US banks tackle 2008 bonus conundrum

"I know the American people are outraged about some compensation practices on Wall Street," John Mack, chief executive officer of Morgan Stanley, told the House Financial Services Committee on February 10 at a meeting convened to discuss what banks have done with the $165 billion of capital they have collectively received from the US government since last year.

And the outrage is understandable. Taxpayers are questioning why financial institutions, which have been bailed out with public money, are using that same money to pay bonuses. The situation is exacerbated by the fact that many taxpayers place the blame for the current recession squarely on bankers. And disclosures by the attorney general of New York Andrew Cuomo, in January, regarding incentive compensation paid by Merrill Lynch for 2008 have added fuel to the fire. 

In a letter shared with the press, Cuomo detailed that Merrill Lynch moved its 2008 bonus payouts up to December -- before it was absorbed by Bank of America on January 1. Cuomo suggested, however, that this was done with the complicity of BoA. Merrill paid out $3.6 billion in bonuses one month before it unveiled a $15 billion loss for the fourth quarter of 2008, leading to a $27 billion loss for the year. The loss prompted a further bailout package of $20 billion from the US government's Troubled Asset Relief Programme to BoA, to encourage it to proceed with its acquisition of the investment bank. (BoA had already been the recipient of $25 billion of Tarp funding.)

The said letter details that at Merrill Lynch the top bonuses for 2008 were as follows:
$121 million to the top four recipients
$62 million to the next four
$66 million to the next six

The top 149 bonus recipients, of a total employee strength in excess of 39,000, received a combined $858 million. In total, 696 individuals received bonuses of more than $1 million each.

No wonder then that at the House meeting, the US banks which were the recipients of Tarp bailouts were at pains to stress that bonuses for 2008 have been adjusted for performance, that incentive compensation paid has been reasonable and largely in stock not cash, and that Tarp funding is not being distributed as bonuses to employees.

Goldman Sachs CEO Lloyd Blankfein told the House committee: "Since going public in 1999 Goldman Sachs has exhibited a near perfect correlation between changes in net revenues and compensation." Blankfein said that overall, 2008 bonuses were down 65%, while the firm's 417 partners received 75% less than the previous year.

The compensation-to-net-revenue ratio for Goldman was 48% for 2008, excluding fourth quarter severance costs of $275 million, Goldman's chief financial officer told analysts on the bank's earnings call, which is posted on seekingalpha. This represented a 46% reduction year-on-year in absolute terms, but analysts remarked that the payout ratio was higher than the 44% ratio in 2007 and the 47% ratio in 2006. Goldman also paid out more equity and less cash in 2008 and CFO David Viniar explained: "We felt it was appropriate to tie people in even more to the firm this year." Sources say that at senior levels, up to 90% of multi-million dollar bonuses were paid in stock, which will vest in years to come and is an effective way of retaining people.

At J.P. Morgan "average incentive compensation per employee was down 38% and average cash incentive compensation was down 43%", the bank's CEO, Jamie Dimon, told the House committee with respect to bonus payments for 2008. Senior management, who receive 50% of their bonus in stock and are required to hold 75% of their stock until retirement, took home 60% less than the previous year. Compensation expense as a percentage of net revenue increased to 63% in 2008 from 44% in 2007, as per the firm's balance sheet, although these numbers are not strictly comparable since J.P. Morgan acquired Bear Stearns and Washington Mutual during the course of 2008.

Morgan Stanley CEO John Mack did not provide details about bonuses at the February 10 meeting, but did stress that the firm was the first "to institute a clawback provision that goes beyond Tarp requirements" and allows the investment bank to recover pay from anyone who engages in detrimental conduct or causes a significant financial loss to the bank. The clawback is expected to relate primarily to the deferred compensation-part of the bonus. No further details were provided on the clawback, but it is generally agreed that cash which has been paid out cannot be clawed back. Thus, clawbacks typically relate to stock, which is vested by terms of its issuance.

In a December earnings call available on seekingalpha, Morgan Stanley told analysts that the bank's full year compensation expense was down 26% from 2007, with the decline driven primarily by the institutional securities business. "The compensation ratio for the firm, excluding severance, was 46.5% as we managed compensation to reflect the lower revenues and earnings environment," said Colm Kelleher, the firm's CFO. This was driven, he added, by institutional securities where the compensation ratio to revenue accrual was 43.9% and adjusted for severance only 39.9%. Kelleher highlighted that on the lower revenues registered, this was a "drastic reduction".

Bank of America's CEO Ken Lewis also did not talk much about bonuses at the February 10 meeting, perhaps because the Merrill bonus issue has become the subject of a separate investigation. But he did say that he and other senior BoA executives were foregoing their 2008 bonus, while employees one level lower faced a cut of 80%.

The largest recipient of Tarp funding, Citi, disclosed that its chairman, CEO and CFO received no bonuses for 2008, while the top 51 people at the firm received substantially reduced bonuses. Executive committee members received at least 40% of their bonus in stock or options, with performance-based vesting conditions. However, some sources say Citi CEO Vikram Pandit managed to get approval to pay his people before the Merrill disclosures shone a spotlight on the whole bonus issue, and that Citi's 2008 payouts were around 90% of the 2007 bonus for some employees in parts of the corporate bank, such as global transaction services, which has continued to perform well, and between 40% and 50% of payouts made in the previous year in parts of the investment bank.

Meanwhile, on February 4, the US department of the treasury issued guidelines on executive pay, which are binding for banks which have benefitted from Tarp funding. Broadly, the proposal caps compensation for senior executives at $500,000 and any amount exceeding this must be paid in locked-up stock. But paying bonuses in stock is not a panacea. The biggest holder of Lehman stock was its own staff, yet some of the same employees built up the portfolio of risky assets which ultimately led to the firm's collapse.

This issue seems unlikely to die down quickly as US media have reported that former Merrill Lynch CEO John Thain was questioned by regulators last week about the Merrill bonus payouts and Lewis could be next. Meanwhile, for the banks in the firing line (no pun intended) easy solutions are not forthcoming. As detailed above, clawbacks have only limited utility and while it is generally agreed that it is an imperative to devise compensation mechanisms which correlate rewards with long-term performance rather than short-term gains, compensation structures also have to address the need to retain the best and brightest bankers necessary to now turn the beleaguered firms around. This is a difficult balancing act.