Bailout Nation (31 page)

How else can you explain CEOs going all in?

Financial engineering took care of the first problem, the killer app. Be it leverage or derivatives or securitization, the wizards of Wall Street had found their Viagra. At least, they thought they did. What they failed to consider was the cost of failure.

That was something that Silicon Valley had down to a science. In tech land, start-ups hit it big or fizzled. The cost of failure was minimal, and working at the right crashed-and-burned company was a badge of honor. During the post-2000 tech wreck,
FuckedCompany.com
was a favorite web site among the geek crowd.

Those who work at start-ups risk thousands of dollars of money from friends and family; they roll the dice with hundreds of thousands of angel investor cash. They gamble millions of venture capital dollars on new business ideas. And when it all goes kaput, hey, it was a long shot in the first place. They all pick themselves up, dust themselves off, and move on to the next project.

Not so with the finance gurus. When you are a 100-year-old company handling hundreds of billions of dollars, there is no easy exit. Big investment banks were not playing with venture capital money, where the expectation was that 99 out of 100 projects would return nothing. They were playing with the rent money and life insurance premiums and mortgages and 401(k) cash of their clients, businesses, and individuals alike.

These weren't modest investments made by people who understood the long odds against them and allocated risk capital accordingly. This was blood money. They bet the house—and lost.

W
e've come a long way from the days when the man atop the organizational chart made 40 times what the person on the lowest rung earned. Over the past few decades, executive compensation has exploded, with some CEOs taking 200, 300, even 400 times the base pay at the company.

With so much of this compensation made via options-based incentives, the bosses had every reason to swing for the fences. The upside was all theirs, and the downside was the shareholders'—and taxpayers'.

But don't for a moment think their terrible track record had a negative impact on their compensation. Despite their performance, these CEOs were paid as if they were enormous successes. The compensation figures that follow are enormous; that they were paid for such abject failure is a national embarrassment.

It is also an indictment of three major corporate governance issues that have not been discussed widely enough. The first is the crony capitalism that was rife in boardrooms across the United States. The cronyism of major corporate boards, especially those in the finance area, has become legendary. Rubber-stamp directors who rarely buck the chairman or challenge the CEO are unfortunately all too common. These boards did not serve either their companies or their shareholders well.

Also enabling this festival of greed are the large institutions that held the companies' stock, most especially the big mutual funds that have been AWOL when it comes to policing the senior management. They have the time, expertise, and incentives to do so; it is beyond the capability of individual shareholders. Besides, it makes no economic sense for someone who owns 100 or 1,000 shares of stock to act as overseer and scold to corporate boards. But it was squarely in the interest of owners of 10 million shares and up to do so. Why the mutual fund complexes failed to protect their shareholders is hard to fathom. Perhaps when it comes to the finance sector, they feared missing out on syndicate deals and hot IPOs if they asked too many questions.

Then there are the so-called compensation consultants. They did a horrific disservice to the shareholders as well as the companies. The role of these primarily ethicless weasels was to give cover for these ridiculous compensation packages. I would love to see a review of the packages as written back then. If the compensation experts were members of an actual profession with standards and ethics, they would be drummed out of that profession. Instead, these people were merely tools used by the C-level execs to transfer vast sums of wealth from the shareholders to themselves.

A
stonishingly, many of the corporate chieftains whose firms have been bailed out at taxpayer expense still maintain very significant net worths, courtesy of those now destroyed firms. Stan O'Neal left Merrill Lynch with $160 million. Ace Greenberg is reputed to have sold over $100 million in Bear Stearns stock. And Hank Paulson, who as both CEO of Goldman Sachs and Treasury secretary under President Bush, dumped nearly half a billion dollars' worth of his Goldman Sachs stock (thanks to his new government job, it was tax defered, too!) Had they been running partnerships when their firms collapsed, they would have been left in a rather different financial situation.

That is how incentive pay is supposed to work—upside gains and downside risks as well. But that's not at all what happened:
¹
,
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These compensation packages for miserable performance were little more than a massive wealth transfer from shareholders to C-level executives. It just goes to show you: In the world of crony capitalism, failure pays extremely well.

—John Stuart Mill, 1867

 

 

S
eptember 2008 started with a bang: Fannie Mae and Freddie Mac were put into conservatorship on September 7, 2008. The following week, Lehman Brothers filed the largest bankruptcy in American history.

The repercussions of setting Lehman Brothers adrift on an ice floe were much worse than either Hank Paulson or Ben Bernanke had contemplated. The complications caromed throughout the financial world, causing panics on trading desks. The cascade quickly froze credit markets.

The month was barely under way, and it was already a September to remember. The same weekend Lehman began its long dirt nap, Bank of America hastily purchased Merrill Lynch for $50 billion. Before the month ended, the Treasury Department would guarantee money market funds; the Securities and Exchange Commission (SEC) would ban short selling; the Troubled Assets Relief Program (TARP) would be unveiled; Goldman Sachs and Morgan Stanley would convert to commercial banks, and Washington Mutual would be taken over by JPMorgan Chase.

Then there was American International Group (AIG).

Once Bear Stearns tumbled, traders' immediate reaction was to identify analogous risk:
Who else held similarly bad assets? What other firms had equivalent risk exposure?
When Bear fell, the obvious answer was Lehman Brothers. Once Lehman went down, the next in line was AIG.

In 2000, AIG had a $217 billion market cap and was the world's largest insurer.
¹
It had numerous divisions, but was in essence two companies under one roof. One was an insurer, the other a structured products firm.

AIG-the-insurer was well known to the public. It was in the Dow Jones Industrial Average, a select club with only 30 members. Regulated by each state's insurance commission, well reserved for in case of loss, the company was a model corporate citizen. It was also a member of an even more select group, one of a mere handful of firms with a triple-A credit rating. The insurance company made consistent if unspectacular profits.

Hidden among the actuarial tables and staid regulated insurance services was an entirely different company: AIG's Financial Products (FP) division, or as it came to be known, AIGFP. It was essentially a giant hedge fund, and like private investment firms, its managers kept a fat 32 percent of the profits it generated. Not surprisingly, FP made outsized bets on derivatives. Even though the firm's CEO, Hank Greenberg, had negotiated the joint-venture agreement between AIG and Financial Products, aspects of the compensation arrangement troubled him. The
Washington Post
noted that FP received “its profits upfront, even if the transactions took 30 years to play out. AIG would be on the hook if something went wrong down the road.”
²

Not, however, the Financial Products team. They were compensated immediately.

Financial Products had begun 20 years earlier with a handful of junk-bond traders from Drexel Burnham Lambert. From 1987 on, the division grew in both size and importance to AIG. From just 13 employees in 1987, FP ballooned to over 400 by 2005.
³
“The unit's revenue rose to $3.26 billion in 2005 from $737 million in 1999,” Gretchen Morgenson observed in the
New York Times
. “Operating income at the unit also grew, rising to 17.5 percent of AIG's overall operating income in 2005, compared with 4.2 percent in 1999.”
⁴