Why Changing Wall Street Paychecks Won’t Change Wall Street - WSJ - August 6, 2008

from Heidi N. Moore @ http://blogs.wsj.com/deals

The
post-credit crunch conversation about Wall Street’s ills gives the
impression that finance guys are one-celled organisms whose only
interest is earning more money.

(We aren’t debating it.)

But by that simple reasoning, if you control Wall Street’s pay, you
control their behavior. A number of prominent economists, including
Martin Wolf, have even proposed curtailing Wall Street pay or
overhauling compensation policies it as a prophylactic against another
credit crisis. Wolf called the current compensation system on Wall
Street as “heads I win, tails you lose.”

Wolf has good company: today, the chief risk officers of 16 financial institutions submitted to the Treasury Department a 138-page list of 60 proposals to fix Wall Street. The group, densely dubbed the Counterpary Risk Management Group,
or CPRMG, wrote a 2005 report presciently warning of the dangers of
collateralized debt obligations. In the report today, the group
suggests Wall Street paychecks are partly to blame for the current troubles, and that reform might change things.

Here is what they write: “the Policy Group believes that compensation practices as they

apply to senior and executive management should be (1) based heavily on the

performance of the firm as a whole and (2) heavily stock-based with such stock-based

compensation vesting over an extended period of time. The long vesting

period is particularly important for high risk, high volatility lines of business where

short run surges in revenues and profits can be offset if not reversed in the longer

term. In broad terms, the Policy Group recognizes that this philosophy
of compensation is hardly new, but its importance looms especially
large given the events of the past twelve months.”

You couldn’t ask for better if you believe compensation is the spigot for risky behavior. Still, is it really a good idea?

Not particularly. In fact, it isn’t even a new idea. Several Wall
Street firms have compensation policies that abide by those rules, but
still they took on high levels of risky securities.

Take one example: Lehman Brothers Holdings, which meets both of CPRMG’s requirements but has taken no less risk than its rivals. Lehman’s employees own about 30% of the securities firm’s stock. Their restricted stock units vest over five years. For years, that long vesting period
made it extraordinarily hard for rivals to hire Lehman bankers; their
wealth of unvested stock made Lehman’s bankers expensive to hire. When
Lehman President Herbert “Bart” McDade sold stock in June, some of the holdings he sold were in vintages that went all the way back to 2001.

Or take Bear Stearns. The now-defunct firm had employees with
extensive stock holdings–more than one-third of the firm’s shares–and
were paid heavily in stock that tied their fortunes ever more tightly
to that of their employer. In fact, executives at the brokerage house
were swimming in stock; at the beginning of the year, former President Warren Spector laid claim to more than $23 million in compensation–even more than the $10.3 million of vested options held by Jimmy Cayne who was still on the board at the time and was the man who asked Spector to leave Bear.

In addition, those most risk-hungry firms–hedge funds–often have
long, five-year vesting schedules for their employees. (Those employees
don’t get stock, but a portion of profits.) And yet hedge funds typically are far more highly leveraged and more active in risky securities than are investment banks.

Giving employees more stock, or stock that vests over many years,
won’t change their behavior; anyone who works on Wall Street knows that
a lot more impacts a stock price than the actions of most employees.
Perhaps what needs to change isn’t the money, but the sheep-like
“follow the leader” behavior that convinces many on Wall Street to take
risk now that they are reluctant to pay for later.