On The Sanctity of Wall Street Pay

I am sorry to make Roger Ehrenberg an object lesson as far as this post is concerned, because I am a fan of his work. He is articulate and insightful. I have often featured his posts in Links as opposed to in posts and felt a bit bad about it, in that I wanted to give them more attention, but had nothing to add.

However, I am sick and tired of the “sanctity of contract” theme as far as outsized bonuses from “dead other than by the grace of the US taxpayer” organizations are concerned, and Ehrenberg lobbed in a vote firmly in the “sanctity of contract” camp. And while he does argue for changes in what he calls the Wall Street trader compensation model, the record does not give much reason to think his suggested remedies will actually change behavior all that much.

First, to the “sanctity of contracts” bit. I don’t seem to recall many, or frankly any Wall Street types going on about sanctity of contracts when agreements with the UAW were reworked to save GM. So tell my why should big financial firms that would be toast other than by virtue of the munificence of the suffering American taxpayer be any different? The case that is getting everyone exercised is Andrew Hall of Citigroup, which is the lead candidate in the zombie bank casting call. Hall would have NO contract had nature been permitted to run its course. That inconvenient fact does not seem to be acknowledged by Hall defenders.

Being at a firm means all boats rise and fall with the fate of the firm, That construct was well understood in the days of partnerships and has gone completely out the window in the era of public ownership, aka Other People’s Money. If you did an A job in a C year, you did worse that if you did a C job in an A year. Unfortunate, but those were the breaks.

My beefs about Hall’s pay are not the level per se but the structure. He appears to have a firm within a firm, an arrangement that often leads to bad ends (Mike Milken at Drexel and the AIG Financial Products Group are the poster children, but I have seen smaller scale variants that also wound up causing trouble for the organizations housing them). He refused to comply with efforts to integrate his unit into the asset management group, which presumably would have been better for the bank, so he clearly wants to have his cake and eat it too: enjoy the advantages of Citi’s cheap borrowing costs (an important advantage in his business) and infrastructure (he is relieved of much of the hassle of running a business) and can focus on a year long horizon rather that worrying about Sharpe ratios and monthly NAVs. And his deal appears extraordinarily rich, with the cut for his group below but presumably not much below 30%, well above hedge fund norms.

Second, as I have said repeatedly here, employment contracts can and do get voided and renegotiated ALL THE TIME. I have seen this happen both at client organizations and in my professional circle. And this is true of contracts generally. Circumstances change, people of good will try to recut a deal, and if someone is a pig about it, then the aggrieved side moves on to more aggressive measures. There is nothing terribly unusual about this. It is an unpleasant fact of modern life. Having a contract does NOT mean it is sacrosanct. Please. How many of these people who are carrying on about sanctity of contracts are still on their first wives? “Sanctity of contract” means there are costs of modifying or exiting the deal.

Let’s consider another case where “sanctity of contracts” didn’t stand for much: credit default swaps. A little bit of history that has gone by the wayside: CDS written pre the Delphi bankruptcy required presentation of the bond for the protection buyer to collect. Delphi was the first large bankruptcy and was considered to be a test of the market. The industry realized the Delphi CDS outstanding greatly exceeded the amount of cash bonds. That meant first, there would be a mad scramble to buy bonds to present at the settlement, meaning a huge price squeeze, and second, the overwhelming majority of people who had bought protection would find it to be useless.

The powers that be came up with the cash settlement mechanism even though it was not permitted in the original swap documentation. The big dealers were very keen to keep the market going. Had they stuck with the original construct, CDS protection buyers who did not have bonds would not have profited, and the burgeoning of the market to significant multiples of the value of the underlying bonds probably would have come to a screeching halt. And notice how this was done. To go to cash settlement post Delphi would have been a belated recognition of a need to change procedures. But modifying it on the fly is quite another matter.

Ehrenberg argues that traders should be paid on a long-term basis, with their 80% bonuses reinvested in a capital account, He points out, and I agree, that stock based compensation does not influence trader behavior, They don’t ascribe much value to the shares.

But I am not sure the evidence supports Ehrenberg’s view, that that hedge fund compensation model actually leads to more prudence. The big and obvious benefit is it does allow for losses in bad years to be offset against gains in good years. That is undeniably an important gain. It would presumably put an end to certain year end tricks to pump up positions up and dump losses in the next year, with the idea that the trader has made enough from the chicanery to afford the worst case outcome, namely, a resume put.

However, I am skeptical of the further benefit that Ehrenberg asserts, that it will lead traders to take more of a long-term perspective. Now in fairness, he does say it is “more likely” to improve behavior, and I cannot disagree with that formulation, but I think the change in behavior would be less marked than he believes.

