The financial crisis is now more than a year old, and Americans are still angry — angry that the economy tanked, angry that they're out of work. But mostly, people seem outraged by Wall Street bonuses.
Seeking to assuage that ire, the Obama administration's "compensation czar," Kenneth Feinberg, last week announced plans to cut the pay of top executives at seven companies receiving federal support through the Troubled Assets Relief Program. He has suggested that the cuts, which slashed pay for top executives by an average of 50 percent, should be a model for the rest of Wall Street and corporate America.
In outlining the change, Feinberg has had to grapple with several misconceptions about Wall Street bonuses — myths that have circulated since the beginning of the crisis:
* The Wall Street bonus culture led to the financial crisis.
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There is absolutely no evidence to support this. The crisis was caused by a combination of lax monetary policy, loose regulation across the entire financial sector, yield-chasing by institutional investors craving decent returns in a weak market, and a vast global banking industry that turbocharged the whole process. The bonus system, which has always been part of the securities industry's DNA, may have encouraged risk-taking by major banks, but it also encouraged risk management and other disciplined forms of corporate governance that are supposed to accompany the incentives. In a number of cases, however, these risk-management systems were totally inadequate in the face of the market tsunami that enveloped mortgage-backed securities after home prices began to drop in 2006. The storm carried away several firms, but others performed well despite the difficulties. It wasn't the bonuses that brought everything down; it was a combination of many things, some sloppy or foolish, and most far more important than bonus checks.
* Wall Street is totally indifferent to Main Street.
For people in the rest of the country to get past their bonus rage, they will have to accept that Wall Street professionals are not out to get them and that they actually do some good for the world. "Wall Street" now represents a global capital market that in 2007 was made up of $145 trillion in market value of stocks and bonds, less than half of which was located in the United States. This is a sophisticated marketplace in which firms compete aggressively to secure trade orders and assignments from large corporations and financial institutions. The intense competition for virtually every trade lowers the cost of capital and widens access to financial markets for companies, institutions and governments all over the world. Collectively speaking, Main Street is Wall Street's client and generally has been very well taken care of. In this crisis, Wall Street professionals, through carelessness or errors, lost a lot more money than Main Street did and, proportionately, probably more lost their jobs, too. Wall Street didn't benefit from the market declines, and only in the past few months has it recovered some of what it lost.
* With the job market like it is, Wall Street doesn't need to pay huge bonuses to retain key people.
Traders make up much of the top talent on Wall Street, and even now the best ones who can produce a lot of income are being lured away by big offers from other firms (including foreign banks) trying to displace some of the wounded players in their top ranks. But the real competition for these hot shots is among hedge funds, or private equity shops, which until recently could afford to pay very big bucks to attract savvy experts. The firms can't afford to lose these people, but neither can they afford to lose their other key employees, such as corporate advisers, risk managers and thousands of support people. There is a pricey market for these valuable workers, too, created by the forces of supply and demand. Even injured firms must stay competitive or risk losing more than they already have.
* Wall Street will never restrict its own pay.
The major Wall Street firms are all publicly owned companies with boards of directors subject to fiduciary duties and law. These boards have compensation committees that must justify their actions; they're subject to public scrutiny and potential litigation. Mostly, Wall Street compensation is performance-based, and most of it is paid in stock subject to market vicissitudes, so employees have long-term stakes in the firms they work for. Wall Street directors believe their compensation system, developed over many decades, provides the incentives they need to maximize performance for their shareholders. After a commentary in the Financial Times last spring by Lloyd Blankfein, Goldman Sachs' chief executive, Wall Street is working on a set of best practices for executive compensation. Several firms — including Morgan Stanley, Credit Suisse and UBS — already have announced major changes to their practices.
These are likely to include "clawbacks," or compensation that has to be returned if events unfold less favorably than anticipated, and more compensation to be paid in stock with long vesting periods. These principles were adopted, more or less, by the Financial Stability Forum of the G-20 at the Pittsburgh summit last month.
In addition to these efforts, Wall Street compensation as a percentage of net revenues, historically stuck at around 50 percent, may finally be coming down. JP Morgan Chase's and Goldman Sachs' third-quarter earnings reports both indicated blowout results but much lower compensation ratios — 38 and 43 percent, respectively.
Attempts at this type of reform have backslid in the past, but this time the boards of the firms appear to be committing themselves publicly in a forceful way that may be hard to undo.
* Wall Street pay is so out of line, only the government can fix it.
There is no reason to think that the government could devise a better compensation system for Wall Street, even if it could leave out the politics of its intervention (which it cannot). Certainly Feinberg's actions, though no doubt well-intended, are not going to improve either the government's chances of getting its money back or the prospects of repairing these damaged companies. Because of his recommendations, Citigroup agreed to sell its profitable Phibro unit at an extremely low price of only one or two times earnings in order to avoid having to pay a talented trader a $100 million contractual share of the profits he had earned. The most successful of the remaining employees of Citigroup, AIG and Bank of America have been given an incentive to leave their posts, and the firms will be constrained in hiring replacements. These firms need a lot of rebuilding to recover from their losses, but without fully competitive access to good people, they will be handicapped in doing so.
The top five Wall Street firms are now all bank holding companies, three of which are doing fine. They are all subject to extensive regulation by the Federal Reserve, which also announced new compensation guidelines. Tighter rules for the largest banks are expected soon. Wall Street bonuses didn't cause the current crisis, and reining them in dramatically isn't a cure-all. It's time to give it a rest.