A More Nuanced Look At Wall Street Compensation

I have touched on the compensation issue before, but largely when it comes to trading. My basic rule is: pay on the basis of realized gains and unrealized gains only on the most liquid instruments. The balance needs to be deferred until realization. William Cohan, the former Lazard and JP Morgan M&A banker and writer, has taken a somewhat broader swipe and Wall Street compensation practices in general in his recent Comment column in the Financial Times.

It is no exaggeration to lay the blame for the financial crisis and a host of others - among them, the internet bubble (1999) and the telecommunications bust (2001) - on Wall Street's compensation system. Ignoring that somewhere between 50 and 60 cents in every dollar of revenue that Wall Street receives is paid out in compensating its employees, is it any wonder that when you reward bankers with absurd sums to generate innovative securities - collateralised debt obligations or mortgage-backed securities - they react the same as one of Pavlov's dogs? Or, since mergers and acquisitions bankers get paid and promoted only if deals close, is there any surprise that their agenda is to push deals to close, not to offer unbiased advice?

Whoa, Billy, slow down a bit. Firstly, I think lumping banking (M&A), structuring and trading compensation regimes into one fungible blob is a big mistake. The cultures are different, the characters are different, and the basis on which people get paid are different. M&A fees are generally a function of deal size and deal completion. Structuring professionals sitting on the trading floor (CDOs, MBS', etc.) get paid on the basis of deals originated and sold. Traders get paid on the basis of P&L, which is highly dependent upon firm-specific policies (as it relates to percentage payout, hold-backs for illiquidity, reserve policy, etc.).

I clearly agree with you that as it relates to banking and structuring, deal volume is the principal driver of compensation. But while you are correct in identifying the motives, the fact that you lay the blame almost entirely at the feet of Wall Street seems pretty unfair to me.

First, consider the sophistication and fiduciary responsibility possessed by most of the consumers of their products. Where are their brains and judgment? Also, particularly in the realm of creating structured, liquid assets from a pool of illiquid securities, you don't touch on the market benefits generated by the re-allocation of risk to those best able to bear it. This doesn't mean that investors don't make dumb decisions, but it does mean that it isn't Wall Street's fault that the matches they provide aren't simply used to light the stove but to burn down the house. And what about the rating agencies? They threw gas on the fire, to be sure. The were one of the great enablers of the debt bubble, placing their imprimatur on instruments that they didn't fully understand. Again, the investors bear much of the blame for simply relying on the rating agencies but the work performed by those agencies was clearly shoddy, inadequate and presumptive.

These perverse incentives are exacerbated by Wall Street's lack of accountability. Huge bonuses are deposited and consumed long before the bad deals that generated them can slam investors. If Bruce Wasserstein's "dare to be great" advice to Robert Campeau in the late 1980s on his acquisitions of Allied Stores and Federated Department Stores ended up being more than a little off the mark, should Mr Wasserstein be held responsible? Or are bondholders, shareholders and employees left to bear the brunt of bad advice?

If shareholders and bondholders were willing to finance and support guys like Robert Campeau and Robert Holmes a Court, they deserved their fate. Bruce Wasserstein isn't some kind of Svengali, hypnotizing investors in an effort to do grandiose and irrational things. In the late 1980s he frequently told a story, sold it, people bought it, and they lost. Yes, the 1980s was a crazy period and some of those raiders that were backed and the yarns that were spun were a joke, but the biggest deals of recent times have had a distinctly different character. Time Warner/AOL (TWX)? Was that the advisers fault? Give me a break. In fact, AOL's advisers should have gotten a bonus for turning vapor into valuable, real media assets. Time Warner's advisers or, more specifically, Time Warner's board? Well... It is completely sour apples. Mr. Cohen knows this.

What is a remedy for this vicious cycle? At the risk of seeming disingenuous, since I benefited from this system for 17 years, I propose an extreme makeover for compensation. M&A advisers should be paid by the hour for their advice, just as their well-paid deal colleagues in the legal and accounting professions. This would rein in unnecessarily massive M&A fees and return to the days of unbiased advice. Changing compensation for bankers who innovate and sell financing is harder but must include a way to hold back a large percentage of the pay until - and when - the success of the product can be determined over time. It is evident that the excess that led to the sub-prime crisis was not worthy of reward.

Ah, here is where things get interesting. His proposal for M&A bankers, while theoretically interesting, is a non-starter. Not because his idea doesn't have theoretical appeal, but culturally I just don't see this happening. What could be done, however, is to integrate Mr. Cohen's proposal with a success-based fee, where a retainer/hourly fee arrangement could be put into place that is not reliant upon success, and then for the success fee to be a small amount than it is today. This would do a better job of aligning motives while still providing the banker's upside in the event that their best ideas get done.

It is this incentive that will cause bankers to continue to think creatively about M&A opportunities, not just about mega-transactions but about strategic, fill-in acquisitions and divestitures that are value-accretive for their clients. I think this is a pretty good prescriptive that might actually work in the real world.

As it relates to the structuring professionals, I think the real issue comes down to illiquidity/residual risk of the securities designed and sold. From the standpoint of a bank's shareholders, the "success" of a product is its sale without recourse. The problem is that with much of the structured paper that was designed and sold in the mortgage space, banks found that they needed to retain a measure of exposure either through holding the junior tranches or through the possibility of off-balance sheet assets coming back on books in SIV structures. And, of course, both of these residual risks turned out to bite the banks - and hard.

Therefore, in my illiquidity/residual risk framework those structurers and salespeople should have received sharply discounted bonuses until those pools paid out, or the residual risks were disposed of. This would have created the proper alignment of interests between employees and shareholders, an alignment that has not heretofore existed on Wall Street. So in the final analysis I pretty much agree with Mr. Cohan on this point as well.

I really appreciate Mr. Cohan tossing out some "radical" ideas for solving the mis-alignment problem of Wall Street compensation. I just wish he'd taken a broader view of roles and responsibilities in today's market crisis and not simply tarred Wall Street as is so popular today. Because the story is far more textured and nuanced than that.