Traders are very fixated on maximizing their annual take, and also too often regard their past gains as money in the bank. The LTCM partners famously had pretty much all their money invested in the fund, and we know how that movie ended. And what is more striking is that both Myron Scholes and John Meriwether started new funds, each of which failed. Given their records, I would imagine they were expected to and did reinvest a fair bit of their earnings. Similarly, if you look at the level of hedge fund disasters last year versus those among traders at big firms, would you see much difference? I genuinely do not know the answer, but given the high rate of hedge fund failures, having a lot of cash tied up in the business did not seem to prevent widespread hedge fund implosions.

As much as philosophically anything is better than the current model, I am skeptical that relying on pay to create good incentives is an adequate check for having risk controls, in the form of someone skilled but more conservative act as a check. The egos and short term focus of traders of many traders makes them hard to contain, and unlikely to restrain themselves, even if it were rationally in their best interest.

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  1. Stuhlmann

    I understand that one reason that bonuses are paid has to do with how different types of employee compensation are taxed – which Congress could fix. But I must believe that firms use bonuses as a way to motivate employees. If the employees help the firm do well, then the employees are rewarded with bonuses. If the bonuses are guaranteed no matter what by contract, then the bonuses lose their ability to motivate employees. Wouldn't a firm have to be crazy to obligate itself to pay bonuses during a bad year? I have to see the terms of these contracts before I can support honoring them with tax payer money.

  2. craazyman

    This debate recalls to mind Thrasymachus' position in Plato's Republic that justice is merely "the advantage of the stronger".

    In additions to the examples cited, health insurance companies routinely break contracts by refusing to pay for policy holders' needed medical treatments on the slimmest pretexts of alleged pre-existing conditions (as one of today's links acerbically describes).

    At the start of the dot-com meltdown, one would read news stories of job offers suddenly rescinded after the hire had quit a previous job and moved to the new employer's geographical region.

    How sentimental and transparent of Mr. Hall's defenders to bring the notion of justice into this. It really has nothing to do with it.

    If it did, Mr. Hall would not be able to extract such lucrative rent from society through taxpayer-supported speculations, nor would his employer.

  3. Blissex

    «I don't seem to recall many, or frankly any Wall Street types going on about sanctity of contracts when agreements with the UAW were reworked to save GM. So tell my why should big financial firms that would be toast other than by virtue of the munificence of the suffering American taxpayer be any different? »

    But every Real American knows the answer, which is very easy!

    Wall Street is full of WINNERS, heroes of productivity and creativity, who MUST be rewarded as much as possible; more rewards mean more productivity and creativity, that will trickle down some wealth to everybody. Therefore reducing the compensation of WINNERS is the last thing to do in a recession, because it reduces their incentive to increase GDP. These heroes have every right to enjoy fully the fruits of their labor.

    Why did the recession happen? Probably because Real American heroes like Mozillo, Fuld, Cayne, Thain were grossly underpaid and overtaxed, and as a result did not feel incentivized enough to check credit quality.

    The few trillions given to the banks are just a modest and very partial restitution of some of the wealth stolen by a viciously exploitative state from USA's best and brightest.

    Real Americans instead know that UAW members are vermins, parasites, who produce and create nothing, and are LOSERS who just extort and consume the wealth produced and created by their superiors. These monsters have no rights to the fruits of their labor, because they aren't any; all wealth trickles down from the best and brightest.

    Since for a Real Americans the contracts with the UAW are the consequence of extortion and malice, they are not just immoral but also unenforceable.

    In other words the question is one of social justice: to give workers they pay they deserve, without exploitation of the best and brightest by the vermin parasites.

    In Real America winners (e.g. financial services executive) must win, and losers (e.g. union workers) must lose.

    BTW, I am not a Real American — I am just trying to explain their position./

  4. barnaby33

    Actually I would say the real difference between GM and Citi is that GM went into bankruptcy. The gov is desperately trying to avoid that with Citi as its debts are almost beyond imagining (without a very large calculator that is.)

    Seems very simple and according to our system of laws, broken though they are whatshisnuts has a right to his payout. At least he made money for Citi. Most of the bailout funds went to the LOSERS. Note I'm not defending the payout per se, I'm just pointing out that all evils flowing forward from saving Shitibank are lesser evils.

  5. Siggy

    I believe in honoring the contract. In the case of Mr Hall, I believe he is being paid too much and the contract should be broken and/or renegotiated. His performance is dependence on the support provided by the company and something close to 30% of profits is cutting into the overhead of the activity. Moreover, if his 'bonus' is taxed as a capital gain, that is a travesty, it's ordinary income and should be taxed as such.

