Blood on the streets? You must be kidding ..
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Please welcome Sridhar Iyer back after a long time. He is a financial industry expert, working for the company that loves urban landscapes 😛 – Sukumar
“It’s mayhem out there,” cries the CDO trader to a fat cat investor on a long distance phone line. We could get 20p to a dollar if we are quick and lucky. The client shudders “ I am already down 20MM, and this will wipe me out ”. “Things could get worse. It is best to close positions now. DB is offering 18.6, MS 19 and Merrill only 17.2. 20p is a great price, given the state of the market ” pearls of wisdom on recorded lines travel through fibre optic cables across continents. The trade is booked, the deal is done and the market crashes even further.
And as if to console that far away investor, FT headlines cry out the next day “ Chuck(ed) out – Citi fires CEO ” followed by another lyrical one “O’Neal exits Merrill ”. New phrases are added to the financial services lexicon and bandied about by every expert worth his salt – credit squeeze, liquidity crunch, the balance sheet impact of a low tier one capital, sovereign funds …… . .. If you are not predicting recession, you are definitely not in vogue. Fed cuts interest rates, stock markets plummet, job cuts all over.
Given this scenario, you would think that the financial services industry was in deep turmoil .It is time to tighten belts and see through this difficult period. Well, not quite. That , certainly is not the signal if one were to go by the bonuses that have been handed out to the big shots this week – both to current and former bosses.
Chuck made $94 MM as farewell gift from Citi and O’Neal showed what a good negotiator he was by plucking out $150MM from Merrill. Chuck’s successor, at Citi made a healthy $28MM for 2007 , and the new head of the of Citi’s fixed income division ( which caused all the write downs) a cool $22MM.
But surely, a whole bunch of traders and analysts were fired and they bore the pain. Fired, yes. But pain ? That’s a different story . Look at this career model – a crisis like the present one, occurs once in 5-6 years and lasts at best for a year. The last one occurred in 2001 and was followed by 5 years of undiluted prosperity. In a decent year, an average trader makes a modest $0.5 to 0.7MM. So while the good years last , the kitty fills up pretty quickly. Will s/he complain, if in order to calculate the new average pay for all 6 years, nothing incremental is added to the numerator ?
But what about their reputations, loss of face? Here is a secret – a trader’s worth in the job market goes up with the number of down turns he has managed – whether in the job or out of it. And if nothing else, most top business schools offer great 1 year programs, which will help change career paths.
So who lost out and who gained? – Consumer banks, that wrote off substantial portions of mortgage loans to the sub-prime segment (an estimated 200$Bn) especially in the US made big losses. The CDO crisis, though, is a zero sum game. There are winners and losers who balance each other out. Citi, Merrill and the other big banks, which betted on sub prime lost heavily while Goldman Sachs and numerous hedge funds profited to the same extent. The hedge fund owners who made billions, must be wondering what this furore is all about. One thing is for sure though, the traders and investment bankers, who precipitated the crisis certainly did not lose out. They never do.
So why are you not a trader? Well, that is another long story.
Nice post Sridhar. Executive compensation is certainly getting out of hand in corporate america. I wonder why no company is willing to follow John Mackey’s lead at Whole Foods, where the salary of executives is capped to 19 times the average pay of the employees. They recently raised the cap from 14 to 19 times and John blogged about it.
http://wholefoodsmarket.com/socialmedia/jmackey/2006/11/02/compensation-at-whole-foods-market/
As you correctly point out, the fact that the financial industry lavishing itself with multi-million-dollars smack-dab in the face of retail investors’s portfolios melting down is a horrendous travesty.
I hope better sense prevails on this exec compensation issue.
Thank for the welcome, Sulumar. It feels good to be back amidst the expanded SAST family
Thanks also for drawing my attention to the Whole Foods salary model, which I was not aware of. John Mackey’s idea is a brave and a noble one. But I also think it is an idea that most companies will find very difficult to implement. I can sort of see why companies will not pay much heed to this.
