How Executive Compensation is Like the Weather - 15 June 2009

How Executive Compensation is Like the Weather

Jun 15 2009, 8:42 pm by Dr. Manhattan

There are reasons everyone talks about executive compensation, but nobody does anything about it.

Regarding the latest Obama administration initiative regarding compensation on Wall Street generally, Matthew Yglesias agrees with those who accuse the administration of not doing enough and approvingly cites a Brad DeLong post unfavorably contrasting Wall Street compensation schema to those of Silicon Valley ventures:

The engineers of Silicon Valley startups are significantly
smarter and work a lot harder than do the traders of Wall Street. Some
of the engineers of Silicon Valley make fortunes: they are compensated
with relatively low salaries and large restricted equity stakes in the
startup businesses they work for, and so if the businesses do well they
do very well indeed--in the long run, in the five to ten years it takes
to assess whether the business is in fact going to be a viable and
profitable going concern. And the engineers of Silicon Valley have
every incentive to use all their brains and all their hours to make
their firm viable and successful: they get their cash only at the end
of the process. They don't get big retention bonuses if they stick
around until the end of a calendar year. They don't get big payouts if
they report huge profits on a mark-to-market basis.

The traders of Wall Street, by contrast, get their money largely up
front. If the mark-to-market position is good, they get paid--even
though it is almost surely the case that nobody has tried to actually
sell the entire position to somebody else. If the strategy produces
short-run profits, they get paid--even though not nearly enough time
has passed for anybody to be able to assess what the risks involved in
the strategy truly are. They get "traders' options"--we claim that we
have made you a lot of money, we claim that the positions and
strategies we have left you, the stockholders, with are sound, we claim
that we have correctly managed our risks--but we are not interested in
putting our own personal money where our mouths are but instead we
insist on getting our fortunes up front.

The failure of the major institutions of Wall Street to adopt
Silicon Valley compensation schemes in the 1980s and 1990s was always a
great worry to regulators and policymakers...

On this topic, attention must be paid to former investment banker The Epicurean Dealmaker, who has been writing about this quite often
over the past 18 months.  He has made two main points which haven't
been reflected sufficiently in coverage of Wall Street paydays:

1) The major banks already were giving out a very large share of compensation in restricted stock and other instruments dependent on the value of the firm - i.e., the "trader's option" asymmetry was less of a problem than popularly assumed.

2) More importantly, the heavy weightings of Wall Street
compensation in restricted instruments still hasn't had, and won't
have, the desired effects for the following reasons:

Now, given the differing motivations and incentives of
pure traders and pure investors, there are really only two proven ways
for the investor to control his trader's assumption of risk. The first
is close supervision, monitoring, and control: the investor limits what
securities and positions the trader can assume, he monitors daily
trading activity and marks positions to market daily, and he intervenes
when things go off the rails. This is the simplest model, and it is the
one that used to obtain back in the dark ages before investment banks
became large, externally funded, global trading houses. Yves Smith
points out that this is the model the old Goldman Sachs partnership
used to use, before it went public. There really is nothing better to
keep some young Turk under control than some grizzled, grouchy old
bastard seated next door who used to trade the very same markets you do
and whose personal partnership stake you are trading for a living.

This
model, as we have seen over the past 18 months, begins to break down
when the span of control gets too broad and the chain of supervision
becomes too attenuated, like it did in today's huge global banks.
Complicated Value at Risk models and professional risk managers are no
match for crafty and devious traders, particularly when the money they
are trading belongs to some absent, passive institutional investors
whom no-one gives a damn about. Markets are too fast today, and
securities are too recondite, to make supervision at a distance very
successful.

The second way for investors to control their
traders' assumption of risk is to make them investors, too. Make a
trader eat his own cooking, so to speak, and you will see a marked
change in how he handles and assumes risk. The trader will supervise
himself. After all, it's his money too. Many hedge funds do this, by
paying their important traders in shares of their own trading book, or
the overall book of the firm. Investment and commercial banks have been
doing this for some time, too, by paying traders--along with everyone
else--substantial portions of their annual compensation in long-vesting
restricted stock of the firm.

The problem with this method is
twofold. First of all, you need to make sure that enough of the
trader's compensation and total net worth is tied up in this way;
otherwise, he will just view unvested compensation as "house money" to
play with, and he will have little incentive to care. The temptation to
swing for the fences, or assume dangerous risks, will overwhelm any
proprietary instincts for preservation of personal capital. Second,
even if the trader has a substantial portion of his wealth tied to the
overall results of his firm, the firm cannot be too big in relation to
his stake, or he will feel that nothing he does will matter anyway. The
rubber band tying his personal trading performance to the price or
value of his employer's equity will be too elastic and contingent on
the actions of others to act as a real incentive. This is the problem
faced by large investment banks, where a trader holding even $50
million in unvested stock feels that nothing he can do--good or
bad--will make a difference to the price of Citigroup stock.

(Emphasis addded.)

Those points are some of the best arguments I've seen as
to why the extensive employee equity-ownership of the major investment
banks - and the most notable examples were none other than
Lehman Brothers and Bear Stearns - did not provide sufficient alignment
of interests to prevent franchise-destroying risks.  And they also
point to the most important term in the Brad DeLong excerpt above: not
"Wall Street" or "Silicon Valley," but rather "startups."  The
compensation system for a startup with few employees simply does not
scale up in the same fashion to an institution the size of a Wall
Street firm.  On his sadly-discontinued blog, famed tech entrepreneur Marc Andreessen - who knows the differences between startups and big companies - points this out:

This is why stock options work so well in startups -- and the fewer
people in a startup, the better stock options work, since when there
are only a few people in a company, it's usually crystal clear to each
person how her work will impact the value of the company.

...As a company grows, stock options and other forms of equity-based motivation become less and less useful as an incentive tool, since it becomes harder for many employees in a large company to see how their individual behavior would have any

http://business.theatlantic.com/2009/06/how_executive_compensation_is_like_the_weather.php