[Yves Klein made a very similar point in her interview with Doug, that the partnership structure was the perfect constrainer of financial risk, because a bad mistake would mean partners would lose everything they had ever made -- they had unlimited liability. This article notes that listing rules had to be changed to allow the first financial partnership to go public. Is it impossible to go back?]
March 18, 2010, 9:30 pm
Lehman's Demise, Dissected
By WILLIAM D. COHAN
What if the biggest rewards on Wall Street went to those who thwarted
dangerous and excessive risk-taking instead of to those who enabled,
approved or simply ignored it?
What if every senior Wall Street executive had to worry that he could
lose his entire net worth at any moment -- including his mansions in
Greenwich, Conn., and Palm Beach to say nothing of his job -- if the
revenue he was generating turned out to be unprofitable or excessively
risky?
Wouldn't that combination of potential rewards and fear of calamitous
personal loss instill in every Wall Streeter a zealous desire to insist
that the products his firm was peddling were safe for others to buy?
If such simple incentives had been in place on Wall Street, wouldn't
the latest crisis -- as well as the multitude of others that have been
perpetrated on us in the past 25 years -- been largely avoided?
An autopsy on the failed firm revealed not only false accounting but
also the rot at the heart of Wall Street's culture.
The obvious answer to these questions is that human beings always do
what they are rewarded to do and always have, especially on Wall
Street. Rewarding prudent risk-taking on Wall Street while punishing
recklessness would result in a new ethic on Wall Street, one not solely
driven by generating as much revenue as possible in a given fiscal year
with no regard to the long term.
To that end, shareholders must demand that corporate boards of
directors revamp the entire compensation structure on Wall Street away
from one based on revenue generation to one that rewards long-term
profits. For goodness sake, what other business on the face of the
earth, aside from Wall Street, pays out between 50 percent and 60
percent of each dollar of revenue generated to employees in the form of
compensation!
As with so many simple and obvious solutions, this one has the benefit
of having a long track record of success. Once upon a time -- not so
long ago -- this was how investment banking compensation worked. During
the Golden Era of Wall Street, the years between the reforms of 1933
and, say, 1970, Wall Street was a series of small, private
partnerships. If a firm made money in a given year, a partner would
receive his share of the pre-tax profits. If the firm lost money, a
partner was liable for his share of those losses up to and including
his entire net worth. In those days, Wall Street stuck to prudent
risk-taking.
Firms made much of their profits by giving advice on mergers and
acquisitions, where revenue came essentially free of risk, unless a bad
deal damaged a firm's reputation. They underwrote debt and equity
securities for growing businesses, where revenue came from briefly
buying the securities from companies and then immediately selling them
to previously identified investors. Bankers often sat on the boards of
directors of the companies whose securities they underwrote, in large
part because they believed they had a responsibility to investors to be
as informed as possible about the goings-on at their clients.
That era started to change in 1970, when a small Wall Street
partnership -- Donaldson, Lufkin & Jenrette -- decided to go public.
(The New York Stock Exchange rules had to be changed to allow it.)
Merrill Lynch followed the next year. And, within a generation, the
rest of Wall Street had followed suit in a mad rush to compete with
those firms that had substituted other people's money for that of their
partners. By going public, not only did the partners of these firms
become fabulously wealthy -- when Goldman Sachs went public in 1999,
longtime senior partners were instantly worth around $300 million --
new compensation policies were instituted based on revenue generation
rather than profits.
Over time, prudence was replaced by taking big, unbalanced risks with
shareholders' and creditors' money in order to generate the revenue
that would lead to big annual bonuses.
Given the total lack of personal liability and accountability for such
behavior -- despite Congressional efforts to reform the place -- can it
really be any surprise that, for instance, Howie Hubler, a trader at
Morgan Stanley who engineered a series of mortgage-related trades that
cost his firm more than $9 billion in losses in 2007 was able to resign
quietly and leave without having to cough up one penny of his $25
million 2006 compensation?
<end excerpt>
Michael