Thursday, December 18, 2008

Real bonuses & phoney profits

For years in business school courses I have taught that incentive contracts - fancy language for 'bonuses' or 'performance pay' - are a way of motivating extra effort from business managers or of elimating principal -agent problems between managers and shareholdersw.   Sometimes this is true but the devil is in the detail of how such contracts are designed.  Sometimes the contracts increase risk-taking unreasonably particularly in an investment setting where rewards from sound decision making accrue through time and where the costs of poor investment decisions are not identified immediately.

The NYT  discusses the interesting recent case of Merrill Lynch.  To quote their former CEO E. Stanley O'Neal in March 2008:
“As a result of the extraordinary growth at Merrill during my tenure as C.E.O., the board saw fit to increase my compensation each year.”
When he left Merrill, O'Neal was awarded an exit package of US$161 million.

Moreover, benefits of huge magnitudes were made further down the line. For one employee in 2006, on a salary of US$350,000, total compensation was 100 times that at US$35 million. A 20-something analyst with a base salary of $130,000 collected a bonus of $250,000. And a 30-something trader with a $180,000 salary got $5 million. Many of these bonuses were in cash not equity so employees had little reason to take a longer-term view.

These huge payouts were intended to reflect huge earnings but they did not.  Quoting the NYT:
'...Merrill’s record earnings in 2006 — $7.5 billion — turned out to be a mirage. The company has since lost three times that amount, largely because the mortgage investments that supposedly had powered some of those profits plunged in value.


Unlike the earnings, however, the bonuses have not been reversed'.
The losses Merrill made exceeded all the profits they had made for 20 years.

Furthermore banks like Merrill will dole out bonuses even after they have had to be propped up with billions of dollars of taxpayers’ money.

These bonuses should never have been so big because they were based on 'ephemeral earnings'. They encourage employees to act like gamblers at a casino who can collect their winnings while the roulette wheel was still spinning. Employees contiunued to pursue risky deals even as the housing and mortgage markets weakened because what happened to their investments was of no interest to them - they have already been paid.

Sir Henry Casingbroke's amusing - though pointed - account of the US auto bailout provides further observations on crazy US incentive contracts.  I assuime the business school gurus will publish a whole rash of learned papers pointing out that refining the way incentive contracts are designed can perfect their operation. But something more fundamental seems lacking - corporate morality for one thing.

15 comments:

sir henry casingbroke said...

To set the record straight, I do not claim authorship of the canoe race story, it was sent to me via email.

With regard to incentive bonuses to executives, it is now clearly a scam. It may have started as a legitimate attempt to concentrate the minds of top level execs but it has failed on two main counts:

1. Chief executives will assign themselves bonuses for the same reason that dogs lick their own balls, i.e. they can. As chief executives, by definition, they decide. If any of their assistants blow up about it they get the arse or get a bonus too and shut up.

2. The incessant thrust for ever-greater profit by enterprises, is driven by such incentive schemes. It causes huge damage and dislocation to the real society outside the boardroom walls. This includes the export of labour when a cheaper import is not politically feasible.

To put that canoe story in perspective, the US auto industry management is pulling a major stunt in order to shut down the Detroit model, with its expensive unions and the pension schemes. The idea is to shift the auto workers' pensions unfunded liabilities now amounting to trillions onto the tax payer by going for chapter 11, and start again in "right to work" states such as Alabama, where incidentally, Toyota is.

jc said...

These bonuses should never have been so big because they were based on 'ephemeral earnings'. They encourage employees to act like gamblers at a casino who can collect their winnings while the roulette wheel was still spinning.

With due respect you really don't know what you're talking about Harry. Nearly all bonuses at the I-banks were not based on ephemeral earnings. In fact it was quite the opposite: they were based on REAL earnings for almost every sector of the I-bank.

I worked at 2 two I-banks and can tell you that the people that worked for me and were paid a bonus earned every cent they got simply because they were either good traders or sales people.

The job of managing risk rests primarily with the primary manager.

good traders are hard to find and they are paid exactly the way they should be in terms of what they produce.

You know, it's amazing how you begin to see all the envy slinking out of the the sewer when other people's compensation is discussed.

I-banks had a comp agreement of paying anywhere between 7 and 15% of the net result as a bonus.

It's a great way for a smart person who has no wealthy family to accumulate capital.

There is nothing wrong with the principle of paying bonuses on performance and the sins of the few shouldn't rub on those that were hard working honest traders.

jc said...

