A Fascinating Executive Compensation Story – Yahoo!

henrique_de_castro_lucky
Do you feel lucky?

Every once in a while – ok, every couple of weeks – we get hit in the head with a new example of how “executive compensation” and “executive performance” have close to zero correlation in practice. The key to this disconnect is typically “incentive pay” through company stock or stock options.

This week’s story about Yahoo’s fired COO Henrique de Castro’s compensation is a nice one.

Henrique de Castro joined Melissa Mayer’s team in October 2012, before being fired by Mayer 15 months later, as she explained in this memo. Meanwhile, Castro departed with a $58 million severance package due to a surge in Yahoo’s stock price, which itself is the happy coincidence of a surge in valuation over those 15 months for Alibaba, a Chinese e-commerce company, partly owned by Yahoo.

Yahoo reportedly missed revenue and profit targets during de Castro’s tenure, and he received none of his projected annual bonus $540,000 bonus for 2013. We know how his board and colleagues thought he performed last year – which is to say poorly – because the rest of the top Yahoo management team received more than 80% of their bonus targets, making him a clear outlier at the company.

When you’re executive severance pay gets tied to your company’s stock price, however, and furthermore your company luckily owns a big stake in a hot Chinese internet company despite poor operating performance over that time, who cares about actual performance?

When he joined Yahoo, De Castro originally negotiated, or was offered, a potential $36 million equity compensation package.  Yahoo stock surged more than 2.5 times between his hiring and firing, for which de Castro probably deserves little credit.

Bottom line: Poor personal performance, poor company performance, generous hiring package, lucky Chinese internet company stake, $58 million severance. 

I don’t know. I don’t want to begrudge a guy his lucky fortune, but it seems like the shareholders of Yahoo should not be pleased. The larger point is that this type of disconnect between performance and compensations happens all the time, and shareholders should be displeased. And the culprit in this story is generous equity-based awards, every time.

Yahoo_compensation
Yahoo performance

I’m not really advocating government regulation of executive compensation as, theoretically, this kind of horrific pay-for-performance is self-correcting: Management teams and boards that cut these types of compensation deals should be brutally punished by the market (via a company’s stock price for example) and in the court of public opinion.

On the other hand, we know from enough experience at this point that this self-correcting mechanism does not really work. Compensation consultants who set the standard for recruitment and compensation packages too often have an incentive to keep the numbers high.  They get hired by boards populated by executives who all benefit from this generous equity overpayment scheme. Until we have real shareholder-revolt power (and we don’t yet) my theory of a self-correcting market mechanism is more theory than practice.

It’s complicated.

Other negative-correlation horror-shows of executive compensation and executive pay

De Castro isn’t the worst example of all time for the negative correlation between executive performance and compensation.

That title originally went to Merrill Lynch’s Stanley O’Neal, who wrote down $8 billion in shareholder value from owning toxic CDOs shortly before leaving Merrill with a $161 million equity-based severance payment in 2007.

The reigning champion would be Kenneth Lewis, who took a perfectly healthy Bank of America in 2007 and purchased the giant black hole of value known as Countrywide Mortgage for $4 Billion, a transaction which ultimately cost shareholders an estimated $40 Billion in liabilities, possibly the worst financial deal of all time.

For his next trick, Lewis purchased Merrill Lynch (along with its heaping pile of CDO toxic waste accumulated under O’Neal’s watch) for $50 Billion in 2008, only to quickly write down $20 Billion from Merrill’s balance sheet in the next quarter, requiring a special $20 Billion US Treasury infusion to keep the purchase from entirely sinking Bank of America, previously the country’s healthiest large bank.

After his years of compensation in the $20 million range, Lewis’ departing gift was a $53 million pension from Bank of America. In March 2014, he was banned from management of public company for 3 years and ordered to pay a $10 million fine, as a result of a lawsuit brought by the New York Attorney General.

Ken_lewis_destroyed_value
Heck of a job, Kenny

I’m rendered breathless writing all of that.  Heck of a job, Kenny.

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Four Factors Favoring Fabulous Fab

The Fairy Tale SEC suit against Fabulous Fab
The Fairy Tale SEC suit against Fabulous Fab

Below are my reactions to the US Securities and Exchange Commission fraud suit that began yesterday against “Fabulous Fab” Fabrice Tourre, a Vice President at Goldman Sachs for structured products.

From what I gather in the press, the Feds are suing Fabulous Fab for the following reasons:

  1. He sent embarrassing emails to his girlfriend revealing anxiety about the performance of his markets.
  2. He did not fully disclose his and Goldman’s simultaneous role as broker between one client – John Paulson & Co – who wanted to short mortgage derivatives, and another client ACA Financial Guaranty Corp – who wanted to go long mortgage derivatives.
  3. He’s French.[1]

Listening to the news last night I realized that people might actually think Fab is to blame here.  That is a travesty.  The SEC’s suit is a joke, albeit a really unfunny one if you’re Fab.

Fab is no more to blame for investors’ losses in a CDO known as the Abacus 2007-AC1 than any broker who sold you shares in any publicly traded stock in the year 2007 which subsequently halved in value by the end of 2008.

