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Spree is over

(chinadaily.com.cn)
Updated: 2008-11-21 15:06

When Henry Paulson came back to his Treasury office on Sep. 25, he brought to his aides some bad news: they had to limit executive salaries, and this could be a major stumbling block for the relief package. Democrats in Congress had insisted on slashing Wall Street executives' compensation and abolishing the golden parachutes. The Secretary argued that it would serve as a disincentive for troubled companies to embrace the bail out. But he had to budge in the end. Luckily, what happened next proved he had made the right decision.

On the first Congressional hearing on the financial crisis on Oct. 6, Henry Waxman, Chairman of the House Oversight and Government Reform Committee, posed a tough question of fairness to former Lehman chief Dick Fuld. "Mr. Fuld, your bank is about to go under and suck our economy into the abyss, yet you still made $484.8 million compensation in your 8-year-tenure as CEO. Is this fair to the average American person?" Putting down his glasses, Fuld responded: "No, my compensation is a bit less than $250 million. But I admit it is still a big number."

"You risked someone else's money and won yourself a great fortune. Now you lose, you drag all the taxpayers down; they have to pay $700 billion in clean-up costs!" Waxman said angrily. During this hearing, some congressmen produced evidence that just four days before Lehman filed for bankruptcy, the company had planned to give its two senior executives up to $18.2 million in severance compensation. What's more stunning, in the second day's hearing, a congressman claimed that after AIG received $85 billion of government aid, its top managers showed up on a Californian beach, with the vacation spending exceeding $440,000.

Believe it or not, this is the Wall Street business model: You bet big with someone else's money. If you win, you get a huge bonus. If you lose, you lose someone else's money -- first burdened by the shareholders and debtors and then the government and taxpayers.

During the bull market of 2003 to 2007, The CEOs of the erstwhile "big five" investment banks garnered $3.1 billion, equivalent to last year's GDP of Tajikistan, a country with 7 million people. When their businesses fail, the money men can just walk away with their "golden parachute", take a break on main street, then come back to Wall Street again.

That is what Charles Prince, the former CEO of Citigroup did when he left the bank last November. His big severance package included a limousine, a private driver, a fancy office and $10.4 million in accumulated bonuses. Challenged by the congressmen, Prince sounded reassured, "In my tenure, my company grew dramatically. Its share rallied by 60% from a low in 2002. The Board of Directors thought I deserved all these."

Many experts agreed that Wall Street had been focusing too much on short-term returns, which distorted incentive schemes and partially contributed to this crisis. The executive pay and compensation package did not reflect the company's risk exposure and long-term performance, and thus entailed a moral hazard. Driven by short-term profits, the executives created and traded complicated financial instruments without understanding the intricate risks.

Other experts argued that the transformation of investment bank's governance structure from partnership (i.e. using your own money) to corporation (i.e. using someone else's money) had further tilted the scale towards short-term behavor. Richard Trumka, the Secretary-Treasurer of AFL-CIO, the largest labor union in US, pointed out that lured by stock options and bonus, CEOs of Merrill Lynch, Lehman Brothers, and Bear Stearns put all the stakes on toxic assets. They pocketed big money when dynamics were favorable but left taxpayers vulnerable when things went sour.

That's why when Paulson's program was unveiled, main street was full of anger: Why did taxpayers have to bail out Wall Street elites and sort out their mess? Is it justifiable to see these well-paid people seeking shelter under the "golden parachute" while leaving the public to take on the huge loss?

In the Congressional discussion of the bailout plan on Sep. 25, Democrats proposed to limit executive pay and ban termination compensation for executives of prospective beneficiaries. But Paulson disagreed. He said the austerity would discourage some financial institutions from selling troubled assets to the Treasury. There was a battle between him and Max Baucus, Chairman of the Senate Committee on Finance.

There were other versions of executive pay limits. A Los Angeles Times article put the executive compensation at 50 times the payment of a company's average staff. Republican Presidential candidate John McCain said at a campaign event that "the senior executives of any firm that is bailed out by Treasury should not be making more than the highest paid government official." The President is the best paid federal official, receiving $400,000 a year. McCain's opponent, Democratic Senator Barack Obama also attacked the CEOs of Fannie Mae and Freddie Mac. He said now that the Treasury had rescued the two mortgage giants with taxpayers' dollars, no CEO would be allowed a windfall.

Despite supports from the President, Paulson struggled with the growing pressure. As the former CEO of Goldman Sachs, Paulson himself was among the beneficiaries of this incentive system. He received $38.3 million bonus at the end of 2005, higher than all his counterparts on the Wall Street. So the congressmen blamed the Secretary as a patron of his old friends. This turned out to be the last straw for Paulson.

This was the final executive pay limit under the rescue scheme: if the Treasury purchases assets directly from a company, the company shall not offer its executives incentives for excessive exposure. As well, the company is prohibited from making golden parachute payments to a senior executive. If the Treasury purchases over $300 million of mortgage-backed securities via auction from a financial institution, the top 5 managers of the seller will forfeit tax deduction for the part of their compensation in excess of $500,000. Except for voluntary retirement, a 20% consumption tax will be levied upon severance package otherwise.

According to a China Daily report by Xin Lian, given that the government could be the new shareholder of the financial firms, and that the business model of these firms, particularly the investment banks, has changed fundamentally, it is reasonable to introduce the above mentioned limits.

Richard Cooper, an international economics professor of Harvard and the former Chairman of Federal Reserve Bank of Boston, also supported this practice. In his view, after the crisis, the investment banks should remodel corporate governance, and a new executive compensation culture should be the first step. In 2007, the average annual income of CEOs of S&P500 companies almost doubled, in contrast to a 12% growth in their corporate profit. Even Warren Buffett, one of the world's savviest investors, blamed much of today's ills on the American executives, "The salaries of CEOs are disproportionately and ridiculously higher than their institutions' performance."

In fact, Lehman did have a system in place, employing stock options and employee ownership program to minimize the adverse effects of profit-biased incentive schemes. Its 24,000 employees held almost 30% of the company's stocks, betting their fortune on the company's future, only to find that they were busted with the fall of Lehman. Their loss, on one estimate, was up to $10 billion. Worse even, many of them left the company without a single penny in compensation.