morgan Stanley’s trading establishment, Kaden said, without paying billions to do it.

So, now what do we find? Pandit running the whole of Citi, including a massive and mediocre consumer bank, a large investment bank, an alternative asset management business, and a huge brokerage firm. John Havens, who only ever ran equities at Morgan Stanley, now also has an investment bank, fixed income division, corporate banking, and alternative asset management business under him. I’m sure it’s all the same… Also, the Citi executives have made it a point to bring in Morgan Stanley people at every possible juncture, mainly through acquiring middling (or completely new and not yet open for business) firms staffed by ex-coworkers (although never promoting these acquired people to positions with more responsibility, making it look like they are merely being made rich with Citi money). I’ve documented a fair amount of them in this post. At Merrill, however, Thain is filling positions with people that held those same positions elsewhere. Thomas Montag is running a sales and trading operation after … wait for it … running a sales and trading operation. Noel Donohoe spent eleven years running risk management at Goldman and will now be … well … running risk management at Merrill. Much more symmetry.

2. At Merrill, John Thain is flattening the organizational structure. This is a point the FT piece makes. Mr. Montag, for example, will report to Mr. Thain–This takes a major business unit and un-layers it. It shortens lines of communications and allows one of the C.E.O.’s trusted deputies direct more authority than if a middle ma were involved. At Citi, Vikram Pandit is creating a more complex structure. Now there are regional reporting lines and product reporting lines, resulting in many senior executives with two bosses. When you have the potential for a very opportunistic but very time sensitive investment, and you have two bosses, how many people do you need to get on the phone to make a decision? How many people are pulled in? How conducive is all of this extra work to getting decisions made and promoting a centralization of authority to make and enforce those decisions? As a matter of fact, it’s acknowledged that regional decisions have to travel to the central authority. From the horse’s mouth:

“It’s going to take some time because we have to be diligent,” Pandit said to a questioner in Turkey who asked when decisions can be made without New York’s stamp of approval. Translation: Don’t hold your breath.

At least they know it’s a problem.

3. Merrill’s talent and past leaders were harvested long before John Thain arrived. John Thain even brought back a popular Merrill figure, Jeffrey Kronthal, to help rebuild after Stan O’Neil churned many senior positions. Citi, on the other hand, had all but the most senior executives intact and has taken almost no one from their internal bench and promoted them during Mr. Pandit’s reign. Michael Klein was moved into a new role after threatening to resign (surprising that the C.E.O. would bend to the will of a subordinate who is known for being hard to deal with, but I’m not making the decision). When Tom Maheras and Randy Barker left, Maheras’ old job was filled (and then later demoted) and no one else was named (instead, they reorganized fixed income and equities entirely). The consumer bank, however? The top people are still there (with Ms. Dial augmenting the lineup). Indeed the only people that seems to have changed in senior management are the ones that were between Vikram and the C.E.O. spot (and his subordinates following him up the chain).

4. John Thain was hand picked for the top spot at Merrill and part of the job is being able to hire your direct reports and other key personnel. Indeed it was well documented in the financial press that there were many suitors for the C.E.O. spot at “Mother Merrill” and Thain was selected out of a field of candidates. Vikram, on the other hand, as I stated just above, fell into a power vacuum. It was even reported that most qualified contenders decided they didn’t want to be considered for the job. Clearly this is much less of a mandate to fill the ranks as one sees. There are the egos of the people that were passed over to consider as well as various internal problems that arise from such a sudden shift in power.

It seems pretty clear that once one looks deeper than the surface, there are some subtle but pervasive differences in how the two executives are choosing to fill the ranks at their new firms. These differences will make a massive difference in things like morale, talent retention, and tearing down internal silos. I guess we’ll have to see how all this plays out…

The Citi Shouldn’t be Sleeping (Well, anyway)

Citi is in a troubled spot. There is clearly bad news that is anticipated to come out as securitized products do worse, but there are many criticisms being leveled at Citi and it’s senior managers for not doing enough to fix the situation. Here are a few suggestions (in case Vikram is reading):

1. Respect the conservation of risk. If you move assets into a special group you still own the assets!  Now, it’s clear what the thought was–one could over hedge this book, work out of the positions, and make money doing it. Want to guess what happened? It didn’t work (isn’t working). The items that one can mark-to-model, and that seem to have solid credit characteristics, keep. As for the other assets, figure out fair value, contact fifteen smart firms with deep pockets, sell them these assets at a discount, finance the sale, and take a ten percent residual equity stake in any upside. Firms are doing this left and right. No more writedowns coming on toxic crap.

