On the surface, the particulars of this case seem simple. A Citigroup commodities trader who says he has a contract that could yield him a $100 million payment this year is crossing swords with the new Treasury pay czar, Kenneth Feinberg.
The Wall Street Journal story portrays the pay deal for the trader, Andrew Hall, as a problem for Citi, The bank, maybe. The bank’s top brass, quite the reverse. This is like throwing Bre’er Rabbit in the briar patch. The rich contract established a high pay ceiling. If you know anything about the cognitive bias, anchoring, this is very powerful (if you don’t know the literature, be sure to read on the studies used to test for it. It’s very insidious). Win or lose, that number is now a legitimate. Second, independent of anchoring, Citi is not likely to fight Hall unless pushed by Treasury. A big payout for him provides an umbrella for everyone else.
Before the “sanctity of contracts” crowd tunes up, why don’t you folks wrap your minds around a few other legal obligations of a public company, such as the duty of care that its officers have? Deals like Hall’s are close to a firm within a firm, always a bad idea. Arrangements like that led directly or through knock-on effects to the end of Drexel, the mess at AIG, and the Treasury bond scandal at Salomon. For instance:
Mr. Hall is contractually obligated to receive pay based on Phibro’s profits, and some observers on Wall Street believe Citigroup has a better chance at repaying the U.S. money with its Phibro unit humming.
Critics, however, argue that pay agreements like these need to be redrawn in light of Citigroup’s taxpayer-funded bailout. Soon the U.S. government will be a 34% owner of Citigroup…
Mr. Hall has long operated with remarkable independence. In late 2007 he shot down Citigroup executives who wanted to merge Phibro with the bank’s asset-management arm, which could have clipped his ability to make big investment bets….
Mr. Hall’s pay contract has multiple parts. He has long had a profit-sharing contract with Citigroup and its predecessor banks entitling him to a large percentage of Phibro’s gains. The percentage he and his small team of traders get under the contract terms currently stands below 30%.
Mr. Hall’s pay and independence from Citigroup’s home office reflects a track record of making sizable, successful investment bets. A few years ago, for instance, Mr. Hall, 58 years old, anticipated an important shift in the way the world valued oil, and correctly bet that long-term and short-term energy prices would abandon their historical relationship with each other. In making that investment, Citigroup gave Mr. Hall more leeway to take on risk than it usually gives entire teams, according to traders….
Citigroup doesn’t report Phibro’s detailed financial results, but a footnote in the company’s annual report says that $667 million in 2008 revenue from “principal transactions” related to commodities “primarily includes” Phibro’s results.
Latitude like that is inappropriate in a large organization. Men like Hall hold their employers hostage with the threat that they will go start a hedge fund. But that entails additional duties, like dealing with peaky investors and needing to worry about end-of-month results. While some star traders go on to be very successful hedge fund operators, others fade surprisingly quickly. Those irritating organizational constraints might actually be to their benefit.
Consider John Whitehead, former co-CEO of Goldman, who was incensed that the pay levels in 2006:
“I’m appalled at the salaries,” the retired co-chairman of the securities industry’s most profitable firm said in an interview this week. At Goldman, which paid Chairman and Chief Executive Officer Lloyd Blankfein $54 million last year, compensation levels are “shocking,” Whitehead said. “They’re the leaders in this outrageous increase….
Whitehead, who left the firm in 1984 and now chairs its charitable foundation, said Goldman should be courageous enough to curb bonuses, even if the effort to return a sense of restraint to Wall Street costs it some valued employees. No securities firm can match the pay available in a good year at the top hedge funds.
“I would take the chance of losing a lot of them and let them see what happens when the hedge fund bubble, as I see it, ends,” Whitehead, 85, said….
If the Citi executives really wanted to, they could go over Hall’s conduct with a fine toothed comb and find violations of bank policy (most big honchos break expense rules). And the formalities here do not matter much. Hall is a big producer, perceived to have the upper hand.
No where is the asymmetry of this arrangement mentioned: that Hall and his team get the upside (30%, more than a hedge fund success fee, more than even LTCM in its glory days, which got a 25% upside fee), but the taxpayer gets stuck with the losses. Hall and his bunch have the richest option deal going. Nor does it bother to point out that Hall would find it hard to get access to as much capital as Citi provides him on such rich terms from the outside. Citi not only provides him with more equity than he is likely to be able to raise (certainly for a 30% upside fee) and his cost of funding is sure to be considerably lower than if he were to operate on his own.
Citi is already too big to fail. The Phibro team is a stand-alone unit that takes a lot of risk that is not appropriate for a government-supported entity. The government safety net should extend only to crucial financial infrastructure. This is a great opportunity for Citi to shed a risky, non-core activity, which is exactly what it should be doing.