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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”.


Anonymous Anonymous said...

I like your explanation of the "retention bonus". I personally signed a similar agreements with a former employer, a bank, which was in the process of selling its loan servicing business to another bank as the result of a merger which left them with two such groups, and 20 or so redundant employees, myself included.

There were no positions in the merged bank for us, but someone had to take care of the loan payments until a buyer could be found for the portfolio, a price negotiated, and a closing could be held.

Actually, the loans(which were all non-delinquent) were sold to three different financial institutions, and the closings took place on three different occasions. We were asked to sign an agreement as soon as the intent to sell was announced by the merging banks, which said if we would continue to work until the sale, we would get a bonus after the sale. This meant we could job hunt, but if we left the institution before the sale was concluded, there was no bonus.

In our case, we were looking at about 10% of our annual salaries, which were modest to say the least. This was called at the time a "stay" bonus, and did benefit our employer greatly by having us continue to run a profitable end of our business until the sale was concluded. I have also heard this arrangement called a "golden handcuff" - you are paid something to stay to the bitter end, but you lose your job anyway.

In our case, we were about 15 employees, and the total "bonus" amount paid to each was modest. (Thousands, not millions). 5 coworkers found positions prior to the deadline, and thus were not eligible for the bonus.

However, there is a similarity to the bonuses in question. You are paid to do a job for a limited time - somewhat like a six-month contract. If you complete your assignment, the business is sold, (or in this case unwound) and you are unemployed. The bonus cushions the blow, but you are all still out of a job.

3/31/2009 9:57 AM  
Anonymous Realtor from Vancouver said...

Since the start of this "scandal", it seemed to me just a bit too loud. The politicians were loud, the media were loud and even common people were too loud about it. Now I keep thinking it was all just a smokescreen for something bigger that was meant to stay hidden while the public and media are focused at AIG.

The politicians knew well from the start, including the president. What a shame they can't be jailed for lying..

Take care,

4/01/2009 3:03 AM  
Blogger Carol S. said...

Thank you for your comment, Jay.

In tangled mess that our business institutions are in presently, many parties are culpable in both the government and the private sector. In this blog, on a church-related website, I hope to make the point that our churches can contribute to solutions by preaching honesty and trustworthiness for everyone, regardless of their station in society or their politics. Currently, if we started to jail the liars, there might not be many folks left to run business or government.

4/01/2009 9:32 AM  

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