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Ways of the World

Carol Stone, business economist & active Episcopalian, brings you "Ways of the World". Exploring business & consumers & stewardship, we'll discuss everyday issues: kids & finances, gas prices, & some larger issues: what if foreigners start dumping our debt? And so on. We can provide answers & seek out sources for others. We'll talk about current events & perhaps get different perspectives from what the media says. Write to Carol. Let her know what's important to you:

Monday, March 30, 2009

Wall Street Bonuses: AIG and Otherwise

The American public has been visibly angry over news that some of the federal bailout money has gone to pay bonuses to Wall Street workers, particularly those at AIG. Since I spent the vast majority of my own career at Wall Street firms and I have a close friend who worked for AIG for some years, I have been more than casually interested in this issue, and in fact have bristled at the blunt criticism. There are at least two stories here, and they’re different from each other. So allow me to expound on both, and we can see if there’s a constructive lesson we might glean.

The AIG situation has been distorted in the telling, and after some examination, we would actually defend the payments to the employees of the Financial Products group. They are not really “bonuses”, in the sense that employees were being rewarded for extra good work. The workers at AIG-FP were operating under a contract that had been in place for a full year, since March 2008. We have a copy of the agreement; it is actually dated December 1, 2007. It was put into place about the time the manager was fired who directed the company’s foray into the disastrous credit default swap (“CDS”) transactions. That person and his associates were not the parties to the agreement; they were gone. The agreement stipulated that the remaining employees would continue with the firm long enough to conclude those transactions and try to wind down the division’s other business in as orderly a way as possible under increasingly distressing financial conditions. A number of them took cuts in their regular salaries for this period, with the understanding that in March 2009, they would receive a lump sum compensation in an amount determined by a formula set forth in the contract. All of this was known as the “Employee Retention Plan”.

By September, it had become evident that the CDS positions were on the verge of taking down the entire company and, because of their substantial volume, disrupting financial markets around the world. The U.S. Treasury and Federal Reserve came to AIG’s aid. At various times during the autumn, there were press reports about various “retention payments” at AIG, and government officials negotiating with the company were made aware of the formal Retention Plan in AIG-FP. Some government officials knew that a portion of the aid funds would be used to make these payments. At any time, the agreement could have been renegotiated, but was not. In fact, the payments were covered by an exemption in the compensation cap provisions of the stimulus act passed by Congress in February. As the flap over the payments began in earnest in early March, lawyers for both the company and the government indicated that failing to make the payments would potentially incur substantial extra liability. Ironically, it is a wage-fairness law in Connecticut, where the division is located, that the company could be seen as violating if it didn’t fulfill the Retention Plan payments.

Someone I know and respect argued to me that if a company is hard up, its employees can expect to see such compensation fall by the wayside. I agreed with this initially; employees are frequently the first to take hits when cashflow dries up. But that’s why the autumn negotiations with the government are significant; everyone was aware that the payments would be one use of the aid money. And the goal of the rescue operation is the same as that of the Retention Plan: to facilitate the resolution the company’s turmoil in the most expeditious way possible with the least harm to other financial market participants of all kinds.

None of this says these payments are “nice” or “a good thing” or “fair” in the first place; I have no idea of the fairness of the calculation formula. Our comments here simply describe that the payments were made in accordance with longstanding, legal arrangements that were originally well-intentioned but were not amended even as dire circumstances later developed.

This is thus a different issue from one of the basic questions of the day about the way Wall Street compensation is fundamentally designed. Discretionary, incentive income for even lower-level employees is frequently at least as large as the entire annual salary. If a trader or salesperson wants to earn more, they must conduct increasingly larger amounts of business and bring in more and more revenue. Doing more business when there are lots of competitors means you devise a product or a service with a new wrinkle. If all the plain vanilla business is being done that’s practical, you conjure a new kind of business, which might well entail more risk. Or you stretch the existing products to reach more and more customers, even if they’re not as creditworthy as your current clientele.

Earlier today, an industry association, the Institute of International Finance (IIF), released a new survey study of this question. In answers compiled over just the last few months, respondents from 37 firms around the world examined and commented on their compensation practices. The IIF has established seven principles for healthy compensation policies; in the main, these standards emphasize larger roles for risk and long-term firm profitability in determining compensation formulas. So far, the respondents report, more than half of them are fully “aligned” (IIF’s term) with four of the principles, and the other firms are by and large making progress toward them. The companies understand that their pay policies have been problematic.

There are three kinds of exceptions to progress on pay reform. About an eighth of the respondents seem unconcerned so far about making their compensation scheme more transparent, even to their own shareholders. Twenty-five percent have not thought to make a connection between performance and the generosity of severance packages. And only 11% of firms’ policies are aligned with a key IIF principle that would gauge an employee’s performance in risk-adjusted terms. Many have begun to work on or plan for this, but so far, actual compliance with the principles is weakest in the area of adjusting an employee’s compensation for the riskiness of the business they bring in. Quantity still reigns over quality. An incentive that could well be detrimental to the underlying health of the firm is thus still in place then in the way traders and salespeople are paid, despite the elevation of risk as a concern to the firm and to the economy as a whole.

In recent weeks, our posts here have highlighted two characteristics of character: honesty (February 22) and trust (March 14). In the current risk-filled environment, we cannot say often enough how important these are. So yes, people are angry about perceived extravagance in remuneration, but whether the pay is excessive seems less crucial to fixing the system than whether the employees and their managers do business in an honest, forthright manner to begin with. If they are really contributing to enhanced value that is sustained through time, their pay won’t make us angry.

