Wall Steet Compensation: Gaming the System

I have written about the practice of re-labeling expenditures with a different, nicer sounding name. Financial service companies are masters at this practice. Want to advertise an eye-catching low interest rate. Use a different word for the finance charges. Labels such as: transaction fee, points, rebate, origination fee, can all be used as reasons take money from consumers without using the emotionally charged label “interest.”

Given that financial institutions are masters at re-labeling, I am completely mystified by their use of the word “bonus” in labeling parts of employee compensation. This past week John Thain was fired when it became public that the day before his failed company, Merrill Lynch, was taken over by Bank of America he dispensed over $4 billion in bonuses. At the same time, the full extent of liabilities Bank of America had assumed was not fully disclosed. Probably because no one really knows just how much bad debt Merrill Lynch owned. Bank of America, after discovering that it had acquired a deeper and possibly bottomless money pit than it previously thought, was forced to go back to the government and plead for more bailout money.

Meanwhile a report that total year-end bonuses on Wall Street exceeded $18 billion brought a rare public display of anger from President Obama and promises to rein in Wall Street compensation packages. The practice of executives rewarding themselves while their companies and clients are ruined is described succinctly in a Forbes Magazine piece titled “Five Legal Scams” by William Baldwin. One scam labeled “Heads I win” is this: “Be a hedge fund manager. Pocket 20% of the gains if you are lucky, but chip in for none of the losses if you aren't.”

Executives on Wall Street defend bonuses as being performance-based and necessary to attract top financial talent. Which makes me wonder why they haven’t re-labeled “bonuses” with the word “commission.” From their defense of the practice its sounds to me that the kind of compensation they are describing is known as a “commission” in most other industries. The public might wonder why anyone would pay for the kind of “performance” and “talent” that created the mess on Wall Street. But, if a car dealership went belly-up no one would dispute that the salespeople should still receive their commissions.

However, the fact that it has never occurred to these executives to use the word “commission” is a telling statement about the kinds of products they sell. Auto salespeople are paid commissions for selling a tangible product. Each car manufactured has a vehicle identification number that is recorded and tracked by the manufacturer, dealership, state government, insurance company, lien holder and owner. As cars arrive and leave the lot it is nearly impossible to fake selling them. It is difficult for dealers to simply make up sales figures.

For financial services firms, making up numbers to describe profits and losses is easily doable. As the financial system unravels it is apparent that many firms did make up numbers. The fact that someone like Bernie Madoff could get away with a $50 billion Ponzi scheme for more than a decade is telling about the lack of real accountability in the financial services sector.

Perhaps instead of a different label executives should rethink their compensation packages and incentives. As it stands now, workers and managers have an incentive to “game” the system. I have written in my book, The Two Headed Quarter, about what I call “The Numerical Outcome Principle.” Once a number is used to judge outcomes, people will adjust their behavior to maximize that particular number. The actual outcome no longer matters. Because numbers are so fluid on Wall Street that is exactly what happened.

Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy