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Sunday, August 2, 2009

Andrew Cuomo and the Bank Bonus Culture

The Heads I Win, Tails You Lose, Bank Bonus Culture
Andrew M. Cuomo
Attorney General
State of New York
July 30, 2009

Through various inquiries, the New York State Attorney General's Office has been examining the causes of last year's economic downturn. We have reviewed the failures of the credit rating agencies, the role of government regulators, the flaws of the credit default swap market, and the effects of over-leverage and fraud in the housing and mortgage markets, among others.

As part of this review we have also been examining the compensation structures employed by various banks and firms. Accordingly, over the past nine months this Office has been conducting an investigation into compensation practices in the American banking system. We have reviewed historic and current data on numerous banks' compensation and bonus plans. We have taken testimony from participants in all aspects of,the process, including bank executives who set and administer the compensation process, members of boards of directors who review company salary and bonus structures, compensation consultants who advise the companies, and the
recipients of bonuses.

As one would expect, in describing their compensation programs, most banks emphasize the importance of tying pay to performance. Indeed, one senior bank executive noted recently that individual compensation should hot be set without taking into strong consideration the performance of the business unit and the overall firm. As this executive put it, "employees should share in the upside when overall performance is strong and they should all share in the downside when overall performance is weak."

But despite such claims, one thing is clear from this investigation to date: there is no clear rhyme or reason to the way banks compensate and reward their employ~es. In many ways, the past three years have provided a virtual laboratory in which to test the hypothesis that compensation in the financial industry was performance-based. But even a cursory examination of the data suggests that in these challenging economic times, compensation for bank employees has become unmoored from the banks' financial performance.

Thus, when the banks did well, their employees were paid well. When the banks did poorly, their employees were paid well. And when the banks did very poorly, they were bailed out by taxpayers and their employees were still paid well. Bonuses and overall compensation did not vary significantly as profits diminished.

An analysis of the 2008 bonuses and earnings at the original nine TARP recipients illustrates the point. Two firms, Citigroup and Merrill Lynch suffered massive losses of more than $27 billion at each firm. Nevertheless, Citigroup paid out $5.33 billion in bonuses and Merrill paid $3.6 billion in bonuses. Together, they lost $54 billion, paid out nearly $9 billion in bonuses and then
received TARP bailouts totaling $55 billion.

For three other firms -Goldman Sachs, Morgan Stanley, and JP. Morgan Chase -2008 bonus payments were substantially greater than the banks' net income. Goldman earned $2.3 billion, paid out $4.8 billion in bonuses, and received $10 billion in TARP funding. Morgan Stanley earned $1.7 billion, paid $4.475 billion in bonuses, and received $10 billion in TARP funding. JP. Morgan Chase earned $5.6 billion, paid $8.69 billion in bonuses, and received $25 billion in TARP funding. Combined, these three firms earned $9.6 billion, paid bonuses of nearly $18 billion, and received TARP taxpayer funds worth $45 billion. Appendices A and B, attached hereto, provide further information on the 2008 earnings, bonus pools, and TARP funding for the nine original TARP recipients. We note that some of the nine recipients maintain that they did not request or desire TARP funding.

Other banks, like State Street and Bank of New York Mellon, paid bonuses that were more in line with their net income, which is certainly what one would expect in a difficult year like 2008; For example, State Street earned $1.8 billion, paid bonuses totaling approximately $470 million, and received $2 billion in TARP funding. Thus, the relationship between performance of the firms and bonuses varied immensely and the bonus incentive system does not appear to have been tethered to any consistent principles tying compensation to performance or risk metrics.

Historical financial filings support the same conclusions. At many banks, for example, compensation and benefits steadily increased during the bull market years between 2003 and 2006. However, when the sub-prime crisis emerged in 2007, followed by the current recession, compensation and benefits stayed at bull-market levels even though bank performance plummeted. For instance, at Bank of America, compensation and benefit payments increased from more than $10 billion to more than $18 billion in between 2003 and 2006. Yet, in 2008, when Bank of America's net income fell from $14 billion to $4 billion, Bank of America's compensation payments remained at the $18 billion level. Bank of America paid $18 billion in compensation and benefit payments again in 2008, even though 2008 performance was dismal when compared to the 2003-2006 bull market. Similar patterns are clear at Citigroup, where bull-market compensation payments increased from $20 billion to $30 billion. When the recession hit in 2007, Citigroup's compensation payouts remained at bull-market levels -well over $30 billion, even though the firm faced a significant financial crisis. Appendix C, attached hereto, provides further historical data.

