Bank CEOs and the infinite pile of cash

By Roger Martin
October 5, 2011

By Roger Martin
The views expressed are his own.

The three-week old, 60’s-style Occupy Wall Street protest raises once again the question that won’t go away: What on earth were those bankers doing in the period leading up to the 2008 financial meltdown? This street-level insurgency combines with last month’s smackdown-from-on-high administered by the U.S. Federal Housing Finance Authority’s (FHFA), which sued 17 leading global financial institutions for $196 billion, charging that they knowingly peddled shoddy mortgage-backed security products to unsuspecting customers. With the European financial system continuing to teeter on the brink due to the massive bank losses and bailouts, the U.S. economy stagnating and its equity markets close to free-fall, the answer of Chuck Prince, former Citigroup chair, that “we danced until the music stopped” has not mollified either Occupy Wall Street or the FHFA, or anybody else for that matter.

It is obvious that they did keep dancing.  But it leaves unanswered the question: Why did it make sense to them to keep dancing?  And also: When the music did finally stop, how did we manage to have asset-backed derivatives contracts outstanding with an estimated value of three times the size of global GDP?

The answer was that thanks to the structure of their compensation, major bank CEOs were obsessed with their stock price and trying to keep beating expectations until the music stopped.  And the asset-based derivatives market was their clever device for beating expectations for much longer than could have happened before – because it was the world’s first market of infinite size. And it worked for them.  When the music stopped and expectations came crashing down, they were by and large wildly rich.

Public companies, such as FHFA’s target list, operate in two markets.  In the real market, they produce and sell real services – like mortgages and mutual funds – for real customers – like you or me or your company – who pay them real money, which, in a successful company, results in a real profit at the end of the year. They also play in an expectations market, where investors observe what is happening to the company in the real market and, on the basis of that, form expectations about what will happen in the future. It is the collective expectations of investors that determine the company’s stock price.

While most assume that stock-based compensation is an incentive to improve real performance, it isn’t.  It is an incentive to increase expectations about future performance because an executive’s stock-based compensation will be worth a penny more than when it was awarded only if the executive can cause expectations to rise. So the primary incentive at all times for executives with heavy stock-based compensation is to increase expectations – even when expectations are so high they can never be met.

So how heavily stock-driven were the bank CEOs?  There is very nice data in the study of the compensation and stock sales of the CEOs of the 14 leading American financial institutions by scholars Sanjai Bhagat and Brian Bolton. Seven of the American financial institutions accounting for 94% ($116B) of the FHFA suit totals for the American firms ($123B) are included in their study (Bank of America, Citigroup, Countrywide Financial, Goldman Sachs, JP Morgan Chase, Merrill Lynch and Morgan Stanley).  It shows that over the 2000-2008 period, the CEOs of these seven companies were making small fortunes by exercising options and selling stock – an average of $139M per CEO. That is almost double what they made in cash compensation ($78M apiece). They lost, on average, $83M in the market crash, causing some to argue that they weren’t taking excess risks because they had so much skin in the game. But it is hardly a compelling argument for a group that was left with net proceeds of the 2000-2008 period of $133M each, plus remaining stock holdings of $76M each.  Remaining personal wealth of $209 million is not bad given the massive destruction of value suffered by their shareholders and the American taxpayers.

So why did Chuck Prince feel so compelled to keep dancing? Shareholder expectations for Citigroup performance just kept rising.  During the 1990s, its stock increased 15-fold. Hence, expectations of future performance for Citi rose an incredible 1500%. And they increased another 50% between the beginning of 2000 and May 2007.  Goldman Sachs almost tripled between January 2000 and October 2007.  On the other side of the Atlantic, Barclays quadrupled in the 1990s and then more than doubled between 2000 and February 2007. These were universally sky-high expectations – and their stock-driven CEOs had to keep increasing expectations from the already sky-high expectations or their stock would fall, disappointing their overly optimistic shareholders and taking a chunk out of their wealth.

