HP Gets It Almost Right Compensating Meg Whitman as Its New CEO

I recently wrote about the effect on the mass of unemployed managers seeing Meg Whitman, an HP board member and ex-eBay CEO, become the new CEO of HP. Specifically, I claimed that it was painful for those unemployed former corporate executives to,

"see Whitman asked to take a lushly-compensated job for which even pundits on the business cable networks this morning assert she has no serious credentials to qualify."

So I was partially pleased to read in this morning's Wall Street Journal that Whitman is working as a dollar a year CEO.

Good for her, and good for HP's board.

Here's the rest of her compensation deal, as reported in the Online Journal today,

"Whitman also was granted options to buy 1.9 million H-P shares over eight years. She can’t cash out most of the options until H-P stock’s price reaches 120% or more of the company’s current share price. Whitman’s target bonus for fiscal 2012 is $2.4 million, H-P says."

The print version is slightly different. It says that HP stock has to rise by 40% to fully pay out. It also says the "maximum opportunity equal to 2.5 times the target, subject to performance criteria."

Well, it's close, but no cigar.

You see, were there to be an unexpected upsurge in the S&P, HP's equity price will be lifted, regardless of Whitman's accomplishments, along with the index.

What HP's board should do is condition Whitman's payout on HP's equity gaining 40% above the S&P over the period, and no more than, say, 2 out of the 8 years having a total return less than that of the S&P.

That way, Whitman is conditioned against both rises and declines in the S&P which would make the 40% target meaningless.

I don't frankly understand why boards full of allegedly smart members fail to insulate CEO performance from the obvious correlation of the firm's equity price with the broader market.

If Whitman can keep HP from declining as much as the S&P in a severe downdraft, or propel it 40% above a rising S&P, then that's worth the bonus she is being offered.

But it has to be flexibly conditioned to account for the S&P's performance, not simply fixed over time.

It's About Time!

Wednesday's Wall Street Journal contained an article disclosing that finally, after nearly ten years as inept CEO of GE, Jeff Immelt's incentive compensation is being tied to GE's performance relative to the S&P500.

In this post from early 2009, I discussed Immelt's compensation,

"As the Journal reported recently,



"In addition to not receiving a bonus for 2008, Mr. Immelt also suggested -- and the board agreed -- that he forgo a special three-year, long-term incentive payout that would have totaled $11.7 million.


Mr. Immelt, 53 years old, earned $3.3 million in salary in 2008 and hasn't received a raise since 2005. He's also receiving a $2 million equity award.


That's a 61% decline from his compensation in 2007 of $13.81 million, which included salary, the $5.8 million bonus and equity award."


Boo hoo. A 61% decline from his 2007 compensation. If you read my prior posts concerning Immelt's total compensation as GE CEO to date, you will see that he could do with a few years of no pay, and still be overly-compensated for the immense damage he's caused his shareholders.


It's truly staggering to think, based on that second chart, that the GE board could give Immelt any sort of 'award,' not to mention the gross overpayment of $3.3MM...."
 
I've argued for years that CEOs such as Immelt should have incentive compensation tied to beating the S&P500 total return over several trailing years.
 
Thus, even the newly-announced $7.4MM of GE options being conditionally granted to Immelt are, again, favoring the CEO to the detriment of the firm's long-victimized shareholders.
 
For instance, the Wall Street Journal reported,
 
"Under the new terms, 50% of the options will vest only if the company pulls in cumulative industrial cash flow from operating activities of at least $55 billion between the start of 2011 and the end of 2014.
 
The other half will vest only if GE's total shareholder return is equal to or better than that of the S&P500 over the same period."
 
Hilariously, the Journal stated,
 
"Mr. Immelt, who saw GE through a rocky patch during the recession, received his first bonus in three years in 2010."
 

Rocky patch? Immelt's firm had to be bailed out by the federal govenment, for God's sake! Look at the nearby chart comparing GE and the S&P500 Index for the past five years. Even from 2007, GE has underperformed the index.
 
How can the firm's board justify giving this failing CEO anything over his base salary for such poor performance?
 
The new options contain overly-generous terms, especially for a CEO who has, as you can read in this post from 2006,
 
"So that makes a total of roughly $23MM in cash Immelt has now managed to loot from his employer since late 2001, when he began his reign as a failing CEO at GE. If the firm meets certain (fairly low-ball, as I recall from earlier articles) revenue, earnings and cash generation targets, and meets some stock price performance relative to the S&P, Immelt will receive as much as $18.6MM in 2007."
 
