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Did bonuses help to fuel meltdown?
Sunday, September 21, 2008
Questions are being asked about the multi-billion-dollar rewards that were paid to top banking executives in the US, writes Richard Curran.

Before the dust settles on the enormous corporate collapses and near misses of the last few days, there is a growing clamour to establish how it all happened, who is to blame and what can be done about it.

There is no single reason why Lehman Brothers collapsed, AIG almost fell, Fannie Mae and Freddie Mac had to be bailed out and Morgan Stanley finds itself in merger discussions. But, equally, the contagion that started in the US, and has resulted in HBOS being taken over in a stressed sale by Lloyds TSB in Britain, will not easily be explained away as just part of a normal cycle.

Questions are already being asked regarding the role the system of bonuses paid to executives in leading banks has played in fuelling the bubble. Combine this with weak regulation, particularly in the US, and two key ingredients for a collapse were in place.

The payment of substantial bonuses plays an important part in the financial services industry across the globe. It isn’t confined to top executives. The sale of sub-prime mortgages in the US, sometimes to people who didn’t have a job, would have yielded hundreds of millions in bonus payments to brokers in the front line of sales.

Further up the chain, investment banks bought financial instruments that were based on bundling these mortgages together. As they were sold on, commissions, profits and subsequently bonus payments were made to middle and senior-ranking executives.

These factors, combined with low interest rates, boosted profits. In turn, this fuelled the stock market and investment returns. The two years of 2005 and 2006 set records for corporate profits and corporate bonuses.

Wall Street bonuses hit $23 billion in 2006.Onthe back of those record performances, huge bonuses were paid to top executives in the US, Britain and elsewhere. In 2006, there were 4,000 bankers in the City of London who received bonuses of over £1 million.

Several of the Wall Street chief executives who have been forced out of their jobs because of the sub-prime debacle earned tens of millions in bonuses during the heady days of 2005 and 2006.

The amounts of money are staggering. Because of the performance -bas ed nature of US corporate executive pay, the scope to make large bonuses was dramatic.

Also in the last few years, several improbable factors combined to create an environment in which the normal checks and balances went out the window. A wave of deregulation included the abolition of the Glass-Steagall Act, something which kept retail and investment banks separate. This combined with low interest rates and a wave of innovative financial products that converted toxic loans into souped-up fancy credit products.

Martin Sullivan, the former chief executive of AIG, which received an $85 billion bailout from the American taxpayer last week, earned $40 million between 2005 and 2006.He received a severance package of $47million and his resignation took effect from July 2008.This is despite the fact that AIG has lost over $20 billion on sub-prime writedowns after insuring over $57 billion-worth of financial instruments linked to sub-prime mortgages.

Charles Prince, the former chief executive of Citigroup, who resigned under pressure in November 2007, exited the firm with a $68million severance package. He had been paid $53 million in the previous four years. Remarkably, his 2007 bonus of $12.5 million in cash was based on a formula that adjusts the 2006 bonus to take account of the 2007 share price but was not directly based on the performance of the company in 2007. His predecessor, Sanford Weill, left the bank with $874million in shares and share options.

Stan O’Neal, who is credited with turning around the fortunes of Merrill Lynch when he took over in 2002, drove the company in the direction of equity dealing and sub-prime-related financial products.

He earned $36 million in 2005 and a further $47 million in 2006.When he was ousted in October 2007 after Merrill racked up multibillion-dollar losses on sub-prime products, he walked away with $161.5 million in stock and options. Last week, Merrill Lynch was bought by Bank of America in a distress sale.

Dick Fuld, the chief executive of Lehman Brothers, was nicknamed the ‘gorilla’. He is known for his love of bodybuilding and colourful language. He threatened to break the legs of any Lehman executive who was short-selling its stock. His hard-nosed style at the Wall Street firm was typical of the culture that prevailed at the company. He is reported to have earned a total of $500 million at Lehman.

Fuld is now being blamed for not selling Lehman several weeks ago when it is alleged that a Korean Bank made an offer. It has been speculated that Fuld turned down the offer because it wasn’t high enough and that he was in denial about what could happen at Lehman.

The collapse of the firm last week made it the biggest bankruptcy in corporate history - ten times larger than the collapse of Worldcom.

Fuld took bigger and bigger chances with Lehman in recent years, piling into high-risk mortgages. Lehman built up an $88 billion mortgage-backed portfolio. In 2006, he earned $40 million, a year in which total Lehman group bonuses to staff and executives topped $5.7 billion.

Like many other chief executives on Wall Street, Fuld’s basic salary was modest by corporate standards. His base salary was $750,000, less than the base salary of several Irish bank executives. Jimmy Cayne, the former head of Bear Stearns, was paid a base salary of just $250,000 in 2006, but total bonuses and stock earnings amounted to $33.6million.

Low base salaries are part of the efficiency and incentive approach of the American corporate system. Reward success and punish failure. However, the wisdom of this kind of approach has now been questioned.

The decisions by the top Wall Street executives to pile into mortgage securities was partially driven by the desire to maximise their personal earnings and the assumption that everyone else was doing it.

In Europe and, to a lesser extent, in Ireland, base salaries for executives of banks are a much higher portion of their total earnings.

The American system encourages performance, but there are also inherent flaws in the system. First, the amounts of money involved are so excessive that it can also encourage unsustainable risk. That is borne out by what has happened with the sub-prime crisis. Also, in the US model, boards of banks can set the performance bar low, which ensures big payouts even in bad years.

The way the bonus system morphed into naked greed in the US sub-prime meltdown will form part of the debate about ensuring nothing like this happens again. The failure of regulators to tackle the inherent risks in the system is another day’s work.

The big earners

Dick Fuld, chief executive, Lehman Brothers
Reported to have earned $500 million at Lehman. Received remuneration of $40 million in 2006 and ten-year stock options worth $186 million. In 2007, he received $39 million. The bank collapsed into bankruptcy a little over a year later, having lost over $10 billion on mortgage products.

Martin Sullivan, former chief executive, AIG
Sullivan was ousted earlier this year, having received over $40 million in 2005 and 2006. His severance package was $47 million. AIG lost over $20 billion on sub-prime writedowns.

Stan O’Neal, former chief executive of Merrill Lynch
O’Neal took over in 2002 and earned $36 million in 2005 and $47 million in 2006. He walked away in October 2007 with $161 million after being sacked. Merrill announced $14 billion in mortgage writedowns just months later.

Charles Prince, former chief executive, Citigroup
Resigned in November 2007 with an exit package worth $68 million. He had received remuneration totalling $53 million in the previous four years. Citigroup lost $10 billion on mortgage-backed securities. His predecessor, Sanford Weill, left the bank with $874 million in shares and share options.

James Cayne, former chief executive, Bear Stearns
He received remuneration of $23.2 million in 2005 and a further $33.6 million in 2006. His basic salary was $250,000. Bear Stearns collapsed having lost over $3 billion on sub-prime products.

Marcel Ospel, former chairman, UBS
Resigned last year after UBS racked up $10 billion in losses. In 2006, he was paid $20 million.

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