Does Switching Wall Street Compensation to Stock Really Decrease Risk-Taking?

by Darwin on January 13, 2010

With all the public ire over Wall Street compensation and the public inquiry occurring this week demanding the heads of the major Wall Street banks testify (oddly, they’re grilling the heads of firms that survived rather than the ones that failed), one key theme has been Wall Street compensation.

Politicians are grilling executives over compensation and the risk-taking that ensued, which surely, at least indirectly, was a result of tying compensation to some of the behaviors that led to the financial crisis (notwithstanding the role of Congress and failure of oversight from regulatory bodies).

From Cash Bonuses to Stock and Options – Does it Matter?

In order to divert attention away from the enormous bonus pools by the likes of Goldman Sachs and JPMorgan that were estimated to average $600K and $400K per employee, respectively (don’t be fooled by statistics of course), many large firms are doing away with or reducing the amount of cash bonuses and instead using stock and stock options (see How Stock Options Work) as a primary form of compensation.

This begs the question as to whether this is even effective.  Weren’t the 90’s and 2000’s wrought with stock option abuse and risk-taking to juice share prices?  And remember the stock option back-dating scandals?  By relying on leveraged returns from options or restricted stock, it’s somewhat incenting the same behavior, isn’t it?  And as outlined in my article on Selling Covered Calls against company stock and options, executives with massive blocks of stock can still reap a near-term payday no matter what share prices do.

And as far as placating mainstreet, it may have the opposite effect.  With many Wall Street firms doubling and tripling their share prices over the past year during the recovery, employees that were rewarded with stock instead of cash are looking at huge windfalls when the vesting period expires.  So, instead of a Goldman senior trader taking in $700K in total compensation next year, it might be something like $2.9 million because of the unprecedented rise in shares from the grant price.  Will Congress then start all over with the feigned outrage and question:

“Why are these Wall Street fatcats being compensated with so much stock”?

There is certainly something to be said for clawback provisions some firms have put in place, which surprisingly, during an interview today, Jamie Dimon said has already been executed on more than one JPMorgan employee.  What a clawback provision does is it allows for the board/CEO to determine that previously awarded compensation can be taken back if the behaviors that led to such compensation were inappropriate.  For instance, if the head of a unit took on excessive risks or inflated performance in some way to increase the value of shares that were exercised, then the clawback provision could mandate the return of those funds.

The thing about a clawback provision is that it could just as easily be applied to cash compensation.

I just really question whether it even matters.  Because the government invoked this “too big to fail” mentality for financial firms, bailed out the auto industry, bailed out homeowners who took on exotic mortgages, and virtually anyone else with lobbying dollars or a voting base, there’s now a strong history of bailouts and bias toward risk-taking with the understanding that a safety net exists.

I also question whether paying in stock will actually do anything to address the compensation that so angers main street.

Perhaps if Congressional efforts were instead directed toward job creation and preventing terrorists from blowing up planes, we’d be more prosperous and secure.  But instead, they’re focusing on banning loud TV commercials and how much people in private industry get paid (yes, they want oversight over banks that didn’t even need or participate in TARP).

Thoughts?

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Weekend reading: Another tale of a woeful financial adviser
January 16, 2010 at 3:59 am

{ 3 comments… read them below or add one }

1 Financial Samurai January 13, 2010 at 11:09 pm

Darwin – Just one point you are missing. The stock compensation doesn’t give a retroactive strike. The stock compensation is more or less the latest price of when the stock grant is given!

What matters is how the stock performs over a 1, 2, 3, 4 year period, b/c that is the general vesting dates of the stocks given in year 0.

The real question is why the public gave BOA, Citi, and Wells $60 billion last Nov/Dec, so the banks can back back TARP (the public) to pay themselves big bonuses.

[Reply]

2 Kevin January 14, 2010 at 11:28 am

Yeah the key is the vesting over time.

[Reply]

3 Monevator January 15, 2010 at 12:36 pm

I think it has to be better than compensating via cash, though I agree the whole thing with banks is bigger than just *how* they get their bonuses.

At the senior level, and with a long vesting time, there has to be more incentive not to let the company blow up.

But I’d question what it will achieve further down the ranks though. If I’m in Department A and Department B is up to financial black magic that eventually blows up and threatens the company, will the fact I’ve got outstanding options make me go over there and give him a piece of my mind?

I suppose it might foster a less gung-ho company culture.

[Reply]

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