Why have a cash flow-oriented bonus condition? All Immelt needs do for that is make some acquisitions which boost this measure. And only equalling the S&P's return is not sufficient for a single company's CEO to be rewarded. The S&P is a broadly-diversified index, while GE is just one firm, leading to more risk for holding it rather than an index. At a minimum, Immelt's total return hurdle ought to be risk-adjusted for the variance of its total return. An easy way to do this is to set an average total return divided the standard deviation of that return over the time period equal to or better than that of the S&P for the same period.
 
Once again, we see that the GE board is behaving like a bunch of shareholder-looting cronies. Even when they pretend to make Immelt's incentive compensation conditional, it's on terms which are too forgiving. For such a large industrial firm, you'd think they could manage some theoretically-sound terms which reflect a basic understanding of finance.

Two Interesting WSJ Pieces On Financial Sector Regulation

Wednesday's Wall Street Journal editorial page featured the regular matched editorials by Holman Jenkins, Jr., and uber-liberal Frank Thomas.

While Jenkins wrote a thoughtful, insightful piece, as usual, what was surprising was Thomas' unexpectedly reasonable call for a return of Glass-Steagall.

I found Jenkins' editorial refreshingly candid on why it's Congress that "doesn't get it" about some bankers' compensation, and not the other way around.

He bluntly observed that taxpayers made money, via the Fed, on the assets whose depressed values got so many investment and commercial banks into trouble. That the Fed had record profits of $52B in 2009. A fact about which the administration and the Fed are being rather, well, quiet.

As Jenkins points out, like it or not, traders and investment bankers are highly mobile, so when they add value, they will either be paid commensurately, or leave for another outfit. And let's also be candid about who would do a better job devising admittedly imperfect compensation schemes- government or management? It's going to be management, because they have a vested interest in keeping their talent.

Meanwhile, the usually-ludicrous Thomas actually argued for something sensible. Something my friend B and I have been discussing for over a year. Call it a return of Glass-Steagall, or simply prohibiting any financial institution which enjoys the benefit any government support or insurance scheme, e.g., FDIC, Fed window access, etc., from engaging in: proprietary trading, securities underwriting or any other non-plain-vanilla lending.

Thomas is right to note that Bill Clinton's solemn intonation in 1999 about Glass-Steagall was completely wrong,

"worked pretty well for the industrial economy....But the world is very different."

Granted, as usual, Thomas wrongly blames a general rush to deregulation.

In this case, it was actually the concerted efforts of some stupid commercial banking CEOs who largely failed to understand, or deliberately ignored, that allowing more, and less-capable capacity into proprietary trading and general securities underwriting would cause disastrous systemic consequences for both businesses.

There are ways in which you could allow wholly-owned, separate subsidiaries of commercial banks to do these businesses, but the key would always be two-fold: no leverage, and no government backstops, insurance or aid of any kind, should the riskier units go down. Their failure would have to be fully absorbed by the units' equity, with no debt left unpaid.

It's simpler, of course, to simply forbid insured, government-assisted financial entities from those businesses. But it really is time to restore a functional equivalent of Glass-Steagall.

More than any current regulatory so-called reform afoot in Congress, this one act would do more to minimize the consequences of the inevitable future systemic financial disasters than any other suggestion in circulation today.

Henry Mintzberg On Executive Bonuses

It's rare that I read a Wall Street Journal article that is almost completely wrong-headed, but recently, I found one. It was in the November 30th edition's special section, entitled "No More Executive Bonuses!" by Henry Mintzberg. Mr. Mintzberg is a professor at McGill University in Montreal, Canada.

Here's how Mintzberg begins his half-page-plus rant,

"These days, it seems, there is no shortage of recommendations for fixing the way bonuses are paid to executives at big public companies.

Well, I have my own recommendation: Scrap the whole thing. Don't pay any bonuses. Nothing.

This may sound extreme. But when you look at the way the compensation game is played—and the assumptions that are made by those who want to reform it—you can come to no other conclusion. The system simply can't be fixed. Executive bonuses—especially in the form of stock and option grants—represent the most prominent form of legal corruption that has been undermining our large corporations and bringing down the global economy. Get rid of them and we will all be better off for it."

