While I don’t want to overdo the criticism of Wall Street pay practices (on second thought, I am not sure such a thing is possible), I’d be remiss if I neglected to highlight a very good job of analysis and reporting by Eric Dash of the New York Times (and Footnoted.org) on this topic.
The Times has been picking apart a partnership that Goldman preserved after it went public in 1999 and is the vehicle that holds stock options and shares allotted to the top producers of the firm, a 475 member group. It already holds 11.2% of the firm and its share is likely to increase as options vest.
The report published tonight reveals that members of the Goldman partnership would routinely hedge their Goldman exposures. That defeats the purpose of share grants and equity linked pay. The recipients are supposed to have their fates rise and fall with those of the outside shareholders. After all, the idea is they have a vested interest to do what is right for public owners. If they can truncate their downside, it simply reinforces the the tendency to take undue risks since the management group received the bennies of price appreciation and can shed the loss of failures.
As the Times points out, for that very reason this practice is restricted at most corporations, but there is a key difference between Wall Street and Main Street: at most major companies, only very top executives get large grants of equity linked compensation. By contrast, at major capital markets firms, a large cohort of “producers” gets most of its pay in bonuses, and those bonuses are increasingly paid in stock, particularly in the wake of the crisis. But typically only the top executives, whose compensation is subject to greater disclosure, are forbidden from engaging in hedging:
Institutional hedging policies vary across Wall Street. Bank of America bans all employees from hedging their company stock, although management can make exceptions for “legitimate, nonspeculative purposes.”
But most big banks — including JPMorgan Chase, Morgan Stanley and Goldman Sachs — prohibit only their highest-ranking executives from such transactions. At Goldman, the chief executive, Lloyd C. Blankfein, and nine other top officers are not permitted to hedge their holdings.
Independent observers reacted negatively to this practice:
“Many of these hedging activities can create situations when the executives’ interests run counter to the company,” said Patrick McGurn, a governance adviser at RiskMetrics, which advises investors. “I think a lot of people feel this doesn’t have a place in a compensation structure.”….
“Wall Street is saying it is reforming itself by granting stock to executives and exposing them to the long-term risk of that investment,” said Lynn E. Turner, a former chief accountant at the Securities and Exchange Commission. “Hedging the risk can substantially undo that reform.”….
Regulators are taking a hard look at the practices. The Financial Stability Board, a group of global banking supervisors, wants firms to restrict employees from using the strategies. The Federal Reserve is examining hedging in its review of bank compensation.
And the Federal Deposit Insurance Corporation is expected to propose on Monday a new rule requiring big banks to defer at least 50 percent of annual stock and cash bonuses. That compensation would be released over the course of three years, so that executives don’t reap big, short-term windfalls even if their bets don’t pan out.
When Goldman was still a private firm, vice presidents (who are actually are much like the producers in modern financial firms, in that they do not suffer the liability of loss) had a substantial portion of their annual bonus deferred one year and invested by the firm. The argument was that it helped smooth compensation in an inherently volatile business. I always suspected that reasons that served the partners were actually the driver: that it would be harder for the very top VPs to quit with a large chunk of dough tied up at the firm; that it would give the partners some ready recourse if they found someone had engaged in shady behavior.
It isn’t clear that a high level of share ownership really does lead to more prudent, long-term-value-maximizing behavior. Both Bear Stearns and Lehman had very high employee shareholdings. But consider what happened with the top brass at both concerns: even though their wealth took a large hit when their firms failed, they were still handsomely well off by any real world standard. But it seems pretty clear that letting firms pretend that they are improving incentives and then allowing them to be gutted behind the scenes is not a wise idea.