With regard to incentive bonuses to executives, it is now clearly a scam.

Bloody nonsense. Absolute drivel. I suppose we should go back to the times when the only thing that counted was the school tie and the family name like some of the idiots that ran our mining companies before globalization for generations.


It may have started as a legitimate attempt to concentrate the minds of top level execs but it has failed on two main counts:

1. Chief executives will assign themselves bonuses for the same reason that dogs lick their own balls, i.e. they can. As chief executives, by definition, they decide. If any of their assistants blow up about it they get the arse or get a bonus too and shut up.


The board decides comp, so take it up with the board and the other shareholders. Otherwise it’s no business of outsiders.


2. The incessant thrust for ever-greater profit by enterprises, is driven by such incentive schemes. It causes huge damage and dislocation to the real society outside the boardroom walls. This includes the export of labour when a cheaper import is not politically feasible.

Terrific ideas. Let’s put up the barriers again, have import quotas on textiles and ignore idea little matters like comparative advantage. Our economy was a sewer heap prior to the 80’s for exactly these reasons. Our living standards lifted as we opened our economy allowing efficiencies and specialization etc.

To put that canoe story in perspective, the US auto industry management is pulling a major stunt in order to shut down the Detroit model, with its expensive unions and the pension schemes. The idea is to shift the auto workers' pensions unfunded liabilities now amounting to trillions onto the tax payer by going for chapter 11, and start again in "right to work" states such as Alabama, where incidentally, Toyota is.

Let it got go to Chap 11. That way a bankruptcy judge can decide on the best course of action available. Ever asked why no acquirer entered the market and took GM over through the years. … not even at 2 dollars a share? The reason is that the toxic and venomous UAW treats Detroit as captured capital. Now that they have cannibalized shareholder and bondholders money they’re going after the taxpayers money.

hc said...

JC,

The employees at Merrill Lynch got huge bonuses for making investments that sent the company broke and forced a bailout.

Pointing this out isn't envy - its identifying a financial system that has become totally disfunctional.

Indeed the money paid to the agents here is of secondary concern. The main issue is that agents were incentivised to invest in rubbish.

jc said...

yea well harry, if you knew it was rubbish, why weren't you sounding the alarm bell before it happened rather than later?

Hindsight has made me into an imaginative billionaire.

Put the blame where it's deserved harry. Right at the foot of the Feds door for creating the environment that incentivised people to speculate and take unnecessary risk.

They have monopoly on the freaking currency and they are the ones that created the environment with interest rates that were criminally low.

As a matter of fact Merrills was not bailed out. It was was bought by BAC.


One other thing, Wall street has spent 150 years trying to figure the best way to compensate people. It's interesting how everyone now has an opinion and are immediate experts on how to compensate traders.

sir henry casingbroke said...

Hey JC I know where you’re coming from. Liquidate labour, liquidate stocks, liquidate the farmers, liquidate real estate. That will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people. Right?

Just like this conversation between us is totally private, JC, company executives and their boards can vote themselves anything they like and it’s no business of outsiders. Sol Trujilo gets a multimillion bonus on top of his $9 million salary package and its no business of outsiders, although Telstra is the major supplier of essential services.

Sol Trujillo spends $54 million on consultants to produce a “strategic plan”. For this bit management genius alone Sol picks up a bonus of $1.3 million. But this is no business of outsiders.

During Sol’s first year in the job, he was paid $10 million in cash, shares and bonuses but during that time the market value of the company fell at a rate of $50 million a day. But that's no business of outsiders.

And just this week Telstra shares plunged 48 cents, or 11.62 per cent, wiping $6 billion off the company's market value. But is that any business of outsiders?

Hey, psst, JC, just between you and me pal, I reckon Sol should be given a few licks of the stockwhip and then locked up in Villawood pending his deportation as an undesirable alien.

jc said...

Hey JC I know where you’re coming from. Liquidate labour, liquidate stocks, liquidate the farmers, liquidate real estate.

Or do what Hoover and FDR did which is to prop them all up and let the recession turn into a depression by artificially holding up prices thereby not allowing the market to clear. Good one.

That will purge the rottenness out of the system.

Nothing wrong with the system per se, Dude.



High costs of living and high living will come down.


Perhaps they should or do you think the price of oil should have stayed up at $145 a barrel by consumers refusing to accept lower prices.Ummm? Do you because that is what you’re arguing?