I have a lot of problems with large cash or even equity bonuses awarded for short term performances and, if equity, vesting for sale in only a year or two. But I'd hardly go so far as to eliminate bonuses entirely. And Mintzberg never provides evidence for his claim. None. There's no empirical evidence anywhere in his screed.

His next interesting passage reads,

"First, they play with other people's money—the stockholders', not to mention the livelihoods of their employees and the sustainability of their institutions.

Second, they collect not when they win so much as when it appears that they are winning—because their company's stock price has gone up and their bonuses have kicked in. In such a game, you make sure to have your best cards on the table, while you keep the rest hidden in your hand.

Third, they also collect when they lose—it's called a "golden parachute." Some gamblers.

Fourth, some even collect just for drawing cards—for example, receiving a special bonus when they have signed a merger, before anyone can know if it will work out. Most mergers don't.

And fifth, on top of all this, there are chief executives who collect merely for not leaving the table. This little trick is called a "retention bonus"—being paid for staying in the game."

Mintzberg does a tricky thing here, which is to mix performance bonuses with other types of special payments, such as for exits, mergers, or merely staying. I am with him on eliminating these types of bonuses. But, frankly, that's not what I believe is the major concern of most observers. And retention bonuses are really a non-performance version of performance bonuses, i.e., they are normal annual occurrences.

As for the performance bonuses, the first comment is irrelevant. I honestly don't know what it means for bonuses. But on the second point, I have argued since 1997, in an article I wrote for Russ Reynolds' Directorship Magazine, that the appropriate manner of paying executive bonuses is for them to include the following:

1. Cover a five year period.
2. Be measured as total return.
3. Performance for the period must be above the S&P500 total return.
4. If performance is for a year, then the bonus is to be paid in equity which can't be sold for five more years.
5. If performance is measured for the trailing five years, it may be paid in cash.

By these guidelines, a CEO can't pump the company's performance for just a year or two, collect cash or sell the bonus stock shares, and watch as shareholders experience subsequent negative absolute or, relative to the S&P, total returns as the after effects of his actions become clear.

Mintzberg then lists what he believes are "faulty assumptions" surrounding performance measurement and bonuses,

"But I believe that all these efforts are doomed to fail as well. That's because the system, and any proposals to fix it, must inevitably rest on several faulty assumptions. Specifically:

• A company's health is represented by its financial measures alone—even better, by just the price of its stock.

Come on. Companies are a lot more complicated than that. Their health is significantly represented by what accountants call goodwill, which in its basic sense means a company's intrinsic value beyond its tangible assets: the quality of its brands, its overall reputation in the marketplace, the depth of its culture, the commitment of its people, and so on.

But how to measure such things? Accountants have always had trouble when they have tried, as have stock-market analysts, investors and even potential purchasers of the company. (That's one of the reasons so many mergers fail.) No board of directors is going to have much luck finding that elusive measure, either."

This is just silly. We know that the market value of equity represents the value of a share of a company, as determined by both those wishing to buy or sell the equity. Mintzberg obsesses about book value and accounting issues, but simply ignores the fact that market values just is the current value, in consideration of expectations of future value. And it does, indeed, represent intangibles, in an accounting sense, but valued in dollar terms by the market.

"• Performance measures, whether short or long term, represent the true strength of the company.
For years, the idea was that a company's short-term performance represented its long-term health. The banks and insurance companies have pretty much laid that assumption to rest.

So now there is focus on trying to link bonuses with longer-term measures. Well, I defy anyone to pinpoint and measure such performance in any serious way and attribute it to one or a few executives.

How do you assess the long-term performance of a chief executive? Some proposals look at three years, others as many as 10 years. But can we even be sure of 10 years? Is a decade long enough in the life of a large company, with all its natural momentum? How many years of questionable management did it take to bring General Motors to its knees?"

Again, Mintzberg misses the larger point. CEOs are responsible, accountable and have the authority for resource allocation and performance of the firms they lead. Different boards may choose different timeframes, depending upon their products and markets, over which to measure performance and grant bonuses. But just because Mintzberg can't conclude there is one best timeframe doesn't mean each board can't arrive at a suitable one for their situation.

The best may be the enemy of the good in Mintzberg's eyes, but it need not be for board members.

"• The CEO, with a few other senior executives, is primarily responsible for the company's performance.