In my view, in those businesses where net profit/employee is v high, and compensation is one of the primary drivers (if not the only driver) of performance, a ceiling on compensation, no matter how high it is, will always be viewed as a de-motivator. The factor that determines executive pay here, is supply and demand, benchmarked against value ($) generated. Banking, specifically investment banking is one fine example – the annual bonus of an executive here has no co-relation to his/her base salary level or to the average pay across the company. It depends solely on the profits generated by the individual from the deals done in the year. And that is the practice in the industry. The fact that, in this business it is relatively easy to establish that Mr./Ms X (or team X consisting of 3 people) was solely responsible for generating $Y of profits could be the underlying basis of this comp structure.
Considering that this arm of the banking business generates massive profits – as % of total earnings of the company (or massive losses as in 2007,), meddling with pay structures here is always fraught with huge risks, particularly when only one player in the industry decides to introduce a cap on pay. A mass exodus could ruin a bank while bolstering competition, given that ibankers are a relatively small family. Management consulting and commercial banking to a lesser extent have similar issues.
In which case, we are talking of industry-wide changes to pay structures. That looks far less probable. considering that simpler things (like not poaching ex-employees) have been tried without success.
One way this could work though, is if CEOs decide to have a self–imposed caps. In essence honorary posts. But then one would need noble, efficient and committed CEOs like Mackey who are rare to find. We obviously do not want organizations run like the BCCI!
Thanks Sridhar. I didn’t realize the compensation structure in investment banking. What you’re saying makes sense. And it also true that John Mackey type people are rare in the executive suite.
Posting this on behalf of Vamsi. Somehow his comment got deleted.
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Nice post Sridhar.
Can we postulate – Law of Conservation of Wealth – Wealth can be neither created nor destroyed. And the house always wins…
I know dotcom bust created millions of common investors, who lost their life incomes, jobs etc at the same time. That should have still made brokers and the VC companies rich. And the new age CEOs straight from the cradle also would have got fat pay checks.
This subprime crisis, I just cannot understand. How could any bank give credit if the person has no means to pay it on the first hand. How could one get an Equity LOC within 2 years of buying the house? How can valuators peg the value of the house artificially? All 5/1 ARM loaners now have to pay either 2 times more mortgage(plus escrow). I blame Fed on the first hand to have cut the interest rates to historical low. It probably would have created this boom. It sounds like a mega scam to me. One Database Admin in my company left her job (that pays well over 80K in Tampa) and worked as a real estate broker for 3 years and now back to her old job. She said that it was a good run and a welcome break. That is the height of the situation.
I heard about part-time MBA demand this year, I heard that Stern School is expecting significant increase of applications this year, thanks to recession.
But I see situation in USA is still healthy compared to speculation of Real Estate market in Hyderabad. One day they say Telanga will come and the market goes bearish…next day YSR will pose picture with Sonia Gandhi (with her famous weepy smile). It is worser than Dalal Street. Quite a sham.
Nice to hear from you Sridhar. Timely post too. Obviously executive pay packages are out of whack and these golden parachutes absolutely do not make any sense. The rules applied to a CEO getting fired obviously do not apply to any other employee.
Talking to Vamsi’s point of blaming Fed and the government, what about this new “stimulation” package announced by the US Federal government that would result in a $600 (single) or $1200 (married) paycheck for various households. Do these really help? In the end I think such largesse is just an expensive gimmick. I have a nagging suspicion that this will help fill the coffers of Sony, MS and Nintendo rather than do anything to the economy. I think that the free market should be left alone to clean up the mess.
Ganesh
Sridhar – Interesting post.
Ok, so if we can base exec compensation on the $$ or the profits a person made – that’s good. But, when a CEO is chucked out because of poor performance – I just can’t digest the “golden parachute” getting activated then. There should be some clause there that says they’ll forfeit their parachutes if they are shown the door because of poor performance.
Are the boards strong in the financial/investment banking sectors? Or, are they mostly stooges of the company’s management?
Thanks Priya.