Because expectations take into account everything that investors now understand, the only way to increase expectations from the current level is to positively surprise investors – to produce results better than they couldn’t have expected.  That is awfully hard to do – especially if you did it last quarter and the quarter before that and the quarter before that.  And the financial services business is hardly like the smartphone business, which is growing so explosively that all players can experience dramatic growth simultaneously.  Consumers need only so many checking accounts, savings accounts, investment services and mortgages.  Companies need only so much credit, issue so much stock, and make so many acquisitions.  None of these are the possible source of repeatedly surprisingly great growth for the entire sector.  A given player can produce expectations-busting results by grabbing share but everybody can’t simultaneously – share change is a zero-sum game.

To keep producing positive expectations surprises, the leading financial firms had to create something unreal – something with no physical limits unlike the number of consumers, or real share certificates of real companies.  Their creation was the wide array of mortgage-based derivative instruments.  There was no limit to how much of it could be produced, sold and traded – trillions of dollars’ worth, in fact. As is chronicled in Goldman’s infamous Abacus transactions, all Goldman had to do is call up a crafty hedge fund and a couple of dumb insurance companies and create a product out of thin air to make some extra bucks while taking zero responsibility for any economic consequences. And since investors were not accustomed to the creation of infinitely large ethereal markets, they would be positively surprised for a while – maybe forever, the most delusional of CEOs might have hoped.

But nothing lasts forever – even an infinitely-sized product market – and boosted by enthusiastic and self-interested bank CEOs, expectations get overly high and then crashed spectacularly back to earth in 2008.  And the world is now dealing with an entirely new task: unwinding an expectations-driven market multiple times the size of the entire global real market. No wonder it ain’t going so great!

There is much discussion of tighter regulation of the banks, now that we’ve found out how damaging bad behavior on their part could be for the economy. One regulatory change would dwarf all of the others in protecting the economy: banning stock-based compensation for bank employees. It is not so much about how much they make but what incentives their compensation structures produce. Bank executives need to be turned back to managing the real market rather than dreaming up ways – and there will always be ways – of manipulating the expectations market and making off like bandits while the economy takes it in the teeth.

PHOTO: A demonstrator (C) holds a sign while two onlookers stand by during an Occupy Wall Street protest in lower Manhattan in New York October 3, 2011. REUTERS/Mike Segar


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This is a good article. I cannot add a thing. I do wonder why the US Government is being led around by the nose by these same bankers. If I had something that did me wrong like these bankers, I would push push it into a hole and bury it.

Posted by fred5407 | Report as abusive

Does anyone else find it ironic that working class voters will still vote to for less government regulation and lower taxes on these parasites?

Posted by codiusmonkius | Report as abusive

Thank you for a well written, comprehensible explanation of what happened to our banking industry. It makes me seethe to think about what was pulled on us. I’m sure those who profited are still laughing about it.

This gets to the heart of what the Occupy Wall Street protests are about, and why the protests don’t seem to be very focused. There’s no way to protest this complex type of fraud that was perpetrated on the citizens of the US and the world, but it’s imperative that those in power understand that they’ve been put on notice that change has to come one way or another. This isn’t going away. The perpetrators deserve much worse than just protestors marching outside of their castle gates.

Posted by doggydaddy | Report as abusive

GREAT article. In the era of e-funds and shady authorizations to shadier banks, anything and everything goes, and has – and the rest of us have paid for it.

As a former FDIC Chairman’s grandson, I FULLY support the #OccupyWallStreet movement and #OccupyTogether and a full independent audit of the 2008 and 2009 TARP proceedings. There was no oversight on TARP. Four-page applications were approved for multi-billion dollar loans. Criminals were bailed out and given time to shred and destroy whatever evidence they needed.

When this happened to Japan in 1992, such banks quickly gained a proper name – “zombie banks”. The failure of the government to reform these banks in Japan was a major contributor to their Lost Decade.

My grandfather was critical of Paulson’s handling of TARP, as was I, and Obama has not supported the movement to audit the Federal Reserve. We need to get banking back to banking, and end casino capitalism. Please continue to provide wonderful and thoughtful coverage on this issue, Reuters.

Posted by AndrewHall | Report as abusive

[...] Bank CEOs and the infinite pile of cash [...]

It seems to me that someone or something got over 2+ trillion of the taxpayer’s money, 196 billion doses not add up. I think the gangsters who made this scam should have to pay the 2+trillion back in full like other criminals have to pay restitution. This will give the taxpayer a break to stimulate the economy. WE THE PEOPLE / TAX PAYER know that interest and inflation are coming so it will be a long road for all of us. No one should get a free lunch or a get out of jail free card. We are in an Economic War and Congress and the President should not take this to lightly.

