Hey Santa Claus,
You want to make me happy this year?
Listen to me, honey:
Give Pearl something that'd be of some use to me, like a ...
Like a five pound box of money.

Now, now there’s a little gift
That’s loaded with
Lots of sentiment.
See, when uh ever I get blue, Santa,
I’m gonna think of you,
But at the same time have a little change to pay my rent, you see?

— Pearl Bailey, Five Pound Box of Money

Compensation, O Dearly Beloved, is a complicated thing.

I
say this without fear of contradiction, because I have been thinking
carefully about this subject for quite some time. In particular, I have
been thinking and writing about compensation in the investment banking
industry on this site
for many moons, ever since a rag-tag collection of highly-credentialed
yet woefully uninformed pundits began taking potshots at the source of
my livelihood early last year.
However, whenever I think I have the broad outlines of the conundrum
clearly in my sights, I find that concentrating my attention on any one
aspect of it tends to make the problem skitter away like mercury on a
mirror. At other times, I feel like I am trying to nail jello to a wall.

In other words, Dear Friends, figuring out compensation is a bitch.

I
should know this, of course, from my many years in the industry, both
as a junior investment banker hanging breathlessly on some pompous
Managing Director's pronouncement of the one number which represented
the culmination of a year's worth of difficult, demeaning, and
exhausting work and as one of those aforementioned MDs watching the
frightened eyes of my junior bankers as I delivered the news. It is
indicative of the tension and emotions boiling beneath the surface of
the annual bonus discussion that the firms I worked for discovered they
should separate the announcement of a banker's annual compensation from
his or her year-end performance review. They soon figured out that once
a banker heard The Number, all prior and subsequent conversation might
as well have been conducted in Swahili.

People who do not work
in investment banking simply cannot relate to this process. That is
because, for most workers in most other industries, an annual bonus is
a purely discretionary award, given to acknowledge good or exceptional
performance, and one which they learn not to expect as an entitlement.
Furthermore, a normal bonus outside the investment banking echo chamber
is something like 10% or 20% of an employee's annual salary. For the
big cheeses, sometimes you will even see a bonus of 100% or more of
salary, for a year in which senior management really knocks the cover
off the ball.

In banking, by contrast, bonuses—except for the most junior footsoldiers—can range from 200% up to 100 times
or more of base salary. This is because bankers' base pay is a
comparatively tiny proportion of their expected annual compensation. No
matter how senior or how well-compensated a banker expects to be at the
end of any year, it would be hard to find anyone in the industry who
makes a salary in excess of $650,000 per year, including my favorite
balding squintillionaire, Goldman Sachs CEO Lloyd Blankfein. This
system is an historical artifact, dating back to the annual "draw"
members would take from the equity of the original investment banking
partnerships to pay personal expenses until they could divy up actual
profits at the end of the year. (It is also a dusty relic of a time
when $200,000 was a lot of money, even in New York City.)

While
this legacy plays havoc with the personal finances of all but the most
wealthy of investment bankers, it actually makes a good deal of sense.
By paying even the most senior investment banker a relatively small
percentage of his or her expected earnings as salary, the bank not only
keeps the banker honed to a keen, aggressive, business-getting edge but
also maintains a call on revenues the banker expects to bring in with a
relatively low-cost option. If the banker doesn't deliver, poof!: he is
fired, or paid a pittance as an option on next year's revenues, and
told to pound sand if he doesn't like it. It is about as draconian a
system of pay-for-performance as can be found anywhere.

It also
makes sense because many business lines and forms of revenue at an
investment bank are highly lumpy and extremely volatile. In any one
year, a highly effective client-facing MD in traditional M&A or
corporate finance can bring in anywhere from a few million to $100
million or more in revenue (net of direct expenses), depending on luck,
fate, timing, and a million other circumstances beyond his or her
control. It makes good economic sense to keep people like this on a
small retainer, in the expectation that sooner or later they will hit
the cover off the ball.

In contrast, what is an outstanding
performance at a typical consumer goods company, selling another
500,000 units of Huggies to WalMart? Not to denigrate Huggies, or
WalMart—God forbid—but you can see why a run-of-the-mill banker without
management responsibilities can earn a $10 million bonus, while a
consumer goods product manager is happy with a 20% bump to his salary.

Now
this venerable system of paying your revenue-generating partners just
enough to keep them solvent until the end of the year, when the bank's
net profits after expenses were divvied up and distributed, began to
change when investment banks began taking corporate form and retaining
equity to fund their growth. Participation in growing global capital
markets became a necessity,
according to the heads of most of the leading investment banks, and
funding that balance sheet and income statement growth was increasing
leverage that required a growing cushion of equity. Eventually, of
course, most of the old partnerships went public, and got public
shareholders to fund their growth. But before that, and afterwards as
well, they accumulated substantial equity by deferring a substantial
portion of their bankers' annual pay in the form of restricted stock
and options (or, as cynics like me like to think of them, interest-free
loans).