People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people. Right?

see above and then argue the opposite silly assertions and claims you made. You can’t ignore market forces. Or if you can and still maintain living standards…. Perhaps you need to share with us the secret formula that avoids doing so. Can you?




Visey board is private company. Do you think it's owner should tell you how much he earns? If you asked would you be offended if he told you to fuck off?

Why then is it that much different what a CEO is paid running a firm that happens to to be listed on the stock exchange of which you are not a shareholder?

In short it's absolutely none of your god damn business despite you thinking it is.

As far as I'm concerned Sol is running a a great ship and hope he continues that way.

if you don't like what Telstra offers go someone else as no one is topping you.

If you think it is behaving uncompetitively go tell that to the ACCC and see what they think. You are perfectly within your rights to do so.

otherwise stop behaving like an interfering old aunt.

sir henry casingbroke said...

Look JC, I can see that it is pointless in engaging you, on any level, least of all humour.

I inserted the infamous 1929 quote from US Secretary of the Treasury Andrew Mellon, who thus advised President Hoover, by way of irony, but that seems to have confused you into a critique of it.

If you think it is such brilliant solution, why not put your time where your mouth is and knock out a guest post on the Mellonesque remedy for the recession/depression?

One more thing. I take it that you bring up Dick Pratt's remuneration as a counter-argument and contribution to the earlier discussion about the outrageous practice of hired CEOs of public companies awarding themselves ridiculous and extreme bonuses, overwhelmingly without any justification?

Pratt and Visy are hardly relevant to Sol Trujillo, who was hired to head a semi-government telco that is still largely a monopoly and essential service provider.

Anyway, if you are trying to suggest that Dick can do whatever he likes with his company, this is not so. In June this year he was charged by ACCC with lying about his knowledge of a price-fixing scandal and engaging in a price-fixing cartel. He was subsequently fined $36 million.

Funnily enough, I know how much Dick gets out of Visy as he has told me many times at Raheen, his lovely little place on Studley Park Road in Kew. He has never told me to f/off. Dick and I are distantly related, we're both born in Poland and both Pratt and Casingbroke are anglicised Polish names. Dick's original name was Przecicki. I shan't tell you mine.

Now, son, this correspondence with you is closed.

jc said...

Henry

Telstra is a public company and has been for a long time.

Sol is a good manager and deserves to be paid comparably to other managers in the industry around the world.'


If you pay peanuts you end up getting monkeys and his predecessor was as the place was a mess before Sol.


Publicly owned forms are not government owned utilities. Boards and shareholders determine compensation, not busy body old aunts.

If Pratt chooses to tell you what he earns that up to him, so thank you for making my point.

sir henry casingbroke said...

Jeez JC. Explain to me and to the punters out there in blogland how you came to the heroically self-confident conclusion that Sol Trujillo is a good manager and deserves to be paid his outlandish bonuses. I humbly submitted some evidence, including figures of plummetting value as a consequence of Sol's action (or inaction), but you know different. An oracular assertion from you is sufficient against any sort of evidence.

jc said...

Henry

Instead of spouting nonsense you ought to try and think a little. You spend a lot of time sharing the same views with like minded souls at Quiggin's site so you're never challenged these days.

Sol's time at Telstra has been excellent. I would rate him one of the best managers in Oz.

He stopped the rot in terms of losing market share/profitability and turned everything around while the firm has actually been gaining in those areas since the second year he's been there. He fired excess staff and the firm is now as lean as it ever was.

The way to look at Telstra is to compare it with its peers here in Australia and those overseas. In almost every measure, Telstra has been at the top. Domestically it has been killing the competition in every sector including those where it enjoys no advantages.

Stock price wise, it trades at higer mutiples than its peers and is one of the better Telco stocks in the world with people singing its praises. Even Barrons gave Telstra and Sol a top score giving the firm a buy /undervalued rating.

Here, I took it from behind the pay wall just for you, shuggerlugs.
FEW CHIEF EXECUTIVES HAVE HAD A ruder welcome than Sol Trujillo, the American CEO of Australia's largest telecom, Telstra.