Posted by whogotmymoney | Report as abusive

[...] 5, 2011 – Read Full Article “While most assume that stock-based compensation is an incentive to improve real performance, [...]

To the Guillotine!

Posted by Raymond1959 | Report as abusive

By all accounts written, I come to the conclusion that the “zero-sum game” is as fraudulent as a Ponzi scheme.

I support the suggestion that stock-based compensation be eliminated in the banking industry. I would further suggest that market makers and insurance companies do not belong in the banking industry and roll-back in our regulations is in order.

Posted by OFA7 | Report as abusive

[...] CEO's de los bancos y la pila infinita de dinero [ing] 5/bank-ceos-and-t…  por hadasa hace nada [...]

[...] » noticia original Esta entrada fue publicada en Noticias por Harto de la crisis. Guarda el enlace permanente. [...]

[...] argument for a group that was left with net proceeds of the 2000-2008 … Read more on Reuters (blog) Nouriel 'Dr. Doom' Roubini on Why 'Karl Marx Was Right' by Simorgh5555 on Sun Oct [...]

This is a good article, but I don’t think it’s accurate to attribute all of the shortsightedness, mismanagement, greed, and undeniable fraud we’ve seen to stock based compensation. Shouldn’t we also be remember the deregulation of the banking industry, and how allowing institutions with massive amounts of cash (from our checking and savings accounts, mortgages, etc.) to experiment with these exotic instruments (derivatives, etc) might have contributed as much or more to the current situation?

I personally would rather see increased effort spent on reinstituting the firewalls that used to exist between these segments of the financial community. Shouldn’t that automatically limit the tools bankers have to increase their compensation, as well as protect main street?

Posted by SotaVol | Report as abusive

There are numerous studies studies of compensation and performance and they invariably show that the higher compensation the worse the performance. You can check out the study by Ariely and others commissioned by the Federal Reserve Bank of Boston for a starting point. If we go by the science, then the compensation packages are virtually guaranteeing poor performance. Why are these studies ignored by the Federal Reserve, boards of directors, etc? Possibly, because they don’t jive with their preconceived notions, but more selfish reasons come to mind.

Posted by weing | Report as abusive

OK, here’s the scoop – Pres Obama came in and hired the same
guys that put us in this situation – Geithner, Summers, and half of Goldman Sachs. Of course our Government looks after the banks – they ARE the government. That said, what a wonderful article – what a great idea to stop stock based compensation, if only… Always remember with these CEOs and top echelon bankers: it’s nothing personal, they’re just playing “The GAME”: “You 99% rabble should understand, you lost! You are losers. I am a winner. Accept it! It’s nothing personal, it’s JUST BUSINESS!”

Posted by klbjcb | Report as abusive

What a powerful analysis, Roger.

So clearly explained. And so plainly diagnosed for people like me who can’t understand a word about the banking industry as well.

I wonder why do you think that no one has offered this explanation or examination before now? I mean you are describing a cataclysm that is three years old. And an industry pathology that is – at least – a decade old. Why for example, is someone at the WhiteHouse, or the Congress, or the Senate, have provided this service to its citizens? Clearly it is not a problem of political ideology. It is a problem of practical ideology. The way regulation is planned, designed, implemented and amended.

And why is this article not posted on the New York Times, CNN, or FoxNews?

Your recommendation of banning stock compensation for bank employees, is clear about how it would alter incentives. But why stop at bank employees? [which include CEOs].

Would you not agree that this conflict of interest is hollowing out executive leadership at Fortune 500 Companies in all industries? Yahoo, HP, Kodak, all come to mind as misdirected by short term expectations. If you are right about bankers Roger, does your hypothesis apply to the valuations of Facebook, Twitter, GroupOn and the like as well?

Posted by mdavisburchat | Report as abusive

@weing – Point me to some of these studies and I’ll check them out, but I’m betting that they’re confounded by payments execs receive AFTER being fired (a year’s severance, guaranteed bonus payouts, accelerated vesting of equity, etc.). In other words, failure equals high pay, rather than high pay equals failure. Both are bad, but it’s inaccurate to say that “science” provides proof of your belief.

Posted by SotaVol | Report as abusive