The SEC prosecution appears to rest primarily on the idea that Goldman brought together clients with opposite views of the mortgage derivative market, and then didn’t tell all sides of the trade who everyone was.

Factor #1

What?!!  You mean to tell me Goldman brought together clients with opposite views on the market?

One of the disappointing aspects of William Cohan’s Money and Power: How Goldman Sachs Came to Rule the World is Cohan’s seeming misunderstanding of how a broker-dealer works.  Cohan seems shocked, as the SEC attorneys in the Fab trial want the jury to be shocked, that Goldman could match up clients with diametrically opposed views on the mortgage derivative market.

Hey guys?  Let me give you pro tip:  That’s how a broker-dealer works.

It’s the job of a broker to find willing buyers and willing sellers, all day long, to take diametrically opposed views on the future direction of securities and markets.  It’s also the broker’s job to generally protect and make anonymous the counterparties to a trade.

[NB: Cohan clearly does know how a broker-dealer works and he has an excellent review of the Fab case here on Bloomberg.  My jab at him is about his book in which he doesn’t clarify just how ridiculous Sen. Carl Levin, and by extension the SEC’s theory is, on potential conflicts of interest within a broker-dealer]

So the fact that Paulson and ACA had different views on mortgages means that Goldman did its job.  The fact that Goldman didn’t overly advertise the central role of Paulson in the CDO structuring is not evidence of a crime.

The level of expected disclosure in CDO structuring will be a combination of

1. law, and

2. informally agreed-to market standards.

I spent enough time around the persnickety legal compliance folks at Goldman to have confidence that Fab’s team complied with the letter of the law over counterparty disclosure, or what is called in the business ‘name give-up.’

Some types of trades require it, some types of trades forbid it, and some types of trades will rely on market standards to determine the correct level of disclosure.

At the moment of structuring the Abacus CDO it’s less clear to me, from a distance, whether Fab’s team reached a less formal level of ‘market standard’ when it came to disclosing Paulson’s role.  But market standard is a kind of nebulous concept for which I can’t believe Fab can be found guilty by the SEC

Factor #2

Why go after Fab and not bigger fish?  Because he’s the only one against whom you could find embarrassing emails to his girlfriend?  (Give him a break.  He’s French.)

Fab was a relative nobody.  Like Greg Smith (of Muppets fame), or like me, Vice Presidents are in charge of very little at a Wall Street firm.  From his ill-advised emails we gather he was an over-worked, under-sexed, anxious, and narcissistic guy, but what 31 year-old on Wall Street isn’t all of those things?  If that’s a crime, then lock ‘em all up.

I’m not a fan of the Eliot Spitzer- trademarked prosecution-and-trial by embarrassing email.[2]  That appears to be why Goldman settled for $550 million with the SEC a year ago, because of Fab’s anxious, flirty emails to his girlfriend.[3]  Goldman, as is typical in these situations, did not admit guilt, they just paid the money in order to move on.

I’m not saying the SEC shouldn’t bother to prosecute bad actors even if they are low on the totem pole, but I am saying two things:

1. Fab was a small cog in a big machine doing exactly what he was paid by his bosses to do, and

2. There’s nothing bad about what he did except try to sell squirrely investments to willing, professional, sophisticated buyers.  And that’s his job!  CDOs are squirrely.  Everybody knows that.  CDOs, we used to say on the desk, are “sold, not bought.”  Meaning, once you’ve placed them in a client’s portfolio, pray they never ask to sell them back to you.  You do not want to buy them back.  They’re too squirrely.

Factor #3

ACA was no innocent victim

ACA was not an ‘innocent victim’ of mean, nasty brokers tricking them into buying destined-to-soon-fail derivatives.  These were highly compensated, professional, CDO investors.  ACA charged their customers millions of dollars in fees, and collectively paid themselves millions of dollars in compensation, to provide their “unique insight” into buying complex financial products.

As Michael Lewis pointed out before in The Big Short, if any fraud or crime was being perpetuated, it was by ACA on their own customers, for pretending they knew how to separate the profitable from the unprofitable, the gold from the dross, the good from the garbage.  If you can’t do that, you’re just tricking your own customers.  If you lose money buying a terrible product in the way ACA did, you should only blame yourself.

Factor #4

But ACA was on the wrong side of John Paulson without knowing it.  Paulson’s a genius!  It’s so unfair!

John Paulson in 2007 was not John Paulson.  He was just another contrarian hedge fund guy taking a swing at the overly frothy mortgage and housing market.  Everybody who had done this type of trade previously – betting big against mortgage credit and housing in the run-up – from 2001 to 2007 – had lost their shirt, as the market moved against them.

Everybody who took Paulson’s side of the trade before things broke in 2007 was an idiot and a money loser.  What’s obvious now in retrospect was not obvious then.  The ACAs of the world – buying the stupid, illiquid, highly-levered subprime, garbage CDOs – had made much more money in the previous years than the John Paulsons of the world.

That’s why Paulson was so damned successful.  Because there were only a few Paulsons around to take the other side of the mortgage derivative trade in 2007.

Being on the short-side, like Paulson dared to be, appeared to be for suckers.