What if the CEO was lucky enough to have been in the right place at the right time? When it comes to a company's current performance, history matters, culture matters, markets matter, even weather can matter. How many chief executives have succeeded simply by maneuvering themselves into favorable situations and then hanging on while taking credit for all the success? In something as complex as the contemporary large corporation, how can success over three or even 10 years possibly be attributed to a single individual? Where is teamwork and all that talk about people being "our most important asset?"

More important, should any company even try to attribute success to one person? A robust enterprise is not a collection of "human resources"; it's a community of human beings. All kinds of people are responsible for its performance. Focusing on a few—indeed, only one, who may have parachuted into the most senior post from the outside—just discourages everyone else in the company. "

Nobody said a company can't give bonuses to each worker. Some smaller firms do precisely that. It is argued by those CEOs that it's only fair that every worker be similarly motivated along with senior executives.

So, again, Mintzberg sets up a straw man argument, but overlooks an obviously better, actually workable one.

On that topic, later, he writes,

"One alternative, of course, is to pay bonuses to everyone, perhaps according to their base pay. That solves one problem but not another: how to ensure that the goodwill is not being cashed in by everyone, collectively. Once again, who is to come up with the measures that assess performance correctly?

So, again, there is but one solution: Eliminate bonuses. Period. Pay people, including the CEO, fairly. As an executive, if you want a bonus, buy the stock, like everyone else. Bet on your company for real, personally."

Again, there is a solution- set an appropriately lengthy timeframe over which performance is measured. It's really very simple. Also, the board can adjust these measures as they observe how the performance bonus calculations are working.

He does, however, mention one thing which is hardly new, but is sensible. It's the only paragraph in the entire editorial with which I agree.

"People pursue the job of chief executive for all kinds of reasons: the prestige of the position, the sheer pleasure of heading up a major company, the chance to make a real difference to an institution they cherish, and, of course, remuneration. When push comes to shove, do you think pay is more consequential to these people than the other factors? All this compensation madness is not about markets or talents or incentives, but rather about insiders hijacking established institutions for their personal benefit."

It's no secret that boards are often composed of CEOs of other companies. Thus, when a board hires a compensation consultant, and that consultant recommends all manner of higher compensation to "attract" CEO talent, these higher levels of CEO compensation bleed into the other companies over time. Voting for higher pay for a CEO by a sitting board member who is also CEO of another firm is almost like voting her/himself a similarly higher compensation level.

This is one area in which all shareholders are injured by the nature of boards. The fact is that most CEOs would gladly take their job at 2/3 or 1/2 the total compensation they now receive. They just don't talk about it publicly.

On a related note, yesterday, on CNBC, I heard a debate considering some recent speech on senior executive compensation, bonuses, and greedy behavior allegedly given by inept, underperforming GE CEO Jeff Immelt.

One of the program's guests accurately fired off a remark to the effect that Immelt has already hauled down enough from GE's overly generous board (see my posts labeled "Immelt") to be able to speak sanctimoniously. And he hasn't offered to give back the overcompensation for actually reducing his shareholders' wealth.

For the record, I believe CEOs should be paid no more than about $350,000 in cash. Period. No special bonuses in cash.

Then, their incentive compensation should follow some variant of my recommendations in the early part of this post. That is, equity in some percentage of the difference between their 5-year average total return for shareholders and that of the S&P for the same period. If the measurement period is annually, then the equity should only vest after five years. If the measurement period is five years, then the bonus may be ex post, in cash.

The important elements are a smaller absolute cash amount than is typically paid now, and an incentive bonus which is tied to multi-year performance, measured by total return, in excess of what a shareholder could have received from merely holding the S&P. The difference might even be increased to adjust for the risk of holding the company's equity in isolation.

Business Odds & Ends

Quite a bit of flap has arisen in business circles over the administrations "pay czar" slapping 90% salary cuts on a number of executives at firms which requested or took government aid, e.g., GM, Citigroup, AIG, BofA.

If anything, this illustrates the point of this post back in April about a lack of boundaries between government and business. I wrote,

"In my opinion, as well as others, such as William McGurn of the Wall Street Journal and even liberal Nobel Economics Laureate Joseph Stiglitz, the bankruptcy option has been avoided far too much in the past twelve months.

Bear Stearns, Lehman, BofA, AIG and Citigroup, upon appealing to the federal government for assistance, should all have been referred to bankruptcy court or the FDIC for closure. GM and Chrysler, too, should be in Chapter 11.

Somehow, corporate executives have come to expect their government to play favorites, pick winners, and temporarily prop up failing companies, rather than admit their own mistakes and close up shop.

