Wall Street compensation needs major overhaul

Some welcome changes are starting to emerge in how executives at Wall Street firms are compensated. The top brass at Goldman Sachs, Merrill Lynch and other firms are pledging not to take bonuses this year, and Morgan Stanley says it will start reclaiming cash awards that were based on what turned out to be failed bets.

But those things don't go far enough to rid the system of the excessive pay that put this industry at the center of today's financial storm. That will come when all components of compensation are significantly reduced as part of a rethinking of how risk taking is rewarded.

"Everyone is dancing around what really needs to happen," said compensation consultant James Reda. "The bottom line is that they are getting too much money to begin with and that has to come down."

Because so much pay at the nation's banks and investment firms was based on the achievement of short-term results, that meant employees from the CEO to junior traders were more willing to take on larger risks in order to secure quick and lucrative rewards by way of cash bonuses and stock awards.

Had they had to consider the longer term, they might have been more resistant to rush into investments like mortgage-backed securities that are at the core of today's crisis. The plunging value of these investments have caused banks to falter and lending to dry up.

Conditions have gotten so severe on Wall Street that the government had to step in with a $700 billion taxpayer-funded bailout, which is giving banks access to capital so that they avoid a fate similar to now-bankrupt investment bank Lehman Bros. Holdings Inc.

"What's really different about this mess is that virtually all the financial institutions were busted by deliberate fleecing," said Gary Lutin, an investment banker who chairs a group known as the Shareholder Forum that addresses compensation issues. "We gave everyone running our economy short-term pump-and-dump stock incentives, and they did exactly what we paid them to do."

But getting Wall Street to alter its ways won't come easily, because these compensation practices are decades in the making. They began when many firms were run as private partnerships, which set compensation levels and distributed profits as they saw fit.

That structure never changed once they became publicly owned, and compensation only ballooned as executives demanded that they get as much or more than competitors.

Today's damaging publicity surrounding pay presents an opportunity for the boards of Wall Street firms - and companies throughout the United States - to look hard at their pay formulas. What they've come up with to date are baby steps toward change.

For instance, there have been a string of recent announcements that the top banking-sector executives wouldn't get any bonuses this year due to their companies' dismal performance.

Morgan Stanley's John Mack is among those not taking a bonus, and the compensation for the 14 members of the firm's operating committee will be down an average of 75 percent this year, according to a memo Mack sent to all of the firm's employees.

The firm also plans to tie compensation for all employees eligible for bonuses more closely to performance. That will include a new policy that will allow for "clawbacks." These would let the company reclaim any bonus paid to an employee if his or her actions led to "the need for a restatement of results, a significant financial loss or other reputational harm," the memo said.

Compensation experts call that a notable move, and hope that others on Wall Street follow suit. But they also point out that much more needs to be done to directly deflate pay over the long term.

Reda talks about how Wall Street CEOs have typically wanted their cash bonuses to be five to six times their salaries and their stock compensation to be valued at about eight times their salaries. Those kind of expectations need to be brought way down, he said.

Another route, suggests compensation expert Alan Johnson, would be to prevent executives from selling any of their stock holdings until at least two years after they've left their companies, and require a longer time frame for stock options to be exercised, like three to five years.

"If you have to keep most of your money in stock and can't sell, then you might have to get something done in order to get rich," Johnson said.

These kind of changes won't come overnight, but those leading these companies would be smart to consider them. They have to in order to prevent another financial crisis of this size.