ACA must have been laughing all the way to the bank.

 

If Fab is guilty, then I’m the big bad wolf.

Bloomberg News wrote that

U.S. District Judge Katherine Forrest, who will oversee the trial in Manhattan, summed up the SEC’s allegations this way in a June 4 opinion: “Tourre handed Little Red Riding Hood an invitation to grandmother’s house while concealing the fact that it was written by the Big Bad Wolf.

The SEC’s version of the case is so absurd it’s hard for me to believe they’re pursuing it.  It’s a fairy tale.



[1] In my opinion, this is the only valid reason of the three.

[2] For more on this, as well as a great primer on why Spitzer should never, ever, be elected dog-catcher, I recommend this blast-from-the-past article.

[3] Broker-dealers always, always, always settle with regulators because the cost of fighting regulators in court is that you’re out of business.

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Busting the Rating Agency

Frat Party

Yo everybody 5-0! 5-0!  The cops are here!

The US Justice Department filed a lawsuit yesterday against Standard & Poors, for its role in over-rating mortgage bonds, CDOs, and other securities in the years 2004 to 2007, securities which later proved to be weapons of mass financial destruction – the initial catalysts of the Great Credit Crunch.

When I read the story this morning, I suffered an involuntary eye-roll, the type I discourage in my daughters.

If a fraud was committed in those years, the rating agencies, frankly, are not the prime suspects here.

If the Wall Street mortgage bond market was the greatest financial frat party of all time, in the years 2002 to 2008, the rating agencies were the freshman pledges.  We needed them for continuity, and because they provided a reason to host a party.  But look, nobody really respected them.  They did what Wall Street told them.[1]

But then the party went horribly awry.  Somehow the upperclassmen frat brothers are way too smart to still be at the scene.

Now, with the frat house furniture stolen, the neighbor’s cat shaved and duct-taped, the Dean’s house toilet-papered, and the entire kitchen and basement burned black, the police have shown up and seized all the stupid pledges they found passed out in the back garden.

Yes, the pledges were at the party.  And yes, they kind of knew it could all go wrong somehow,[2] but not really.  They weren’t really in on it.  They didn’t have the upside that the Wall Street firms had.  They were just trying to appeal to the big frat brothers, who might someday invite them to be part of the inner circle.[3]

So, I rolled my eyes this morning because the cops can definitely bust Standard & Poors, but it begs the question of “Why?”



[1] Who paid their fees?  Oh, Wall Street firms did?  ‘nuff said.

[2] The US Justice Department has damning emails from S&P employees saying things like 1. ““Let’s hope we are all wealthy and retired by the time this house of card falters.” And 2. ““We rate every deal. It could be structured by cows and we would rate it.”  Hey guys?  I know you have that personal opinion, but seriously, never write that shit down.

[3] Michael Lewis makes the great point in The Big Short that the rating agency folks generally didn’t have the educational pedigree of the Wall Street in-crowd, but many hoped one day to join the firms themselves.  This “next-job” focus often leads to conflicted professional behavior and may help explain why the rating agencies acted like pledges at the frat party.

 

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Book Review: The Big Short, Inside the Doomsday Machine

In one obvious respect, The Big Short follows Michael Lewis’s winning formula for a blockbuster book on sports or finance: character sketches so compelling, funny, and sympathetic that he makes an arcane industry understandable by the average reader.

Less recognized, but even more impressive, however, Lewis bucks the dominant trend in media coverage of the 2008 Crisis.  Lewis does what almost nobody else in journalism has even tried over the past few years, namely, he makes the short-sellers the heroes.  He makes us root for:

  • The plucky one-eyed neurologist Michael Burry with Asperger-spectrum personality, whose investors repeatedly tried to betray him
  • Steve Eisman, a down-beat and beaten-down stock analyst covering the least glamorous industry, subprime lenders
  • Two entrepreneurial founders of a seemingly Too-Small-to-Succeed hedge fund Cornwall Capital

Only Deutsche Bank mortgage trader Greg Lippman gets profiled as the arrogant gunslinger that we’ve come to expect from financial journalists, and the profile is so specific that you can’t help but think Lippman must be exactly like that.

Most coverage of the Crisis gives the strong sense that innocent homebuyers were tricked by greedy bankers and their Wall Street enablers into mortgages they could not afford to pay back.  The popular press rarely mentions the basic idea that lending to people who cannot and will not pay back their mortgages is not a strategy or a goal of bankers and their Wall Street enablers.  It happened, but it was not their plan.

Lewis’ has the gumption not to defend, but to celebrate, the few clear-headed folks who managed to profit while the financial herd – bankers and borrowers alike – ran themselves off the edge of a cliff.

Start with The Big Short to get a clear sense for the players, triggering events, and financial technology of the Great Credit Crunch of 2007 and 2008.  It’s as good as anything else written on the Crisis to date.

 

Also see my review of Michael Lewis’ Liar’s Poker – The best book on Wall Street ever.

and see my review of Michael Lewis’ Boomerang – Funny, if not terribly substantive.

Please also see related post, All Bankers-Anonymous Book Reviews in one place.

 

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