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The Root of All Evil is Money

By Brian | December 20, 2008 | Share on Facebook

This was the front-page article in the New York Times this past Thursday. Here are some quotes:

In all, Merrill handed out $5 billion to $6 billion in bonuses that year. A 20-something analyst with a base salary of $130,000 collected a bonus of $250,000. And a 30-something trader with a $180,000 salary got $5 million.

But Merrill’s record earnings in 2006 — $7.5 billion — turned out to be a mirage. The company has since lost three times that amount, largely because the mortgage investments that supposedly had powered some of those profits plunged in value.

Unlike the earnings, however, the bonuses have not been reversed.

Scrutiny over pay is intensifying as banks like Merrill prepare to dole out bonuses even after they have had to be propped up with billions of dollars of taxpayers’ money. While bonuses are expected to be half of what they were a year ago, some bankers could still collect millions of dollars.

[Merrill's CEO, Stan] O’Neal . . . was paid $46 million, according to Equilar, an executive compensation research firm and data provider in California. [Head of Fixed Income Trading, Dow] Kim received $35 million. About 57 percent of their pay was in stock, which would lose much of its value over the next two years, but even the cash portions of their bonus were generous: $18.5 million for Mr. O’Neal, and $14.5 million for Mr. Kim, according to Equilar.

I expect this kind of talk on radio call-in shows, or man-on-the-street interviews, or other places where people who are relatively ignorant about investment banking offer their opinions about it anyway. But if you’re writing on the front page of the New York Times, shouldn’t you be a bit more informed than the general public on the subject you’re writing about? The author of this article, Louise Story, has either completely failed to do her homework, or is much more interested in stirring up jealousy and anger than she is in educating or informing her readers.

To begin with, Merrill Lynch’s $7.5 billion in 2006 earnings were not a “mirage.” They were real. The firm actually made $7.5 billion dollars that year. And the “mortgage investments that supposedly had powered some of those profits” actually did power them. No one lied to anyone here. A group of investments increased dramatically in one year, and then decreased dramatically two years later. The aptly named Ms. Story is implying some kind of corruption here, but never comes out and says it because it simply doesn’t exist.

She also doesn’t go out of her way to point out that many of Merrill’s investors, a lot of whom are not multi-millionaire investment bankers, benefited tremendously from the purchase and sale of the securities that generated that income. Not to mention its shareholders, who saw the stock go from $75.07 to $93.10 (an return of 24% in one year). [Disclosure: I was, and still am, a shareholder]. So yes, the people who made the decisions that generated all that income were very well compensated.

“Unlike the earnings,” Ms. Story continues, “the bonuses have not been reversed.” Well, two things. First of all, the bonuses have, to some extent, been reversed (see below). Second, the presence of losses in subsequent years is not nearly the same thing as the reversal of earnings. Reversed earnings suggest fraud, or at least some large accounting errors. The last few years have seen a spate of accounting scandals in major corporations, many of which did result in reversed earnings, and the subsequent reversal of executive bonuses (through fines and/or jail time).

The current situation, however, is not even close to the same thing. Turbulent financial markets result in large gains followed by large losses. That’s what turbulent means. Those who help make the large gains are compensated very well. Those who contribute to large losses are compensated less or sometimes not at all, but they are not asked to return the money they earned in the prior years. Those feeling Wall Street rage at this point should note that the same can be said of the owner of a small business (the food market where Bob works made $75,000 last year, but lost $50,000 this year.  Bob has been asked to return last year’s salary…)

But back to Ms. Story and the New York Times: “While bonuses are expected to be half of what they were a year ago,” she concedes, “some bankers could still collect millions of dollars.” In other words, even though compensation is tied to performance, those rich banker bastards are still screwing us…

Perhaps this is a good time to explain how bonuses work and why they exist. The 30-something mentioned earlier who gets a $180,000 salary and total compensation of $5 million, does not make $180,000 per year. He/She makes $5 million per year. The bonus is not “extra money” – it’s part of his/her annual compensation. The difference between him/her and say, a professional baseball player who makes $5 million per year, is that 96.4% of the banker’s income is at risk compensation. In other words, for doing the same job he/she did last year, for which he/she was paid $5 million, he/she may receive as little as $180,000 this year. Assuming this banker worked just as hard in both years, then he/she is grossly underpaid in the second year relative to the first. It is precisely because bankers take on this kind of risk that they are highly compensated when things go well. High risk; high return.

The last quote I provided talks about the equity portion of the large bonuses. What Ms. Story describes is not atypical. The bigger the Wall Street bonus, generally speaking, the higher the percentage is tied to the company’s stock price. So not only are Mr. O’Neal and Mr. Kim not getting big bonuses this year (both have left Merrill Lynch, but if they’re in the same industry – trust me, they’re not getting big bonuses this year), their bonuses from last year are worth far less than when they received them. Using the numbers quoted in the article, and pointing out that the $93.10/share stock from the end of 2006 closed at $11.89 on Friday, we can conservatively estimate that Mr. O’Neal lost $22 million and Mr. Kim lost $7 million of 2006′s bonus in this year’s market. In other words, roughly half of their bonuses werereversed, due to subsequent market losses. And they don’t even work for Merrill Lynch anymore. So much for incentives that produce short-term, speculative thinking, huh?

One more fact that isn’t in the article: equity bonus compensation is typically tied to a vesting schedule (something like 20% per year for five years or 33% per year for three years). So, if schadenfreude is your game, rest assured that neither Mr. O’Neal or Mr. Kim sold much, if any, of that stock before it dropped in value.

Look – I’m not throwing a pity party for these folks. They’ve taken large risks, and have been compensated with millions of dollars as a result. None of them will be destitute in 2009 because of the millions they’ve lost in the markets, or due to their reduced compensation packages this year. Reasonable folks may argue, convincingly even, that they never should have made that much money to begin with. To that point, I can only say that compensation for highly-skilled employees is a market in and of itself.  But this quickly becomes a circular discussion – if you don’t trust markets, then you likely don’t trust the labor market either, so round and round we go…

All I’m saying is that it doesn’t make sense to count every penny of executive compensation as “real money,” while treating past profits for customers and shareholders as ephemeral, fleeting “mirages.” It’s counter-productive to suggest that Wall Street executives walk away scott-free with their millions as the markets fall, while the rest of us watch our portfolios, pensions, and college savings accounts plummet in value.

It drives fear, anger, and jealousy. It drives our leaders to focus on the millions of the few while tossing around the billions of the many. And it doesn’t do a damn thing to solve the actual problem at hand, which is what we should be reading about on the front page of the New York Times.

Topics: Money Talk, News and/or Media | 1 Comment »

One Response to “The Root of All Evil is Money”

  1. FamilyGreenberg.Com - Fair & Balanced… says at December 23rd, 2008 at 1:36 am :
    [...] The Root of All Evil is Money [...]


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