Wednesday, May 13, 2009

MarketWatch has an interesting pair of articles today about executive bonuses on Wall Street. The first, Eyes on the prize, informs us that Wall Street pay packages were not always so extravagant .
"By the late 1960s, Wall Street was living hand-to-mouth. Basically, you had partnerships where at the end of every year they split up the kitty and started out fresh with a zero balance sheet . . . you were never really sure what your capital position was going to be." - Former Merrill Lynch Chairman Donald Regan in Eric Weiner's book "What goes up: The uncensored history of modern Wall Street as told by the bankers, brokers, CEOs, and scoundrels who made it happen."
The change apparently came about as the
bankers and brokers went public.

The private partnership days began to slowly dissolve as investment banks who survived the stock market doldrums of the 1970s forged ahead in the 1980s, a go-go period on Wall Street. The decade saw new debt-securities sold from the likes of Salomon Brothers, the rise of junk bond sales, and high-profile leveraged buyouts.

While Donaldson, Lufkin & Jenrette was the first to go public in 1970, soon followed by Merrill in 1971, and later Salomon in 1981, most others went public in the late 1980s, including Morgan Stanley and Bear Stearns. Lehman completed its IPO in 1994.

Goldman made the leap in 1999.
It seems the capital infusions became the kitties for bonuses of a size not previously possible. Bonuses, generally awarded on an annual basis, encourage risk taking; i.e., speculation. One executive, quoted in the article, makes the telling observation that the way executives were being paid came to resemble that of professional athletes. The goal was to maximize performance in the current year since that is what would make one valuable for the "next season" -- which, after all, might not be a winner anyhow. Repeal of Glass-Steagall fanned the flames, but the fire was already started.

So what to do?
Some suggestions being floated to alter the relationship between Wall Street pay and risk include: Making Wall Street CEOs take a higher salary, subjecting long-term incentive awards to cancellation provisions, structuring pay arrangements to avoid excessive risk-taking, and forcing senior executives to retain the bulk of stock awards until they retire.
To me these look exactly like the sort of tinkerings that produces unintended consequences. More thought needs to be given to root causes. This would include the model of "corporate democracy" upon which corporate law in the various states are based. Shareholder are insufficiently protected from management greed and irresponsibility in my opinion. States compete with one another to be attractive to executives making the choice of where to incorporate. Perhaps for corporations engaged in interstate commerce there needs to be a federal share holder "bill of rights", although not neccessarily that recently proposed by Senator Charles Schumer, (D-NY), which I have not yet examined. Of course, it is opposed by corporate CEOs but it could be a bad bill anyhow. The general idea, at least, needs to be seriously considered.

The other MarketWatch article, Big losers in the compensation chase by Peter Brimelow, is mostly about Brimelow's long advocacy of higher pay for members of Congress. At the end, however, Brimelow recounts that:

In Britain in the 1970s, there was a salary freeze, punitive progressive taxation, massive inflation. An American banker then working in the City of London remembers:

"Every merchant bank had its own chef. There were three-and-a-half hour lunches, aperitifs, two types of wine, cognac and cigars. The Americans couldn't handle it, they were used to iced tea."

"But no one would take any risks. You couldn't get anything done."

This all abruptly vanished, along with much else, when Margaret Thatcher cut marginal income tax rates.

This goes to my concern about unintended consequences of government action forcing reductions in executive pay. It may incidentally point to a need to figure out where the optimum and fair marginal tax rates are. As explained above, there was a rush to go public in the 1980s but it is noteworthy that this was also the period in which marginal tax rates were greatly reduced -- first by the Economic Recovery Tax Act (ERTA) of 1981 and again by the Tax Reform Act of 1986. Coincidence?

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