Monday, April 13, 2009

Wall Street Bonuses Needs A Revamp

I kept quiet when anger was spilling all over the streets over the millions of bonuses paid to some AIG executives. Technically, the guys (they were all guys) were entitled to the bonuses because it was written in their contracts. The new CEO had no choice but to honour those contracts. However, there are also a legal and an ethical side to the issue. AIG has had to take so much money from American taxpayers in order to stay afloat. If the American taxpayers did not fund the bailout, there would be no AIG and these executives would never ever see a cent of their so called contractual bonuses. You sign a contractual bonus to protect yourselves from uncertainty. In that sense there may be some credence to them getting the bonuses. It is precisely from these kind of fallouts which causes the executives to sign those bonuses. Realistically, many of those who got the bonuses were not part of the unit which got AIG into trouble, most of those have left the building already - those ones responsible for creating and selling Credit Default Swaps on the CDOs.

The public isn't really angry about greed on Wall street, thats a given, greed is Wall Street. The public's anger is you shouldn't get bonuses for doing a shitty job. People are losing their jobs because of the financial crisis brought on by the "bad things on Wall Street", they are seeing their home values being decimated because of that, they are seeing their retirement fund being wiped out by half because of that ... and you still want your bonuses??!!!

Now its confirmed that these AIG bonuses would be taxed at 90%. That was a popular new law which was put in place to clawback the sums paid out. The ramifications from all this is that the banks who also took TARP and other government money may find themselves in similar hot water should they also pay out exorbitant options and bonuses. Thats why Goldman Sachs and a few others have come out to address the "new compensation scheme" for its bankers. Many of the banks new scheme basically puts most of the bonuses in the form of options and may only vest after a certain period, usually 3 years. There will also be clawback clauses which means that options may be taken back if future years see a huge dip in profits before they vest.

Bank of America and Citigroup are a bit stupid when the CEOs said that they may be raising the senior executives salary packages to compensate for the fact that they will only receive mostly share options that will take longer to vest as bonuses instead of cash. That is a slap in the face of what the spirit of the "new compensation scheme" is trying to achieve. They are just trying to find a way around the new paradigm, not working with the new paradigm.

I have argued in previous postings that there has to be a new way of determining compensation. The whole shebang in tying in senior executives compensation to "share price performance" only is flawed. This cause instructions and strategy from the top to MAXIMISE profits on limited deployment of capital. It encourages excessive risk taking to rake in profits - bankers would bet with 10x leverage on capital on market direction and will stand to collect when it turns out well, but if it goes the other way, hey, I will resign and look for another firm to ply my trade. There is no real punishment for mistakes on huge bets but there is great rewards for guessing correctly.

The mistake in linking bonuses only to share price compensation also result in management to immediately use any positive cashflow to buyback shares, as this would enhance eps and thus boost share prices. As their share options will rise in value when the share price move higher, management will be quick to do share buybacks. You can go through a number of research papers and they will confirm that companies doing share buybacks always under perform the rest of the market. Buying back shares may not be the most prudent thing to do. Management has to be incentivised in planning for longer term, and to make acquisitions and disposals to sustain their market share growth - all of which requires a more diligent use of cash flow and capital. Many of the banks are in trouble now because of their wafer thin capital adequacy. In good times when they raked in profits, most of it was sent to buyback shares. Now that they need to have more capital, they are forced to sell lucrative assets and/or sell more new shares at very depressed prices - both kicking the minority shareholders interest in the face.

My view is that an executive's compensation and bonus should be tied to a matrix of:

a) share price performance

b) eps enhancement

c) prudent returns based on capital deployed

d) making sure the company stay within defined boundaries of acceptable leverage, debt ratio and debt servicing

e) allowing management to only buyback a maximum of 2% of outstanding shares a year

f) the bulk of the bonuses should be based on a review every 3 years on how well management has planned and execute their longer term strategy in ensuring market share growth

We basically need to reduce substantially the quantum of bonuses paid out annually, and move to a bigger sum being based on a 3 or 5 year period. It encourages longer term planning, less shuffling of assets, less misuse of cash reserves.

What I lost last year

p/s photos: Angelababy (yes, that's her name, what a marketing coup)


Naysayer said... watch Beautiful Cooking also huh? I like that too.

see said...

Well just threaten their bonuses & suddenly they don't need bailout & can pay back real fast

Kiddomo Universe - Where Playland Meets Technology

First of all, this is not paid content. I never take money for product placement for my blog. Thats why my blog is always free of ads an...