Mirabile Dictu! Wall Street May Start to Rein in Compensation

Hauling executives from the private sector before Congress and lambasting them about pay has had zero impact on top level compensation. However, now that the banking industry is a ward of the state and the Democrats might not just win the Presidency but also could get a filibuster-proof majority in the Senate, the banking industry appears to realize it might behoove them to make stronger efforts to curtail hard-to-defend pay levels before restrictions are imposed on them.

The Journal has two related pieces, one on how Wall Street is taking the idea of curbing its practices seriously, the second on how most of the complaints about pay have overlooked a big source of future outgo: pension and deferred comp programs for ex-execs.

Before you contend that these moves are unreasonable, consider the criticism from a former Wall Street co-CEO, John Whitehead, from a post last year:

John Whitehead, former co-chairman of Goldman, who with John Weinberg, presided over the firm when it went from being a commercial paper dealer and institutional equity broker to a top investment bank, decried Wall Street compensation levels in a Bloomberg interview:

“I’m appalled at the salaries,” the retired co-chairman of the securities industry’s most profitable firm said in an interview this week. At Goldman, which paid Chairman and Chief Executive Officer Lloyd Blankfein $54 million last year, compensation levels are “shocking,” Whitehead said. “They’re the leaders in this outrageous increase.”

Whitehead went even further, recommending the unthinkable, that Goldman cut pay:

Whitehead, who left the firm in 1984 and now chairs its charitable foundation, said Goldman should be courageous enough to curb bonuses, even if the effort to return a sense of restraint to Wall Street costs it some valued employees. No securities firm can match the pay available in a good year at the top hedge funds.

“I would take the chance of losing a lot of them and let them see what happens when the hedge fund bubble, as I see it, ends,” Whitehead, 85, said….

Goldman during its rise to preeminence had a very different compensation formula. The joke at the firm was that partners lived poor and died rich. That wasn’t precisely true, but new partners actually had lower cash earnings than senior vice presidents (their interest on the debt borrowed to buy their partnership interest left them with modest pay packages in their early years as partner, a brilliant formula to keep them working hard). Consider that Bob Rubin, who was co-chairman of the firm after the Whitehead/Weinberg era, had an estimated net worth when he left the firm of $100 million. Not shabby, but the point is that Blankfein in one year earned half of what Rubin made in this career at Goldman.

From the Wall Street Journal:

In a sign that Wall Street is waking up to the political tempest over billions of dollars in year-end bonuses likely to be paid out at securities firms lining up for government infusions, top executives are in discussions to possibly cap their own compensation,…

At least one major firm has looked at former PepsiCo Inc. Chairman and Chief Executive Roger Enrico’s move in 1998 to give up his $900,000 salary. Instead, Mr. Enrico asked PepsiCo directors to fund scholarships for children of “frontline employees.” Mr. Enrico still got a $1.8 million bonus that year.

And as Wall Street firms examine their pay and bonuses, distinctions are being made between the highest-ranking executives and lower-level traders and investment bankers who aren’t widely known beyond Wall Street but could get plucked away by rival firms if compensation practices are significantly altered…..

Yves here. I’d like to know by whom, with the hedge fund industry contracting and the whole industry presumably under pay pressure. Back to the Journal:

Since the start of 2002, Goldman Sachs Group Inc., Morgan Stanley, Merrill Lynch & Co., Lehman Brothers Holdings Inc. and Bear Stearns Cos. have paid a total of $312 billion in compensation and benefits. Bonuses generally account for about 60% of total Wall Street compensation, meaning that the five firms paid out an estimated $187 billion in bonuses…

Part of the problem for Wall Street is that some politicians contend that executives and employees responsible for fueling the credit crisis should now pay a steep penalty, especially since huge profits during the housing boom are being swept away by losses and write-downs. Since the start of 2007, for example, Merrill has had net losses of nearly $20 billion — or nearly all of the profits made by the company from 2003 to 2006…

Overall, top Wall Street executives who might have earned $30 million last year could see their pay plummet to $8 million this year, predicts Mr. Johnson, the compensation consultant. Most of that is likely to come in the form of restricted stock with little or no cash. Other pay experts predict Wall Street bonuses will decline an average of 40% to 45% from last year, reflecting sharply lower revenue and profits.

Yves here. The pay cuts are being depicted as due to pressure, which is clever, when it typically drops like a stone in down times. In the dot-bomb era, managing directors in M&A who had made $2-4 million in the boom years saw it drop to $400,000-500,000, assuming they still had a job.

To the second Journal story, “Banks Owe Billions to Executives,”on the magnitude of deferred pay:

Financial giants getting injections of federal cash owed their executives more than $40 billion for past years’ pay and pensions as of the end of 2007, a Wall Street Journal analysis shows.