By failing to observe the boundaries of responsible corporate behavior, boards of directors and CEOs unwisely opened a Pandora's Box of problems by requesting government financial aid.

This left them open to having their operations and decisions overseen and scrutinized by political officials who have used the excuse of looking after taxpayer money in order to move our economy down the road of fascism.

At the same time, government officials, beginning with the Bush administration, and continuing into the current one, have unwisely consented to helping private corporations, rather than declining, and sending them to their fate in the financial markets or bankruptcy courts.

By failing to observe the clear line between private and public spheres of activity, our government officials have compromised our economic system and given into the temptation to begin manipulating companies for political purposes and pet political agendas."

Right now, the political agenda on display is liberal America's desire to limit executive compensation. And, frankly, the companies involved right now deserve this treatment.

They ran themselves into a condition worthy of bankruptcy court. They begged for government aid. Now, having availed themselves of taxpayer funding, they have no excuse for having compensation become a political weapon to be used against their employees.

But I don't think there is any room for such government intervention in the rest of business.

You don't see the administration suggesting that entertainment or sports figures have their compensation limited, do you?

On another topic, I saw a laughable little piece on CNBC the other day. The topic was women in business, featuring some female MD from Deutsche Bank's derivatives unit.

Hilariously, the woman, whose name I cannot recall, blathered on about how a woman can now take time out of her career to have children, return to the workforce, and still reap substantial corporate success.

Michelle Caruso-Cabrera, a CNBC co-anchor, laughed and retorted that the only truly successful executives of either gender of whom she knew basically slaved like dogs, worked unending hours for years, sacrificed their family lives in order to climb to the top of the executive ladder at an investment bank. The other CNBC on-air personnel bobbed their heads in agreement.

The Deutsche Bank woman protested that this was wrong, and here she was, an MD at DB, to prove them wrong.

Look, let's be honest. DB is no Goldman Sachs, Morgan Stanley, or Blackstone. It's simply not a first-rank US investment bank or asset manager. DB is one of those second-rate-at-best, large European universal banks which bought a US bank, usually in distress. In DB's case, that would be the old, self-crippled Bankers Trust.

I don't think anyone equates rising to MD rank at DB with being a senior executive at Goldman, a first-rate private equity shop, or a hedge fund.

It's not clear just why CNBC even aired this segment. I guess they really wanted to focus on the notion that women can now rise to the top of an investment bank while happily and successfully juggling a family, too.

Unfortunately, I don't think women in senior management at truly first-rate investment banks, private equity groups or hedge funds would waste their time appearing on CNBC to crow about how much time they didn't work while rising to the top.

It seems to be very much a Groucho Marx sort of topic. Anyone foolish enough to self-identify as a successful female financial services exec who has it all probably either a) doesn't have it all, b) isn't that successful, or c) is about to have her career limited by appearing on CNBC to state that she has it all and is successful.

Samuelson's & Stout's Wrong Views On Executive Compensation & Related Matters

It's rare that the Wall Street Journal's editorial page carries two completely erroneously-reasoned, ill-logical and, frankly, bone-headed pieces in the same day. But yesterday was such a day.

The two editorials to which I refer, of course, are "Are Executives Paid Too Much?" by Judith Samuelson and Lynn Stout, and "We Cannot Delay Health-Care Reform" by Senators Max Baucus and Teddy Kennedy. I'll deal with the first piece in this post, and the second in a later one.

In order to make the most focused, germane comments possible, I'll intersperse my remarks between the italicized text from Samuelson's and Stout's article.

"Our economy didn't get into this mess because executives were paid too much. Rather, they were paid too much for doing the wrong things."

This is true. I have long held, going back to the early 1990s, well over fifteen years ago, as a result of my proprietary equity research, that senior executives should be granted incentive compensation as a function of a five-year-lagged difference between their firm's total return and the S&P500 Index. Thus, Samuelson and Stout are observing nothing new whatsoever.

"In the summer of 2006, well before most economists had any inkling of the calamity that was about to unfold, the Aspen Institute brought together a diverse mix of high-level business leaders, investment bankers, governance experts, pension fund managers, and union representatives. When you put successful people with such disparate and conflicting backgrounds and loyalties together in the same room, the result can be a shouting match. But the members of the newly formed Aspen Corporate Values Strategy Group found they shared an unprecedented consensus: Short-term thinking had become endemic in business and investment, and it posed a grave threat to the U.S. economy."