Oh, yes, and when those AIG workers finish cleaning up the CDS mess at AIG Financial Products, it is likely that they’ll be out of a job altogether. So they won’t get any more “bonus”.

Saturday, March 14, 2009

"It's trust, not the economy, that is in a 'downturn'"

Bill Tully is Rector of St. Bartholomew's Church on Park Avenue in New York City. St. Bart's was formerly a "society" church with reserved pews and a formal atmosphere. Some years ago, it fell on its own hard times, and it's been Mr. Tully's challenge to bring it back. He and they are doing well – precarious as all of us are at this time, but otherwise big and alive and lively.* We're on his weekly email list. Here's his take on Bernard Madoff and the deeper meaning of that affair; it's a fine follow-up to our own recent thoughts on honesty ("Ananias", February 22). Thank you, kind sir, for your good words!

It breaks your heart to hear the stories of those who trusted the disgraced "investor" Bernard Madoff and lost all or nearly all their savings. Their agony is real, their anger just, and both are more reminders that it's trust, not the economy, that is in a "downturn."

Our whole lives are based on trust. We count on small things like gadgets and computers to work. We rely on a web of arrangements and customs and laws to keep us safe. But it's the big things – you might say the deepest things – that really make the difference.

You learn trust from the way you're treated and loved from the earliest moments of your life. If I'm hungry, will they feed me? If I hurt, will someone make it better? Will they teach me what's good for me, and where the dangers lie?

When those moments go reasonably well, you grow in a way that allows you to test things on your own, to measure the challenges, to indulge your curiosities, to follow a dream or answer a call. In other words, to make a life.

In that sense all human beings operate on faith. But no one gets it perfectly. There are tests, and disappointments, and, as in the present moment, worse.

The Christian faith, like the basic faith of all life, assumes a fundamental trust. And at its best, it's an answer – a healing response – to keeping going in life when that trust is violated.

Our church community is alive to this moment. We're struggling, too. But let's make it a purposeful struggle. Let's look for ways to make that healing real to ourselves and to those who especially need it now.

I've seen this happen in lives before, and I'm seeing it now. I see and hear the heartbreak of broken trust, but I know the hope, too, and the hope is real.

*Our Geranium Farm colleague Buddy Stallings is Vicar at St. Bart's. He writes every week too, and you can read his good words right here on A Few Good Writers.

Monday, March 09, 2009

The Stock Market: On the One Hand . . . On the Other

The current issues of two Dow Jones publications, the Wall Street Journal and Barron's, both have articles today about whether the well-known stock market barometer, the Dow Jones Industrial Average, can sink all the way to 5,000, almost another 25% loss. "Yes", says the Wall Street Journal. "Not likely", says Barron's.

What's a body to do? These two premier newspapers, leaders in providing U.S. financial market information and published by the same parent company, can't agree on prospects for the most fundamental measure of U.S. business value. It's actually worse; the articles in the two papers take the same analytical approach to getting their answers, and they interviewed experts from the same investment companies. How could they get to different conclusions?

Four months ago here – back when the Dow was moving down through the 9,000 level – we pointed out how its wide day-to-day oscillations were showing that investors had no consensus and no confidence. Obviously, now, 2,400 points lower, that's still true. The writers of today's press coverage both talk about prospective profits – frequently called "earnings" – of the companies in the similar, but broader Standard & Poor's 500 (S&P500) index. They quote estimates for 2009 in the same range of magnitude, $40 to $50 per share of corporate stock. With the S&P500 index presently at about 680, investors are valuing the shares at 13.5 to 17 times the projected earnings per share; the top of that range is near the long-term average valuation of 16 - 19. A drop in the index to 500 would carry the price/earnings ratio down to 10 to 12, historically a very weak valuation; that is, it would show that investors have a low assessment of the vitality of business, compared with the past several decades. (The average P/E since 1950 is about 16.6 and since 1988, it is roughly 19.)

We ourselves don't claim to know how long or how far the market will fall before it reaches a bottom. When someone at work asked recently if it were near there, I heard myself say, "we have to go through the GM bankruptcy first before we can rebuild." That isn't meant as a firm assertion that General Motors will take that path out of its troubles, but it is an indication of my intuition that the financial markets and the economy need to reach some watershed before consensus and confidence can be restored. From that point-of-view, federal government bailouts, while intended to limit damage, can also act simply to prolong the agony, to postpone the needed day of reckoning.

We wonder too if investors aren't nervous about what shape the economy will take when it does start to recover. With all the stimulus programs, healthcare reform and environmental initiatives, how big a role will government have in the economy? How interventionist will public bureaucrats be in managing various programs impacting on business? When will the tax bills start to go up to restore fiscal health to the government following its own current borrowing binge? All these factors will affect the ability of business to do business.

Possibly, though, as we've also said here before, the fiscal stimulus programs will soon begin to do what they're designed to – to bolster "spending" in the economy. Maybe there are other signs of improvement as well: a report today showed lower rates of late payments on credit cards, two major corporate mergers were announced, Ford is apparently making progress restructuring itself on its own, without government funds, and so on. Also, as several other writers have pointed out recently, there's considerable cash sitting on the sidelines, so when those holders of liquid funds think the time is right, the markets could get a sizable upward push as the liquidity flows in.

Our own back-and-forth just talking to ourselves here and coming to varying conclusions does make it easier to understand how the two distinct sources at Barron's and the Wall Street Journal, even if affiliated with each other, could draw differing judgments about the same set of information. As an old industry saying goes, "that's what makes markets".

Ah, that's all fine, but should you buy stock? or sell? I'm skirting that altogether for the moment: I'm buying high quality corporate bonds.

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