You are quite right – a golden parachute for poor performance of the company seems absurd. But the problem is in establishing that the crisis in a large and complex organization/industry is a direct consequence of the CEO’s poor performance . A crisis like the current one happens once in 6-7 years . In the intervening period , even an average CEO would have tasted a few successes not necessarily because of his ability . Changes in regulatory environment, a new fantastic product/market breakthrough, goof ups by competition, or just plain luck could be the reasons. But a clever CEO uses the PR machinery to play this up. Soon s/he manufactures an aura around him/herself and this sticks. And now to blame this “hot shot” for the debacle would be extremely difficult, particularly when the industry as a whole is suffering. And hence an amicable settlement is reached. The CEO steps down citing moral responsibility and the company thanks him/her for all that s/he has done including the current crisis.
A significant portion of this golden parachute is also “hush money”. To ensure that the CEO has a quiet and a comfortable retirement and is not vocal about the company’s strategies. Charity, philanthropy, politics are areas that open up for the “hotshot”.
Considering that this practice has been in vogue for many years now, the legal eagles ensure that the CEO’s contract has the right clauses incorporated to protect the CEO. The board which is made up of CEO like members (not necessarily stooges) find nothing amiss.
Sridhar, thank your for throwing light on the exec compensation in banking. That looks like an interesting place to be 🙂 Fat bonus if you perform. Golden Parachute if you wont. And you can be in more demand from head hunters… wow.
Sukumar, I am impressed by Whole Foods Model.
Ganesh I think the stimulus package is a welcome change. But the Govt is urging the consumers to spend more. And they dont want people to pay off those high interest credit card. Like you said, even if people spend more, it helps the importers, and Chinese companies more than the retailers. Sometimes, despite the meaningless rhetoric, Lou Dobbs is right.
Thanks for your thoughts Vamsi .
Just a couple of point on why/how the sub prime crisis started.
If one were to analyze markets based on their risk /return profile , the most lucrative segment in the market is the low risk, high return segment. But this, as we all know is a small segment , overcrowded with players and one where it is difficult/expensive to reach customers.
The low risk , low return segment is all about numbers. Very low value , high volumes and lot of hard work. Difficult to become overnight super stars if one depends on this.
The high risk, high return segment, therefore promises instant stardom. As long as the macro-economic indicators are good and the luck holds there is plenty to be made in the short term. While the loss rates in this segment are high , the returns are even higher, so the loss to asset ratio or NCL (net credit loss) /margins are attractive. . Considering that bonus cycles are yearly and career stints in one specific product do not last more than a couple of years , it is possible to manipulate moves and ride the good wave while it lasts. It’s only when the wheels come off, like in the current situation, that bankers get worried. But if one looks at the past few years , numerous bankers have progressed careers by being “innovative”/ “pro-active” and by “listening” to customers and market conditions.
The other new animal that helped create the sub prime crisis was the CDO (collateral debt obligation) or the secondary market for bundled loan securities. Once this market was established , the bank originating the loan ,say Bo, was completely assured that as long as the return on the loan portfolio was high, it would definitely find a buyer B1 in the secondary market , irrespective of the credit quality of the portfolio. As a consequence , the little attention that was being paid to credit quality was also relaxed. “Returns” was the name of the game. Buyer B1, in turn knew than he could find B2 and so on. It became so absurd , that buyer Bn did not know what he was buying except the promised return on his investment. And one day, buyer Bn found that he could not find buyer Bn+1, because the credit quality of this portfolio was poor and the loans were likely to default very soon. In panic Bn started reducing prices. All the banks that were Bn or held Bn like positions, panicked and started a series of distress sale/valuations.
Given that banks have to declare “mark to market” positions quarterly, the write downs or the negative revenues started having an impact on their net earnings. On a very general note, the portfolio which was worth $1 is currently valued at $0.4. , with the anticipation that it will go down even further unless the Fed intervenes. And the Fed has now.
Sridhar, Thank you for the detailed overview of the sub-prime crisis. I never knew that the secondary market goes so many levels deep. I only know that the Freddie-Mac and Fannie-Mae will someday buy many loans under certain value. And others will be picked up by certain banks.