I wonder what a "governance expert" is? Who is s/he? What are such a person's credentials? This seems like another one of those loony "institutes" cooked up by so-called experts on the outside, with no prior, inside experience actually doing any of that about which they opine.

Honestly, the term "Aspen Corporate Values" seems a contradiction in terms to begin with. The entire name of the group seems an amalgam of feel-good, sound-good business terms with no discernible meaning.

"This collective myopia had many causes. One cause, the Aspen Group concluded, was the demands of the very shareholders who are now suffering most from the stock market's collapse. It is extremely difficult for an outside investor to gauge whether a company is making sound, long-term investments by training employees, improving customer service, or developing promising new products. By comparison, it's easy to see whether the stock price went up today. As a result, institutional and individual investors alike became preoccupied with quarterly earnings forecasts and short-term share price changes, and were quick to challenge the management of any bank or corporation that failed to "maximize shareholder value."

The authors are wrong in their basic contentions, as expressed in this paragraph.

It is precisely the company's total return that is the sum total and expression of whether the company is "making sound, long-term investments by training employees, improving customer service, or developing promising new products," as such activities add comparative value for that enterprise.

To denigrate the maximization of shareholder value per se is wrong. Short-term maximization, yes. Again, I wrote about this in a Directorship piece over fifteen years ago. But long term, consistently superior total returns is the hallmark of corporate success. Samuelson and Stout mention this basic, simple and rather obvious concept nowhere in their piece.

"Meanwhile, inside the firm, executives were being encouraged to adopt a similarly short-term focus through the widespread use of stock options. The value of a stock option depends entirely on the market price of the company's stock on the date the option is exercised. As a result, managers were incentivized to focus their efforts not on planning for the long term, but instead on making sure that share price was as high as possible on their option exercise date (usually only a year or two in the future), through whatever means possible.

Executives eager to maximize the value of stock options began adopting massive stock-buyback programs that drained much-needed capital out of firms; jumping into risky "proprietary trading" strategies with credit default swaps and other derivatives; cutting payroll and research-and-development budgets; and even resorting to outright accounting fraud, as Enron's options-fueled and stock-price obsessed executives did."

The authors mix too many examples from vastly differing sectors, and attempt to give the impression all are alike. They are not. Rather than provide credible evidence, the authors simply advertise their lack of understanding of business.

And, for the record, next time, ladies, use the correct, pre-existing English language term, "incented," rather than the made-up, goofy-sounding "incentivized."

Did "massive stock-buyback programs" drain "much-needed capital out of firms?" Perhaps not. When managers believe that their firm's equity is undervalued, it is a reasonable use of resources to buy some of that equity back, then reissue it when investors realize the intrinsically higher value later on. Of course, if an inept management is, in fact, destroying value, then buying back stock hastens the proper result- withdrawal of capital from an ailing firm.

Samuelson and Stout miss this fact entirely, railing instead at any withdrawal of capital from any enterprise. In effect, the authors of the editorial seem to claim omniscience, implying that any cost-cutting of R&D budgets, staff, or mitigation of risk with reasonable employment of hedges via derivatives, are wrong on their face.

The business world is not that simple, but, evidently, Samuelson and Stout are, in their own mindset.

"The system was perfectly designed to produce the results we have now. To get different results, we need a different system.

To get business back on track, the Aspen Group concluded, it is essential to focus on not just one but three strategies: designing new corporate performance metrics, changing the nature of investor communications, and reforming compensation structures.

Starting with metrics, we need new ways to measure long-run corporate performance, rather than simply relying on stock price. In terms of investor communications, companies need to ensure corporate officers and directors communicate with shareholders not about next quarter's expected profits, but about next year's and even next decade's."

The authors begin this passage correctly. A change is required, and it is the change about which I wrote for my Directorship article over a decade ago. It's simple and requires no new measures, just the extension of the measurement of existing ones over more years, and subtracting the free ride of the S&P500's effect on corporate total return over five-year periods, in arrears.

The idea that any corporate officer can speak with clarity and credibility concerning expected profits over a year in the future is ludicrous. A decade? What are these women smoking? The only thing that would arise from such practices is frivolous shareholder lawsuits.

Oh, wait. I get it. Lynn Stout is a professor of corporate and securities law at UCLA. Makes sense. Demand that business executives make more litigation-producing earnings forecasts. Great business for law school grads, eh?