In mid-2005, Trujillo, a 30-year industry veteran -- he's a former boss of U.S. West (now Qwest) and France Telecom's Orange mobile group -- took on the challenge of transforming Australia's government-owned telephone monopoly into a modern, publicly owned telecom.
[pic]
Len Irish for Barron's
CEO Sol Trujillo

He immediately became the subject of virulent attacks by Australia's sometimes xenophobic media, focusing mostly on his annual pay of 10 million Australian dollars ($6.4 million) -- one of the highest corporate salaries Down Under. Subsequent commentaries complained about his hard-driving "American" management style and his plan to reduce bureaucracy and cut costs by trimming about 25% of the Melbourne-based company's workforce by 2010. Also duly noted were his battles with regulators over pricing, and his resistance to sharing Telstra's network with rivals.

Somehow, his Mexican heritage became a focal point. The Wyoming native, whose family has 400-year-old roots in America's Southwest, often was caricatured with a long moustache, riding a donkey, wearing a sombrero and carrying saddle bags stuffed with cash. His top three executives, also Americans, were dubbed his "three amigos."

"I am amazed that he's still around, after all the bashing," says portfolio manager Nick Pashias of Auckland, New Zealand-based Portfolio Partners Asset Management, which owns Telstra common (ticker: TLS.Australia; the shares also trade over the counter in the U.S. under the symbol TLSSY). "He's about as American as any American could be, but his treatment by some of the media has really been over the top."

Says an undaunted Trujillo: "The board recruited me to transform the company, and that's what we are doing. And I am still here because we have hit our numbers. We've surprised everyone."

When he took over, the now-57-year-old CEO says, "there was duplication everywhere -- in infrastructure, IT, billing systems. Telstra had too many products, too many vendors and insufficient integration." Now in the fourth year of an A$20 billion, five-year transformation plan, Trujillo has upgraded Telstra's network and replaced outdated technology. What had been a slow, weak second-generation wireless system has become one of the most sophisticated third-generation networks, capable of delivering voice and broadband services to 99% of Australia's 20 million inhabitants.

Launched in October 2006 and turbocharged with High Speed Packet Access technology, Telstra's A$1.1 billion system is 14 times faster than anything in the U.S. -- where the technology was invented. A two-hour movie can be downloaded in four minutes, a song in less than one and a book or bulky attachment in seconds. And the system's speed soon will increase by 50%, making it, Telstra asserts, the world's fastest.
[cahrt]

Trujillo also has bolstered Telstra's balance sheet; the company had A$900 million in cash at last count and is likely to more than double its annual free cash flow to A$6 billion-to-A$7 billion by 2010. He's also slashed costs and eliminated 8,000 employees, trimming the telecom's head count to 45,000. New technology and incentive-based pay has improved productivity, as has a 75% reduction in the number of information-technology platforms the company uses to 300. Despite local competition from Britain's Vodaphone Group (VOD) and Singapore Telecom (ST.Hong Kong), Telstra is the dominant Australian player in both broadband and mobile telecom, with 49% and 43% of those markets, respectively.

In addition, Telstra has bolstered its Sensis telephone directory and advertising business, establishing a presence in China. And its 50%-owned pay-TV provider Foxtel now has a record 1.5 million-plus subscribers.

More important, under Trujillo, revenue has climbed steadily, from $A22.7 billion in fiscal 2005 to A$25 billion in fiscal 2008 (ended in June). Average revenue per user, or ARPU, for mobile data has nearly doubled over the past two years, as more customers use their 3G cellphones for video calls, live television and surfing the Web.

Earnings before interest, taxes, depreciation and amortization, or Ebitda -- one measure analysts use to gauge a telecom's health -- went from A$9.5 billion in fiscal '06 to A$10.4 billion in '08, and investors expect it to hit A$12.3 billion by fiscal 2010. Trujillo recently reaffirmed Telstra's previous guidance for the current year, saying that Ebitda would rise by 6% to 7%, and that revenue would be up 3% to 4%.

The Bottom Line
Good business prospects, a solid balance sheet and a decent dividend make some bulls see Telstra shares advancing by a third or more over the next 12 months.

In fiscal 2008, Telstra earned A$3.7 billion, or A30 cents a share, on A$24.8 billion in revenue. Consensus estimates for 2009 and 2010 call for A31.2 cents and A36.1 cents a share, on sales of A$25.5 billion and A$26.2 billion. An 8% gain in Ebitda over two years would far outstrip the compound average growth rates forecast for most of Telstra's international peers. Portfolio Partners' Nick Pashias, for example, sees growth rates of 6.2% and 0.1%. respectively, at Britain's Vodafone and BT Group; 4.5% at Verizon Wireless -- the joint U.S. venture of Vodafone and Verizon Communications (VZ); 5.5% at AT&T (T); and 4.1% at Belgium's BCE.