    Now, am I conflicting in wanting to honor the contract and being perfectly willing to breach Mr Hall's contract? NO! Mr Hall's contract is unreasonable in the circumstance and should either be broken and/or renegotiated. My position of honoring the contract is fixed in the sense that one simply pays according to the contract, one uses the contract as a guide as to what is to be done in the case of exigent circumstances. In the case of GM, the rights of secured bond holders were trampled in order to secure a settlement for the UAW. Now then, it is all the rage to say that we now live in a global economy. It's been a bloody global economy since 1900, perhaps earlier! Were it wage rates alone, the UAW would be close to competitive with world labor. Its the benefits that make the labor arbitrage possible in the auto industry. Saving GM, as the industry is currently structured is not going to save the industry. It's nothing more than money down a rat hole. GM should have been liquidated outright. The unfunded but guaranteed benefits accruing to the UAW should have been modified and the liability assumed by the Pension Benefit Guarantee Corp. That is the social bill that the taxpayer should rightly accept!

    So long as this administration is willing to ad hoc violate contracts, as a society we are giving up one the critical characteristics of our society and political system. Honoring the contract is about honoring the contract and if that is not possible, we apply the body of common and legislated law that has guided western commerce of over 300 years. To say that one must 'honor the contract' in lieu of subjecting the contract to appropriate adjudication is simplistic. And that is my point. We should strive to honor the contract and when that cannot be done we must resolve the dispute in accordance with the substantial body of contract law that we can look to for guidance. It is my view that that body of law would have directed the settlement of the GM bankruptcy to give a much larger consdieration to secured bond holders. As to Mr Hall, his claim is excessive given his contribution and the resources he must have in order to achieve the anticipated gains. If he's so competent and productive, why is he not out on his own with his own equity at risk?

  6. Blissex

    «that body of law would have directed the settlement of the GM bankruptcy to give a much larger consdieration to secured bond holders.»

    That is to say the least extremely questionable. Because as many have written you have to compare not a subsidized bankruptcy with a slightly worse deal for secured bondholders to a subsidized bankruptcy with a slightly better deal for them, but to an unsubdisidzed bankruptcy. The bankruptcy judge and almost all secured creditors chose the subsidized bankruptcy because that was the best deal actually (not hypothetically) available.

    «As to Mr Hall, his claim is excessive given his contribution and the resources he must have in order to achieve the anticipated gains.»

    That is what you say — obviously Citigroup thought otherwise. In any case withing very, very broad ranges, whether his compensation was justified does not matter a to contract enforcement — if he got a very good deal, his contract is still valid.

    For a Real American the broad issue is more whether *in general* contracts are moral and deserving to be enforced: contracts with the best and brightest who produce and create _deserve_ to be paid out, but not those with vermin union worker parasites who don't produce nor create.

  7. Blissex

    «So long as this administration is willing to ad hoc violate contracts,»

    That is totally a lie in this case: the administration did not in any way violate a contract it was not party to. It just offered a subsidy for some solutions but not others.

    The person who violated the GM contracts, if anybody, is the judge who approved it.

    Is he a secret Communist just as Obama is a secret Muslim? :-)

  8. Anonymous

    Hall's contract was broken when Citi went bankrupt and became public institution. There is no way in hell he should get the money unless it comes from Sandy Weil's and Chuck Prince's personal bank accounts.

    I speak as a former trader and former Citi employee, but mainly as a (frickin' stupid) Citi shareholder (instead of what I should have been, a share seller).

  9. Anonymous

    "He appears to have a firm within a firm,"

    This may not be germane but in the early eighties I worked for a computer company that was purchased by a telephone company. This was before the break-up of AT&T. The telephone company had this idea at the time of purchase that they would help the computer company grow by putting money into it. This turned out to be forbidden. The "crime" was cross subsidization. The telephone company was a utility and set its rates and tariffs with the help of the public utilities commission so that it could not lose money. If the government through the various states' public utility commissions guarantees a profit to a company then that company cannot subsidize its unregulated businesses with money from its regulated businesses.

  10. Jojo

    Seems to me that if someone can earn $100 million commission, then the company is charging too much for their product/service. If the company is able to charge too much, then the buyer is paying the price that enables the salesperson to earn such a commission.

    We hear talk of the value of lower prices for consumers and the economy virtually everyday.

    If Wall Street lowered the prices of their services, then their salespeople(traders) would probably not be able to earn such high commission payments.

    I have yet to see anyone cover the point of product/service pricing in relation to commissions earned for this or similar news items.