Only a lawyer out of touch with real business could write that and believe it has any relationship to the modern, fast-paced world of global business. Company fortunes can change in just a few years, due to competitive actions half a world away.

"Finally, and perhaps most importantly, companies must change the ways they reward not only CEOs and midlevel executives, but also institutional portfolio managers at hedge funds, mutual funds, and pension funds. Executives and managers should be rewarded for the actions and decisions within their control, not general market movements. Incentive-based pay should be based on long-term metrics, not one year's profits. Top executives who receive equity-based compensation should be prohibited from using derivatives and other hedging techniques to offload the risk that goes along with equity compensation, and instead be required to continue holding a significant portion of their equity for a period beyond their tenure."

Huh? You're going to forbid an executive from hedging stock options? I seriously doubt that is legal. And, anyway, all that will happen is that they will find a way, or some smart trust attorneys (wow, there are those smart lawyers again) will find it for them, to have an unrelated trust or a family relation hold the hedged position.

And how in the world can you not compensate "institutional portfolio managers at hedge funds, mutual funds and pension funds" based on their correct bets on market index movements? Not everyone invests directly in equities. Or even equity options. Some managers simply buy and sell indices and their options.

Mutual fund managers rarely, if ever, are paid incentive compensation by customers. Perhaps by the firm's managment, but not the customers directly. Hedge and pension fund managers, if they have 2/20 compensation, typically have their "20" subject to a high water mark, i.e., they can't get incentive compensation when the value of the fund declines, until the fund value rises above the prior highest value. Some funds even have escrows which hold back the 20% incentive fees for a year or more, so the manager doesn't even receive that money if short results are reversed. Samuelson and Stout once again display their naivete about that which they write so emphatically.

It's clear Samuelson and Stout aren't living in the real world of business and finance. Perhaps too much time in that Rocky Mountain air?

"So long as our metrics, disclosures and compensation systems encourage executives and institutional fund managers to look only a year or two ahead, we have to expect that that is what they'll continue to do. It's time for a long-term investment in promoting long-term business thinking."

Well, their conclusion is correct. But, as I noted in my first remarks to their opening paragraphs, this is not a new idea by a long shot. Their overall goal is fine, but their details are all wrong. And completely lacking in common sense, real world applicability, and credibility.

I wonder how this piece of bad reasoning ever made it onto the Journal's editorial pages.

Carl Icahn On Boards, Governance & Compensation

Activist investor and former corporate raider Carl Icahn weighed in on executive compensation, boards and corporate governance again in this past weekend's edition of the Wall Street Journal. Building on the recent government-mandated restrictions on compensation for executives of banks receiving Federal investment, Icahn renewed his calls for corporate governance reform.

As he did in the editorial on which I commented in this post only a few weeks ago, Mr. Icahn writes scathingly of entrenched boards and executives. This time, he highlights his own organization, United Shareholders of America, urging readers to join it and him.

While I respect Mr. Icahn's accomplishments, attitudes and actions, the problem I continue to have remains what I wrote in the prior, linked post,

"It all sounds good, and very patriotic. But, really, just how do thousands of individual shareholders mount an attack upon a few members of the board of a large corporation?

Why isn't plain old share price the best investor weapon? Sell shares of companies you don't want. If enough shareholders do this, and other investors short the stock, the price will fall to a level that makes current management vulnerable; to creditors, predators, or simple liquidation, at which point some better management team swoops in to recover any salvageable value.

What's wrong with this scenario? Isn't it the ultimate in capitalist retribution? A poorly-run company simply loses value, until it no longer has capital with which to operate?"

I just don't see how shareholder maneuvering accomplishes anything, unless you happen to be able, like Mr. Icahn, to buy sufficient shares to challenge the board, gain a seat, etc.

But isn't this just exchanging one small group of controlling people for another? What if you don't happen to agree with Mr. Icahn on his choice of targets?

It just seems to me that really pure capitalism uses price- and little else- as the signal and weapon with which to discipline companies and their executives.

Isn't this process how it should work?

1. Company management entrenches itself while the board cooperates.
2. Management begins to enrich itself at shareholder expense, while business falters.
3. Business continues to weaken while executives continue to become wealthy.
4. Non-shareholders don't bid the company's equity up, while disgusted shareholders sell.
5. Equity price gradually, then more quickly, falls.
6. Executives can't raise fresh capital, losses mount, and firm becomes target for takeover.
7. Eventually, another company buys the ailing firm, or it files Chapter 11.

