Monday, February 02, 2009

Righteous Bonuses

Obama is rightly upset about the size of bonuses handed out when banks are getting a federal bailout, but not every bonus is undeserved, so it is not as easy as saying there should be zero bonuses until things are fixed. They key is how close they were to the decision making process. If someone in charge of a complex portfolio has his bonus cut back to zero, implying his future bonuses are also in peril, he has good reason to bolt and start at a new place. Worse, he has an incentive to screw up his portfolio by giving away securities to friends of his on the Street (brokers, other traders he deals with), building up a set of favors for his next position. Once there, the buddies he sold securities to at 72 when they were trading at 78 will remember him.

The reason we pay people a lot is because we think they are worth it. Many times they are not, but not always. A fund I know shut down one of its funds and people there basically gave away their positions before they left, making payments to the favor bank, for when they went to their new jobs. Why? They were told there would be no bonus, just exit your positions, and get your 1 month severance. A zero bonus is a horrible incentive structure for someone in charge of a portfolio, and it is not feasible to think your back office or audit group can monitor this. The portfolio managers know the best price, outsiders don't, that's why they get paid a lot. In the context of a moving market, and illiquid securities (such as mortgages), you don't really know how much money you are leaving on the table, but look at the incentives at the individual level, and expect people to act in their self interest.

Many times, bonuses are layered: the PM gets 10%, his boss gets 10% or the CEO gets another 10%. Infamous trader Joseph Jett made $9MM in his 1993 bonus (off fraudulent profits), and had to pay it back. His boss, Ed Cerullo, got $20MM in bonus that year in large part because of those same fraudulent profits. Cerullo was worse that Jett in that he not only had no idea what Jett was doing, but got paid more than Jett based on his activities, then was not held accountable (Cerullo paid a $50k fine and did not pay back any of his bonus)! This is why we mock 'management'. These higher ups can and should be squeezed.

Fundamentally, there is a continuum of rents earned from capital to labor. Those with special knowledge, or whose effort is difficult to monitor (even ex post), has alpha, because you can't necessarily replace him with a wage slave. Those with alpha negotiate with those with capital to share the proceeds of their venture, and they should be thought of as movie stars, those with talent, that get paid a bunch, but they aren't management, they aren't making strategic decisions. Management is sort of in the middle between capital and alpha, so there needs to be a judgment call as to how much these guys should make, but they generally aren't alpha producers. They tend to be overpaid, because they used to be on the front lines, and now manage those people, and using logic similar to a union (more senior people get paid more), think that anyone managing others should get paid more than them, via a cut of all their books. This is generally overdone, only because those setting their pay usually need the support of these managers, making it difficult to cut their pay. In these times, it would be a very good place to start docking all those Executive Vice President and Head of Global Market Derivatives, because there are lots of replacements on the street.

John Thain, doesn't need a bonus, nor any of his direct reports. But leave the lower level guys alone, regardless of their take. It may not be fair (isn't a schoolteacher worth more?), but they are in a position to do a lot of damage if you zero them out. These are the Atlases you don't want shrugging.


Plamen said...

Excellent post. Most folks do not realize that bonus, in HR parlance, no longer means what it used to - it describes the time structure and potential flexibility of a compensation package, but is not necessarily (or even commonly nowadays) tied to performance.

"If you don't like your job, you don't strike. You just go in everyday and do it really half-assed. That's the American way" - Homer Simpson

John B said...

See also the NatWest/Enron guys - ok, an extreme case where half-arsed turns into possible major fraud, but the reason they went ahead with the cut-price asset sale to themselves was because they knew RBS were winding down the business and would lay them off without much of a payment.