  11. edward

    Give him his hundred million. AT the same time, however, reinstitute the graduated income tax rate of at least 90 percent for all compensation over, say $1 million. Do this across the board, for everyone in that bracket, and close every loophole that allows these guys to "defer" said compensation. From now on, all deferral is strictly on an after-tax basis. Watch all the attitudes shift as these guys figure out another way to keep score.

  12. Nik Kondratieff

    Yves, your argument is cogent and very persuasive, lo I fear it will fall on deaf ears.

    Like you, I generally find Roger Ehrenberg's opinions clear and intelligent, and often agree with him. However it's clear to me that because he comes from a certain business culture, he's closing ranks and taking the absurd view that contracts are sacrosanct. Let's call a spade a spade, it's profligate greed.

  13. Anonymous

    The issue is not "sanctity of contract"…that is a medieval concept that has been replaced in the philosophy of modern contract law with the concept of "economic breach." The issue is no longer in the prevention of the breach or it some equitbale remedy but is now in practice the issue of a legal damage remedy that allows and anticipates a breach when the economic conditions or other conditions change (See writings of Epstien and Posner).

    So, the issue is what is the contract worth in breach? The GM example is inopposit to the point here in that it was modified by agreement and it would otherwise have been modified under the laws of insolvency…that is not the situation with Hall's contract.

    If Citi refuses to pay under the contract and Hall refuses a negotiated settlement, then we will find the value of the contract in breach.

  14. Yves Smith

    Anon of 1:21 PM,

    While you may be correct on the legal points, you are missing the forest for the trees. The "sanctity of contracts" folks are arguing that the contract should be kept in place, that no attempt to negotiate should be made.

  15. Yves Smith


    The comparison to financial models in not honest from an intellectual standpoint. Fundamental flaws with financial models have been well-known since 1963, when Mandelbrot found that the performance of markets was different than what the models predicted (tail risk). Not long after that, Sharpe admitted that the theories basically fell apart if correlations among prices of securities were not stable, and they are not. A third major problem is the continuous markets assumption. Yet the prevailing embody these three, widely known, fundamental flaws. Taleb says the fixes to the tail risk problem are inadequate, and there are no fixes I am aware of for the other two issues.

    Financial models are based on theories of how markets behave. The premises and operations are vastly different than climate models. Climate models are being improved on an ongoing basis, while the fundamental assumptions behind financial models haven't changed since the 1950s.

  16. Anonymous

    Sanctity …

    >>>I am sick and tired of the "sanctity of contract" theme as far as outsized bonuses from "dead other than by the grace of the US taxpayer" organizations are concerned<<<

    Oh really?… The issue of sanctity is not one of whether or not contracts can be "broken" or "re-negotiated", it is a matter of who has the RIGHT to force another to do so.

    If the US government/tax payer wants to step in and save a company, it does so KNOWING that it incurs the liabilities of the company. Just as if a PE guy stepped in prior to bankruptcy….

    IF the company were to go into bankruptcy, and then the US government/tax payer wants to play the PE game and step in… then all the LAWS of contracts apply.

    But to contend that your money, spent by a POLITICIAN that "you" and the people elected, should receive special treatment and throw the CONSTITUTIONAL principle of due process and right to property out the window?…..

    Im sorry. That's not only un-American. It's immoral thievery.


    The greatest lesson Ive learned in this whole market crisis is this; this nation has become filled with people who feel they are entitled to take from others when they FEEL as though their reasons are sufficient.

    And that is crap. Two wrongs NEVER make something right.

    It is un-American and immoral.


  17. Marshall Auerback

    I can't even begin to understand to understand the logic of this moronic post from HCSKnight. Forget about the government. The whole essence of a chapter 11 bankruptcy (which has nothing to do with the government) is that it enables the company to shelter itself from EXISTING CONTRACTUAL OBLIGATIONS. Why is this such a difficult concept to understand? The government has nothing to do with this.

    And it's an even greater absurdity to discuss the sanctity of contract in an environment where, BUT FOR GOVERNMENT SUPPORT, the company itself would be insolvent and incapable of fulfilling its contractual obligations. Mr Hall only can make the case for 'sanctity of contract' precisely because the government didn't allow the company to fall into bankruptcy.

    So we have HCSKnight making the nonsensical argument that a government which interferes with the "free market" and saves Citi from bankruptcy somehow is violating a "constitutional" principle by asserting that its rescue of Citi carries with it certain quid pro quos.

    How about some consistency here. We'll concede the point about sanctity of contract if HCSKnight will concede that Citi should go into bankruptcy minus government support. Then in a bankruptcy hearing, let Mr Hall try his luck by getting his contract affirmed. Good luck!