So finally can we say that this is just a sentiment that so many loans are sub-prime. Or are there really defaulters around? When I speak with my realtor friend, he says that the inventory for new houses is high and that is the reason why market is so slump. According to him, when a potential home buyer can buy a new house (with warranty), why should he buy an old house for the same price in the similar locality. He also says that foreclosures are there as they always were..not in a significant high level. I wish he is true.
Compensation in financial services firms is a hot topic – Martin Wolf (FT), Raghuram Rajan (ex-IMF) etc have written pretty interesting articles about it in recent times.
This is what Martin wrote recently:
No industry has a comparable talent for privatising gains and socialising losses. Participants in no other industry get as self-righteously angry when public officials – particularly, central bankers – fail to come at once to their rescue when they get into (well-deserved) trouble.
See this for more:
http://www.ft.com/cms/s/0/73a891b4-c38d-11dc-b083-0000779fd2ac.html?nclick_check=1
None of the execs are worth what they are getting paid. Exec compensation has gotten out of hand. For example if the AT&T CEO was worth a retirement package of around $170 mn, will he pay it back when the impact of the under-investment in capital expenditures becomes apparent? Or else, what about paying the ex-CEO of Countrywide, the mortgage banker, in sub-prime bonds instead of real cash – he is getting a package of around $120+ mn since his firm is getting taken over by Bank of America. Warren Buffett has proven that he can pay less and get quality execs – so higher compensation is not the real point here. The simple point is that shareholders interests are no longer being taken care of. This US disease is also spreading to India now…
Sajith,
I believe various corporate scandals – Enron, Worldcom, sub prime fiasco etc was due to the emphasis that was placed on shareholders interests and not enough on social responsibility.
In the sub prime scenario – how many lenders’s looked at the quality and affordability of the home owner before doling out the loans. Did the mortgage companies think that the kind of pyramid scheme that Sridhar has mentioned would continue to keep working? The players involved were just interested in making a quick buck at the expense of the common man. Companies big and small, live quarter to quarter and are very reactive to the vagaries of Wall Street rather than pursuing the interest of the customers and employees.
I believe both can co-exist – a socially responsible organization that also works in the interest of the shareholders. It takes a visionary CEO to accomplish this.
Ganesh
Interesting discussion folks.
Sajith,
Interesting article. You’re right compensation is not the only tool. But from what Sridhar has said, if the trader’s performance can be measured individually and compensated I have no problem. The problem is when we apply the exaggerated comp scenario is applied to CEOs.
I think Ganesh’s point is very important. It is all about corporate social responsibility. We need to have corporations move away from the profiteering at any cost model to a responsible corporate citizen model. It is high time that happens.
Ganesh’s point is bang on – social responsibility and increasing shareholders wealth can co-exist but it needs a courageous CEO and patient shareholders, who are difficult to find.
One final comment from my side on exec (CEO) comp –
On the face of it, it seems obnoxious that CEOs are paid the sort of money they are and it causes a lot of heartburn as well. But the thing to remember is that, compensation at senior management level is not just about paying for a person’s worth, though that is one of the most important aspects of it. By paying those astronomical sums, the company is posturing or making a statement to its various stakeholders – competition, to current and prospective employees, to the shareholders and to the public at large. The company is essentially saying that despite the “temporary blip ”, the company is inherently strong and is poised to bounce back. It is also letting employees , current and future , know that if an individual is of high calibre, performs well and plays his cards correctly he could get what the CEO is getting.
And finally this is also insurance money – there is an agreement with the CEO (tacit or otherwise) that the s/he will not join competition and will not be vocal/open about the company’s secrets/strategies.
Despite this explanation, the sums paid out as settlements are absurd, but hopefully this , will make it seem less so.
Sridhar,
Interesting rationale for the CEO comp. That does make sense. But even with that rationale, companies seem to be overdoing it as you say. Hopefully the notion of CSR would stem the tide somewhat.