As this practice spread, there was at first some lip
service paid to the notion that bankers holding stock in their own firm
aligned their interests with those of the public shareholders. Certain
firms—most notably (and sadly for their employees) Bear Stearns and
Lehman Brothers—developed very strong employee ownership cultures, and
thousands of employees ended up retaining large holdings in their firms
even after they vested. But no matter how much stock a banker might
have, if he or she isn't in a position to make decisions which directly
affect the management and direction of the firm, this "alignment" is
mere window dressing, a canard. (You tell me: would you really feel
like an owner if you held $10 million of unvested equity in a firm with
a $50 billion market cap? Would you feel that almost anything you did
or didn't do would have any noticeable effect whatsoever on such a
behemoth? I wouldn't.)

Later, banks began imposing more and more
onerous vesting schedules and restrictions on bankers' deferred pay,
typically preventing them from taking delivery of deferred stock for up
to three years (or even more) from the year it was granted, and forcing
any banker who resigned to join a competitor to forfeit unvested
awards. Management's nominal argument for these practices was that they
encouraged employee retention, making it difficult for bankers to job
hop around the Street.

But if this was indeed the reason, it was
a very blunt and usually ineffective instrument in practice. It
certainly did little to prevent other banks from hiring your star
performers, since all they had to do was "buy out" a banker's unvested
pay with an equivalent amount of unvested stock and options of their
own. The only people these practices really encouraged to stay put were
the average and even poor performers, who could not dream of getting
bought out by a competitor. There was no clawback option in these
plans, either, other than the nuclear option of confiscating an
employee's unvested pay if he or she was fired for "cause," usually
criminal. On the positive side, a bank which lost a star performer to a
competitor could take some consolation by canceling the departing
employee's deferred pay—thereby reducing past and future compensation
expense—or, more commonly, turn around and use the freed-up stock to
poach some other bank's rainmaker.

The
thing which really broke the old Wall Street compensation system beyond
repair, however, was the rise of proprietary trading at investment
banks. As these banks bulked up their balance sheets to take advantage
of larger and larger trading opportunities, traders on the prop desks
began making bigger and bigger bets with more and more borrowed
capital. Investment banks began emulating hedge funds, albeit highly
leveraged ones, and the traders who placed these bets began pulling
down enormous paychecks, even by the jaded standards of the dusty old
i-bankers in corporate finance and M&A. Twenty-five, fifty, even
sixty million dollar paydays became regular occurrences, and caused no
end of envy and hate among the traditional investment bankers who used
to rule the roost on the Street.

Of course, based on the old
system of eating what you kill, those paychecks did make some crazy
kind of sense. If a prop desk booked a billion dollars of net profit in
a year—as the Salomon Brothers traders who later founded Long Term
Capital Management were reputed to have done—why shouldn't they share a
$75 or even $100 million bonus pool? Top management of investment
banks, who increasingly came from the capital markets side of the house
themselves as profits from that division ballooned, began to rely
heavily on the supercharged profits successful proprietary trading
generated to meet growth targets and satisfy shareholders. They did all
they could to keep prop traders fat and happy, which became
increasingly difficult as the independent hedge fund industry blossomed
and any trader worth his salt could get a better bid away just by
picking up the phone.

In addition to corrosive pay envy from
bankers on the other side of the wall, this system also exacerbated the
age-old tensions between the agency side of the business and the
principal side. Client bankers may have groused when a successful prop
trader took home a $25 million windfall in a good year, but they
screamed bloody murder when he lost $300 million the following year.
The injury that an M&A banker with a blowout year could see his
bonus halved because some knucklehead on the govvie desk blew a half a
billion dollars was only compounded by the insult that his unvested
stock got slaughtered when the news hit the tape. It was no consolation
that the offending trader was usually fired without a bonus.

Agency
business—advising companies on mergers, underwriting stocks and bonds,
and trading securities for clients' accounts—generates very little
downside risk: whether you think it's right or not, the M&A
advisors on the AOL Time Warner merger were not held liable when that
deal went down the toilet. Similarly, an investment bank is usually
only on the hook for its commission and incidental losses if an IPO
tanks immediately after the offering. In contrast, principal activity
can generate enormous losses, as we have all seen. This problem was
compounded by the traditional Wall Street practice of paying bankers
each year for the results they generated that year. When proprietary
profits begin to act like insurance premiums, and a $100 million
"profit" in year one carries a substantial risk of a $1 billion loss in
year three, traditional pay-as-you-go comp practices—even with heavy
emphasis on deferred pay—simply break down.

In fact, one could
easily accuse the old system of making the reckless risk taking which
has landed us in our current soup even worse. A clever trader who built
up a $50 million position in unvested stock at Lehman Brothers on the
back of risky long-tailed mortgage trades and who saw trouble coming
had every incentive to jump ship and get another bank to buy him out.
That way, when Lehman blew up, he was sitting pretty with stock in a
firm not subject to those risks. One wonders whether some of these
job-hopping superstars would have been quite so cavalier with their own
bank's balance sheet if they knew that their net worth would remain
exposed even if they swapped employers.

