Putting an end to Wall Street's 'I'll be gone, you'll be gone' bonuses

Read about the guys who made out in the big meltdown and created the economic mess we're in . Left unsaid was that all this 'clever financial engineering with collaterized mortgage debt obligations and credit default swaps' was made possible by Sen. Phil Gramm ( John McCain's economic advisor) bill in 1998 that repealed the Glass Steagall Act. This allowed the clever Wall St Investment Bankers to create these 'clever' financial engineered products.

By Barry Ritholtz
Saturday, March 12, 2011; 6:08 PM

Want to reform Wall Street bonuses? Try clawbacks. That's right. We need to make executives personally liable for their reckless bets if we want to remove the risk for taxpayers. That means giving shareholders, boards of directors and regulators the ability to "clawback" past gains when new speculations go horribly wrong.

The Federal Deposit Insurance Corp. and the Securities and Exchange Commission have floated proposals on performance-based compensation for traders and bankers. Firms that have more than $1 billion in assets would have to disclose incentive-based bonuses. The largest firms (those with more than $50 billion in assets) would have to pay at least half of their bonuses in compensation that is deferred for three years. The SEC could, in theory, deny plans that encourage excessive risk-taking or outrageous bonuses. While this approach is well-intentioned, Wall Street has proven itself especially adept at circumventing compensation laws. Rules that seek to limit bonuses will likely shift compensation more to salary and commissions.

Private profit, public risk

Understand this: I do not care what shareholders and their boards pay the people who create enormous value. Whether it's a chief executive such as Steve Jobs of Apple or a hedge-fund manager such as Steve Cohen of SAC Capital, the people who are paid handsomely for creating incredible profit are not the problem.

On the other hand, many others received huge bonuses for bankrupting their firms and driving the economy into recession. Their job performance should be the subject of your ire and of regulators. They brought the world to the abyss of economic collapse because they had incentives to do so.

If that sounds unbelievable, consider:

l Subprime mortgage brokers who were paid based on the quantity - not the quality - of their mortgage writing. The loans lenders sold to Wall Street to be securitized carried a 90-day warranty. Hence, the brokers' jobs were to find people who would make the first three monthly payments of a 30-year loan. After that, it was no longer their concern.

l Derivative traders who knew that what they were buying was going to blow up. In 2007, I published an e-mail from one such trader who wrote, "We knew we were buying time bombs." The motivation was deal fees and bonuses. Once the derivative machinery was in motion, they had to "keep buying collateral, in order to keep issuing these transactions."

l Collateralized debt obligation managers whose job it was to assemble pools of mortgages, yet had little or no understanding of the underlying loans. The salespeople, traders and managers working in the mortgage sector had incentives that were upside down. The greater the risk they took, the more they were paid. But brunt of those risks was on third parties, never themselves. It was shareholders and taxpayers who shouldered them.

This is backward. The people who should bear the downside are the ones who have the upside. Instead, the system was perversely one of private profit but public risk. Note that it wasn't merely the staff that engaged in this reckless risk-taking. At investment banks, senior managements were so reckless that they managed to destroy their firms. For this act of gross incompetency, they were rewarded with vast bonuses in cash and stock options. By the time their firms collapsed, they had cashed out hundreds of millions of dollars in legal booty.

Consider:

l Lehman Brothers Chairman and CEO Richard Fuld Jr. made nearly a half-billion - $490 million - from selling Lehman stock in the years before it filed for Chapter 11 bankruptcy.

l Countrywide Financial (now owned by Bank of America) founder and CEO Angelo Mozilo cashed in $122 million in stock options in 2007; His total take is estimated at more than $400 million dollars.

l Stanley O'Neal, who steered Merrill Lynch into financial collapse before it was taken over in a shotgun wedding with Bank of America in 2008, was given a package of $160 million when he retired.

l Bear Stearns former chairman Jimmy Cayne, rescued by a $29 billion Fed shotgun wedding to JPMorgan Chase, received $60 million when he was replaced;

l Fannie Mae CEO Daniel Mudd received $11.6 million in 2007. His counterpart at Freddie Mac, Richard Syron, brought in $18 million. In 2008, the two were forced into government conservatorship.

Add to this list Washington Mutual, Wachovia, IndyMac and other bankrupted firms whose senior management took a boatload of money and ran.

Nice work if you can get it - and still live with yourself.

Blame game

How did this happen? Some people blame excessive greed; others say crony capitalism is at fault. I believe we can sum it up in one word: liability. In recent years, there was no legal liability for extreme recklessness. Take a healthy company, roll the dice and if it comes up snake eyes, all you lose are your unvested stock options. Most management does not have significant capital at risk. The cost for pushing a healthy firm into insolvency by excessive risk-taking is some snickering at the golf course. In terms of lost monies, it is minimal.

You might be surprised to learn that it was not always this way. Before these firms went public in the 1970s and 1980s, bank management had full liability for their firm's losses. During the era of Wall Street partnerships, if employees were so reckless as to lose billions of dollars, the partners were on the hook for the full amount. This meant that after the firm was liquidated to pay its debts, the partners' personal assets were next on the auction block: Houses, cars, boats, even watches were sold to satisfy the debt. Not surprisingly, partnership liability worked wonders in focusing attention on taking appropriate risks. Once a bank or investment firm went public, this liability shifted from management to the company's stockholders and creditors (namely, the bond holders). Add to this the rise of stock-option compensation, and you have a recipe for extreme short-termism.

In his book "The Accidental Investment Banker," Jonathan Knee described this mercenary attitude with the phrase "IBGYBG." As bankers signed off on increasingly risky deals, IBGYBG meant "I'll be gone, you'll be gone" by the time the really messy stuff hit the fan. Call it what you will - smash and grab, take the money and run. Without partnership liability or clawback terms, IBGYBG was perfectly legal.

The simple solution to IBGYBG is legal liability. How this works: There must be a civil liability for recklessness that caused a collapse or loss. Liability for loss accrues when a trader knew and disregarded the risk or, failing that, should have been aware of the risks they were taking. The ability to clawback past gains in the event of a subsequent collapse should accrue to the board of directors, the shareholders and the SEC. It is too late to force the big banks and investment houses to go private and become partnerships again. However, we can return the liability for their recklessness back to where it belongs - on the traders, fund managers and executives who profited from extreme risk-taking.

Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of "Bailout Nation" and runs a finance blog, The Big Picture