2. Cut the dividend. Actually, instead of cutting it, set a very specific plan (a formula, for example) for how much the dividend will be. In quarters where there is no revenue, or negative revenue, there is no dividend. Now your capital conservation is linked to your capital needs.

3. Senior management should align themselves with the shareholders. It’s somewhat a public relations move, but if they start taking all their compensation in options,  announce a very public set of criteria for linking their pay to the performance of the firm, and even have some senior managers forgo compensation (they can afford it) then the amount of “skin in the game” will be elevated and it will be a big vote of confidence in the company. Maybe senior members whose purchases are tracked publicly should buy some shares.

4. Communicate. The market is left to rampant speculation if it hears nothing. Further, since not saying anything usually means there is nothing good to say, the worst is assumed. If there will be layoffs, announce that. If Citi will need to raise capital, announce that. The C.E.O. has said nothing of how he intends to remedy the situation (an oft-repeated criticism). And, though this relates to #6 (below),  when you do “waves” of layoffs, the rumor-mongering and having CNBC report things that may or may not be true for all your employees to see, you risk a major exodus of anyone who is mobile (read: talented). This leads me to…

5. Focus on the problem. I have never understood how it becomes the formula for getting out of a big problem to cut jobs. It makes no sense. There is a top line (revenue) and a bottom line (profit), and costs (due to compensation, for example) are an important item in between, but there is a maximum impact managing that item can have. First of all, people that are paid on Wall St. are very efficient to carry–their bonus can be zeroed. If they leave, well, you would have cut their job anyway; if they stay, you have a free option on a known quantity if conditions improve. In any event, if revenues are negative, then you don’t look good by any measure, so spend time working on getting revenues up! I see the numbers, and the amount firms save from not having to pay for people per year, even if you assume they all make $2 million dollars, is a small, small fraction of what’s being lost due to writedowns. Going around the globe and have presentations made to you about Citi’s business in that country is a poor use of a C.E.O.’s time when there is still a set of assets on the balance sheet that have the potential for tens of billions of more dollars in writedowns.

6. End the war on morale. Really. Do I really have to point to examples? Naming old co-workers to key roles? Acquiring hedge funds that haven’t even raised money (well, $150MM)? Buying an odd-fitting shop comprised of former colleagues and giving them the same seat at the table as a large, much more established, group already operating within the firm? Siding with your old shop in a dispute, and agreeing to a worse deal (paying the other shop’s expenses!) than if the original trade has just been pushed through (and destroying value for third parties whose money you are supposed to be managing)? Seriously?

7. Consider breaking up the company. If you can find a buyer for the parts of the company with the toxic crap, then sell it and go from there. The theory is sound, but the execution has failed. There is not one culture, there many warring sub-cultures. Citibank versus Salomon Brothers versus Smith Barney … it sounds like a brawl, and quite often that’s what it is. When one calls over to Citi, no one there even answers the phone the same way (“Citi” “Salomon” “Citigroup”). Also, I would imagine that while the fixed income division at Citi had been producing great returns (from being in businesses that have produced billions in writedowns) it was getting more resources, resources (such as balance sheet) that could have been invested in areas that are now more stable and didn’t create a debacle. (An argument for companies to specialize? Perhaps.)

What do the above steps accomplish? Well, Citi’s balance sheet is freed of toxic crap. The people who work in this behemoth are given some clarity as to their future, they don’t feel like senior management is giving shareholder money to their friends at a breakneck pace, and they all have a set of goals to work towards (once the course is laid out). Oh, and hopefully their employer can remain financially solvent!