Anyone
with half a brain realizes that Wall Street, with few exceptions, is
badly broken. Its compensation practices either contributed to the mess
or did nothing to prevent it. So where do we go from here?

First,
I think we must realize that putting arbitrary pay caps on investment
bankers and traders will be counterproductive. Our financial system is
in a deep and muddy hole, and I, for one, have no interest in
demotivating M&A advisors, capital markets bankers, and prop
traders from making lots and lots of money for the US government and
the banks' shareholders to fill in the hole. I don't think the Treasury
does either, which is why the plan
it proposed last week governing pay for senior executives at financial
institutions suckling at the taxpayer's teat imposes no explicit
limitations on total compensation for CEOs or anyone else. Sure, the
plan imposes a $500,000 limit on annual cash compensation for
"senior executives," but it makes provision for potentially unlimited
amounts of deferred compensation for them and non-senior execs.

Believe
it or not, my friends, half a million in cash, before taxes, is a
pretty skimpy wage to support a CEO-type lifestyle in New York City.
Nevertheless, most of the people who will be looking for these jobs are
rich already, and I am sure their personal fleet of accountants,
compensation experts, and tax advisors will be able to find them enough
of the folding to keep the wife and mistress in Prada. As long as they
can margin the Degas to pay the rent, I can think of a hundred guys who
would love to book $25 to $50 million in deferred stock every year for
three to six years, especially at the ridiculously depressed levels at
which the banks in question currently trade.

As long as they
repay the Treasury, and repair their institutions, I see no reason why
we shouldn't wish them Godspeed. Furthermore, deferring the bulk of every
banker's pay in like fashion makes eminent sense, too. M&A bankers,
corporate security underwriters, and other investment bankers whose
revenues carry no long-tail risk might legitimately complain that they
are being tarred with the same brush as proprietary traders, and
deferring the bulk of their pay constitutes an unfair hardship. But
there are two reasons to disregard their complaints. First, one of the
first things the walking wounded banks subject to these rules must do
is re-equitize their balance sheets, and what better captive source of interest-free loans
common equity is there than your employees? Second, while bankers like
these on the agency side of the business contribute little risk to the
overall organization, they definitely draw a substantial portion of
their legitimacy, stature, and revenue-generating capabilities from
their firm's franchise. Locking them up with long-term deferred comp
seems a modest price to pay for renting Goldman Sachs' or JPMorgan's
good name, in my humble opinion, especially since the bid away is practically nonexistent.

Prop
traders, of course, should be locked up until Kingdom come, or at least
until the cows come home. The ideal solution, actually, would be to set
up internal hedge fund accounting at each bank. Track prop traders on
their individual results, and pay them with long-vesting "shares" in
their own trading book, just like real hedge fund managers. That'd
align those little buggers, alright. Unfortunately, this solution is
probably administratively unworkable, even if it is theoretically very
neat. As a distant second best, pay them in restricted shares of the
parent bank that vest on a schedule which matches as closely as
possible the long-term risk profile of their trading activities.
Effectively structured, such a program would render bonus
"clawbacks"—and all such similar proposals being floated in the court
of public opinion right now—effectively moot. (Given their position at
the top of the food chain, and their responsibility for using
proprietary trading to dig their banks out of the holes they have put
themselves in, senior executive management pay should be structured in
the same way.)

Of course, pushing the entire industry to
deferred compensation will work much better if bankers can take their
stock with them when they move. Let a banker jump ship to a competitor,
if he or she wants to. Let them keep their currently unvested stock,
with all restrictions and required holding periods intact, and the
incentive to jump off a sinking platform onto a new one will be
replaced by a clear self-interest in helping right the ship.
Competitors who want to poach a rainmaker from another bank won't have
to buy out his lifetime earnings from the previous employer, and the
pressure to make big guarantees will moderate at the margin, too. The
additional fact that no-one is hiring, and any bankers still employed
will feel lucky just to have a seat, won't hurt either.

Finally,
if the Treasury really wants to align incentives for banks under the
TARP umbrella, they should stipulate that each bank's Chief Risk
Officer should be compensated no less than the CEO for the duration of
the restrictions. Some meaningful portion of the CRO's pay should be
tied to the maintenance of low volatility and low net losses at the
bank.

Does all this sound
excessively simple, or naïve to you? It probably is. If there is one
truism we can take to the bank, it is that well-designed and
well-managed compensation systems are never simple. There are
unintended consequences from every decision on pay, and comp systems
must be constantly tweaked and adjusted to achieve their primary
objective of motivating employees to effect the company's goals. The
involvement of the government as regulator, lender, and shareholder
only complicates a muddied picture even further.

But there is a
simple solution for this, too. Employ executive compensation expert and
gadfly Graef Crystal to review every compensation plan drafted by a
bank receiving TARP funds. Bill his services at a rate of $500,000 per
hour, and deduct his charges from the aggregate bonus pool available to
senior executive management.

I bet you will see some of the shortest compensation plans ever drafted come out of Wall Street then.

© 2009 The Epicurean Dealmaker. All rights reserved.