In some senses, large payouts became a cultural expectation at banks and a source of competition among the firms. For example, as Merrill Lynch's performance plummeted, Merrill severed the tie between paying based on performance and set its bonus pool based on what it expected its competitors would do. Accordingly, Merrill paid out close to $16 billion in 2007 while losing more than $7 billion and paid close to $15 billion in 2008 while facing near collapse. Moreover, Merrill's losses in 2007 and 2008 more than erased Merrill's earnings between 2003 and 2006. Clearly, the compensation structures in the boom years did not account for long-term risk, and huge paydays continued while the firm faced extinction.

Thus, rather than abiding by steady principles to guide compensation decisions year in and year out, bank executives did just the opposite by delivering high compensation every year. For example, testimony from the head of Merrill Lynch's compensation committee revealed that in 2007, Merrill changed its compensation rationale resulting in huge bonuses in it difficult year:

Q: In 2008 was Merrill Lynch looking at the bonuses as a percent of revenue?

A: No. In 2007 we diverted from that for reasons. We set out in a proxy that Merrill had suffered substantial losses largely related to one unit of the corporation. Overall financial performance is usually a key ingredient. We had to balance that with the need to pay our employees in units that performed....

Q: Did there come a time in 2008 when you revisited that approach that you need to consider having bonuses in some way reflect the economic performance of Merrill year to date?

A: I think we always looked at financial performance, but [beginning in 2007] I think we thought it would jeopardize the long-term health of the firm -and certainly later jeopardize the franchise value of Bank of America -if we didn't pay people who performed and contributed for their performance in the face of large losses on legacy assets in some units....] .

The information contained in the three appendices attached hereto set out, in stark terms, the failure of the compensation structures at many of our nation's largest financial institutions to follow any objective and consistent principles. To the contrary, what these statistics portray is an ad hoc system that does not come dose to meeting the goal of having employees share in the upside and the downside of their firm's performance. We emphasize that the problems we have found relate to problems with banking compensation system-wide and should not be taken as criticism of any particular individual's conduct.

We recognize, of course, that there can be situations where the distribution of profits to employees who created real profits would be appropriate even though the overall firm may have lost money. This might be the case, for example, where one division of a firm earned large profits but another division lost profits. A principled and consistent approach would, however, balance the need to reward and retain those who created profits with the need for bonuses to reflect the overall performance of the firm. In any event, our investigations have shown numerous instances where large bonuses were paid to individuals in money-losing divisions at firms who saw either substantially reduced profits or losses in 2008.

In sum, as we seek to learn lessons from this economic crisis and repair the damage it has wrought, it will be vital to develop and implement sound principles and rationales for executive compensation and bonuses that promote sustainable and rational economic growth. The repeated explanation from bank executives that bonuses are tied to performance in a manner designed to promote such growth does not appear to be accurate. Indeed, our investigation suggests a disconnect between compensation and bank performance that resulted in a "heads I win, tails you lose" bonus system. In other words, bank compensation structures lacked consistent principles and tended to result in a compensation system that was all "upside."

The private market place is, and should be responsible for setting compensation structures. However, compensation packages should be designed to promote long-term, sustainable growth and actual increases in value. This would drive firms towards decision-making that promotes long-term actual growth and performance rather than the dangerous combination of short-term booked profits and blow-up deferral caused by the current bonus culture. Moreover, if market participants begin following sounder and more principled bonus systems, firms would be less susceptible to the "poaching" of their employees by other firms offering unreasonably large compensation packages. Such poaching has too often resulted in irrational bonus bidding wars that harm the entire industry by forcing firms to continually increase bonus levels and leading to a compensation system that is simply a one-way ratchet up.

This rationalization of the compensation and bonus system must be accomplished now. Hopefully, the private sector sees the problem and addresses it quickly. The private sector is the appropriate forum for such reform, and some firms have already taken steps in the right direction. If the private sector does not act, such reform should be discussed as part of the federal regulatory reform effort, and, where appropriate, taken into account by the Obama Administration's pay czar.

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