  18. Anonymous

    To Mr. Auerback…

    Please, spare me. Implied in the point I was making is that the bankruptcy process SHOULD HAVE been used. I would have been fine with that course of action as a means to breaking the contracts. Witout it, the "sanctity of contracts" should, and must be, upheld; otherwise one of the most critical, foundational, structures of the US economic system is severely damaged.

    It DOES MATTER that Citi and the others would have been insolvent had the government not moved in to "save" them. It is called SOCIALISM. And it was, and is, an act contrary to the Constitutional principles upon which this country was founded.

    Mr. Auerback, you clearly need to go back and work on reading comprehension. I was very clear in stating that in bankruptcy contracts are legally "broken" all the time.

    You sir are the one who needs to get a hold of your "consistency" and comprehension.

    Let me be clear. Pay the contract. And if tax payers dont like fulfilling the obligations of contract of the companies their elected officials buy, then tough. Next time vote them out. And if they feel that people acted illegally, then fine, take them to court. But to take ANY other courses of action are simply IMMORAL and unethical. Period.

    The American people, of which I am one, need to stop acting like a bunch of spoiled children who think they are owed everything.


  19. Marshall Auerback

    If the point was "implied", it certainly didn't come across very clearly. But there were other overriding policy considerations that came into it. The key to understanding the Andrew Hall contract issue is that it would be bankrupt and in the process of a court supervised liquidation but for the extraordinary government action that has kept the company afloat. If not for the government bailout, the contracts would be worthless because the employees would be unsecured creditors in a company worth less than zero.

    For the past 70 years or so, we have not applied a free market principle to the banking system and you might decry that as "socialism", but it's more the case that your free market concept is an idealisation which has no bearing on the current realities today. It might be news to you, Mr Knight, but the US is not a free market. Of GDP, 17% is health care (where experts, not consumers decide how to spend), 16% is housing (subsidized by quasi-public mortgage firms and tax deductions), 15% is federal welfare, 14% is local welfare, 4.5% is military spending, 3% is higher education (paid for mostly by government or conspicuous philanthropy1 and consumed for status and not value). Together, 70% of US GDP is planned; it’s just that our facade of a free market makes us less efficient at planning than other countries (especially in health care).

    Given those realities, should we be invoking a mythological "free market" as a means of setting policy?

    If you want to go free market all the way, that's fine, but let's get rid of the ridiculous canard that somehow not enforcing Mr Hall's contract leads to "socialism".

    But if you want to take a more "free market" oriented approach going forward, how about this:
    Many of the worst features of modern America should be understood as the result of government engineering that was designed to redistribute income upwards. What you decry as "socialism". This upward redistribution can best be reversed by simply changing these structures.

    The most obvious case is the extraordinary compensation packages earned by top executives of major corporations. This is due to the fact that the top executives effectively control corporations rather than shareholders. If the compensation packages of the top five paid employees of corporations were sent out for approval by shareholders in elections where only returned proxies counted (management generally has the right to count unreturned proxies as supporting its position), it is likely that executive compensation would be brought back down to earth.

    Since the government already sets rules for corporate governance (primarily to protect the rights of minority shareholders), this would not involve any greater intervention into the market. It would simply be a recognition of the fact that the existing governance structure no longer works, that top management is now running corporations to meet its own ends. If we can put an end to the outlandish pay packages of high-level corporate management, then it may bring down the pay of top management in other areas as well, such as universities, hospitals, and other non-profit organizations.

  20. Marshall Auerback

    ….continuation of comment above

    Intellectual property, in the form of patent and copyright monopolies, is a major distortion of the market that has the effect of allowing a small number of people to become incredibly rich. Bill Gates is the richest man in the world today because the government gives him a monopoly on Windows. It will arrest anyone who makes copies of Windows without his permission.

    The same is true of patent protection for prescription drugs. Drugs that would sell for a few dollars per prescription in a competitive market instead sell for several hundred dollars or even several thousand dollars because the government grants patent monopolies. As a result of these monopolies, Pfizer, Merck and the rest make enormous profits, while hundreds of millions of people around the world have difficulty paying for their health care.

    We do need mechanisms to support creative and artistic work and innovation in the care of prescription drugs, but there are far more efficient mechanisms that could be designed and would involve less interference with the market. In other words, the answer lies with less government rather than more.

    The final example I will mention is the effective protection that highly paid professionals (e.g. doctors, dentists, lawyers) enjoy as a result of professional and licensing restrictions. These restrictions largely protect the most educated workers from having to compete against low-paid workers in the developing world in the same way as manufacturing workers.

    Progressives can help promote both equality and economic efficiency by removing these barriers.

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