The company's solid prospects make bulls predict that its shares, recently around A$4.10, could go as high as A$5.45 in 12 months. Given its good dividend -- 28 cents a share -- Pashias is even more optimistic: "On a sum-of-the-parts basis, and given its high dividend yield, the stock is worth at least A$6."

jc said...

In addition I have never seen an executive so taunted both in the press and elsewhere, particularly on blogs where you hang out, about his racial background. His descendants go back 400 in terms of American roots.

It's an absolute disgrace what small0mindined envy driven Australian fuckheads have said about this guy. And you ought to be ashamed of yourself for associating with them at these various sites.

sir henry casingbroke said...

JC if I want to read "Getting a Telecom Up to Speed Down Under" by Neil A. Martin in Barrons I would have done so without you lifting it for me. There is no paywall.

Martin writes partisan crap and you repeat it verbatim - you may have at least paraphrased it - instead of thinking for yourself. You are easily duped.

The Barrons piece left out Sol's stint as CEO of Graviton, a CIA front. Funny that. Or that Sol has had practically no experience outside Bell or its subsidiaries. Barrons piece also did not tell us about Sol's forced exit from West. You know why? Because the Barrons item on Sol is low-grade propaganda by a two-bob Barrons hack who simply rewrites press releases. And to think that you had the temerity to use up Harry's valuable real estate to lob whole slabs of this "managed information" PR drivel and parade it as your comment, JC!

To deal with the main thrust of Martin's snowjob, it would be very difficult to bury Telstra, a near-monopoly, which still owns massive infrastructure funded by the Australian taxpayer over nearly 100 years, although Sol has been doing his best. Take it from me, Sol will be gone in 2009 and sooner than you think. It's not just me saying that, but today's Fin.

On a more serious note, JC, in a ludicrously inept attempt to paint me as some kind of racist without a scintilla of evidence you commit the egregious sin against logic called the guilt-by-association fallacy; and you do this by inferring that I "hang out" at some blog where someone has posted racial slurs about Sol.

Tell me, JC, how am I responsible (and therefore ought to feel ashamed) for what has been said by someone on some blog somewhere?

And what does "hang out" at a blog mean anyway? It's not like a McDonald's or a mall...

I suspect you didn't do too well in your HSC this year, JC.

jc said...

That's right Henry; kill the messenger rather than the message itself. That's how you operate at those other sites so it doesn't surprise me that you’re trying that with me. But you what, it won't work with me chum.

If you want to dispute the piece perhaps you explain what exactly the writer got wrong about the figures and the comparison to its peers overseas (and here)

Give that a try instead of telling how bad he writer is. As if you would know.

Secondly saying you weren’t responsible for those attacks on Sol’s racial background may be true as I can’t recall if you participated or not, but you’re still hanging around there giving oxygen to those reprobates. Would you say the same if anyone hung around say neo-nazi sites and mostly agreed with what the others had to say and stayed silent on other things? Would you? So you deserve to be painted with the others, as the only time you have protested is when it was brought up.

Hahahahhahahaha Working for a CIA front as you suggest immediately invalidates Sol from doing a good and responsible job Telstra? What is this nonsense? Spare us.


The fin Review is an authority now. How did someone once describe that rag? Oh yes, it's the msot left wing business journal in the world. Judging by the guest ops written for them I think it's even worse.


Getting back to the point of the argument. Sol has done a fine job for Telstra, is paid at a rate commensurate with his peers both here and around the world and no amount of bellyaching sad-lefty nonsense is going to change that. So unless you can come up with some better argument I suggest you stop here before you make an even bigger fool of yourself. Furthermore more stop behaving like an old aunt.

So in sum, Sol has done a fine job by all those metrics I presented and other than doing the same old ad homs etc. you haven’t presented on shred of evidence to suggest otherwise.

(And stop littering Harry’s site with group think leftist drivel and try to think for yourself.)

Artimus said...

Sol aside, Telstra is a monopoly that needs to be broken up! For to long Telstra have had too much control over Australia's internet and the Australian people have suffered with slow and expensive Internet services! The Australian government need to split up Telstra into smaller companies so no one company solely owns the current telephone infrastructure in Australia! As long as one company owns the majority of the telephone infrastructure in Australia there is no competition for price/speed and that hurts consumers and the Information Technology industry in Australia as a whole!