The government is seeking to rein in executive pay at banks getting federal money…But overlooked in these efforts is the total size of debts that financial firms receiving taxpayer assistance previously incurred to their executives, which at some firms exceed what they owe in pensions to their entire work forces.

The sums are mostly for special executive pensions and deferred compensation, including bonuses, for prior years. Because the liabilities include stock, they are subject to market fluctuation. Given the stock-market decline of this year, some may have fallen substantially…

Few firms report the size of these debts to their executives. (Goldman is an exception.) In most cases, the Journal calculated them by extrapolating from figures that the firms do have to disclose.

Most firms haven’t set aside cash or stock for these IOUs. They are a drag on current earnings and when the executives depart, employers have to pay them out of corporate coffers…

The liabilities are an essentially hidden obligation. Even when the debts to their executives total in the billions, most companies lump them into “other liabilities”; only a few then identify amounts attributable to deferred pay.

The Journal was able to approximate companies’ IOUs, in some cases, by looking at an amount they report as deferred tax assets for “deferred compensation” or “employee benefits and compensation.” This figure shows how much a company expects to reap in tax benefits when it ultimately pays the executives what it owes them.

J.P. Morgan, for instance, reported a $3.4 billion deferred tax asset for employee benefits in 2007. Assuming a 40% combined federal and state tax rate — and backing out obligations for retiree health and other items — implies the bank owed about $8.2 billion to its own executives. A person familiar with the matter confirmed the estimate.

Applying the same technique to Citigroup Inc. yields roughly a $5 billion IOU, primarily for restricted stock of executives and eligible employees. Someone familiar with the matter confirmed the estimate.

The Treasury is… imposing some restrictions on how they pay top executives in the future, such as curtailing new “golden parachutes” and barring a tax deduction for any one person’s pay above $500,000. But the rules won’t affect what the banks already owe their executives or make these opaque debts more transparent…

Bear Stearns Cos., the first financial firm the U.S. backstopped, owed its executives $1.7 billion for accrued employee compensation and benefits at the start of the year, according to regulatory filings. When Bear Stearns ran into trouble after investing heavily in risky mortgage-backed securities, the government stepped in, arranging a sale of the firm and taking responsibility for up to $29 billion of its losses.

The buyer, J.P. Morgan, says it will honor the debt to Bear Stearns executives, which it said is shrunken because much of it was in stock that sank in value.

J.P. Morgan will also honor deferred-pay accounts at another institution it took over, Washington Mutual Inc. It couldn’t be determined how big this IOU is. J.P. Morgan’s move will leave the WaMu executives better off than holders of that ailing thrift’s debt and preferred stock, who are expected to see little recovery. J.P. Morgan’s share of the federal capital injection is $25 billion.

Obligations for executive pay are large for a number of reasons. Even as companies have complained about the cost of retiree benefits, they have been awarding larger pay and pensions to executives. At Goldman, for example, the $11.8 billion obligation primarily for deferred executive compensation dwarfed the liability for its broad-based pension plan for all employees. That was just $399 million, and fully funded with set-aside assets.

The deferred-compensation programs for executives are like 401(k) plans on steroids. They create hypothetical “accounts” into which executives can defer salaries, bonuses and restricted stock awards. For top officers, employers often enhance the deferred pay with matching contributions, and even assign an interest rate at which the hypothetical account grows.

Often, it is a generous rate. At Freddie Mac, executives earned 9.25% on their deferred-pay accounts in 2007, regulatory filings show — a better deal than regular employees of the mortgage buyer could get in a 401(k). Since all this money is tax-deferred, the Treasury, and by extension the U.S. taxpayer, subsidizes the accounts.

In addition, because assets are rarely set aside for executive IOUs, they have a greater impact on firms’ earnings than rank-and-file pension plans, which by law must be funded…

While disclosing its liability for executive pensions, the bank doesn’t disclose its IOU executives’ deferred compensation, and it couldn’t be calculated. The bank’s share of the federal capital injection is $25 billion…

To be sure, deferred-compensation accounts can shrink. Those of lower-level executives usually track a mutual fund, and decline if it does. Often the accounts include restricted shares, which also may lose value, especially this year. To the extent financial-firm executives were being paid in restricted stock, many have lost huge amounts of wealth in this year’s stock-market plunge.

The value of Morgan Stanley Chief Executive John Mack’s deferred-compensation account declined by $1.3 million in fiscal 2007, to $19.9 million; much of it was in company shares. Mr. Mack didn’t accept a bonus in 2007.

Executives can even lose their deferred pay altogether if their employer ends up in bankruptcy court. When Lehman Brothers Holdings Inc. filed for bankruptcy last month, most executives became unsecured creditors. The government didn’t come to Lehman’s aid.