Short-circuiting this process via some sort of shareholder action seems, to me, beside the point. First, you're asking thousands of shareholders who don't know each other to agree on a common action.

It's one thing to want current management out. But what next? How do thousands of unacquainted company owners do this? They don't trust the board, but how do these thousands of individual owners assemble a workable new slate of directors?

It's feasible for Carl Icahn to do these things himself. He can amass large positions in target companies, assemble board candidates, and even articulate solutions for the company's ills. But that's not mass shareholder action. That's one wealthy activist or large fund manager behaving like Eddie Lampert.

How well is Sears doing since his takeover of the retailer?

Call me simple, but in my book, a liquid market with very low barriers to buying and selling shares is the best form of corporate governance.

Let equity prices do their work, and skip the heated arguments over more legislation and regulation over corporate boards and their actions.

Roy Smith On Investment Banking, Compensation & Greed

Former Goldman Sachs partner and current NYU finance professor Roy C. Smith wrote a lengthy piece in the weekend edition of the Wall Street Journal entitled, "Greed Is Good."

In his extensive piece, Smith paints the more complete and fair picture of the old Wall Street, a/k/a investment banks, compensation structure, in order to raise some warnings about the effects of the recent compensation caps, and predict some structural changes.

Among other points, Smith notes that many- perhaps thousands- of well-paid investment bankers at Bear Stearns and Lehman lost assets, jobs and companies. This, too, is part of the risk-taking environment which produced such lavish bonuses over the past few decades.

Smith also does a great job tracing the evolution of investment banking from when all of the firms were private partnerships. He, as I have done, notes the entry of commercial banks into traditional investment banking turf as the beginning of the end of the sector.

My mentor at Chase, Gerry Weiss, had predicted this years in advance. As the less-adept, more ham-handed commercial banks began to underwrite securities, margins shrank, volumes had to increase and instruments had to become more opaque in order to justify spreads and maintain revenues and profits.

Eventually, everybody levered up, and the once-private investment banks, having mostly gone public with the deregulatory "Big Bang" of the 1970s, mostly used other people's money to run much more risky businesses, while paying themselves healthy bonuses in good years.

Smith points out, with which I agree and have also stated, that the logical consequence of the recent vaporization of publicly-held investment banks, is a return to boutique, private partnership investment banking. The compensation caps really won't, by themselves, cause talent to leave the commercial banks for the private investment banks.

But they will set a tone that will probably trickle down. And, anyway, investment banking at a commercial bank simply isn't the same as doing it at a pure investment bank, even with the abolition of Glass-Steagal.

Smith endorses the practice of making large compensation payments vest over some years, in order to make them conditioned on continued profitability. Again, a topic on which I have written, in one form or another, for years. Specifically, I've recommended that large components of senior executive compensation be tied to outperforming the S&P500 over a five year period, in arrears. Thus, if performance lags, the payment in any given year for the prior five-year period shrinks. This is the sort of idea now gaining currency in the remaining publicly-held institutions having to grapple with this dilemma.

I like Smith's sense of history. He notes how the regulatory backlash to the 1920s and market crash of '29 resulted in relatively low financial services compensation until the 1980s. Which, by the way, was about the time the previously-privately-held investment bank partnerships began to swell with public money and pay more lavishly.

On the subject of the systemic risks taken by most, if not all, of these banks, which eventually came home to roost via mortgage-backed CDOs and such, Smith and I agree that, in the future, it's likely that such risk will be minimized only by the existence of many smaller investment banks, rather than a few large ones.

Even now, as I discussed with a Morgan Stanley employee at a social function this past Sunday, quite a few large hedge funds and private equity shops, not to mention the explicitly-identified boutique investment banks, stand ready to re-enter the riskier areas of underwriting and trading in the coming months and years. As private firms, they have no shareholders ranting at annual meetings, need justify their compensation to no external parties, and can only grow at the rate at which their private capital allows, plus judicious borrowing.

As Smith notes, the industry will reinvent itself, and, in fact, already has. My various posts about Blackstone and other private equity shops noted this as far back as the 2007 IPO of that large private equity enterprise.

In truth, as usual, what we see happening with compensation, regulation and risk management of the remaining former-investment banks-cum-commercial banks, Goldman and Morgan Stanley, and the crumbling commercial banks, Citigroup and BofA, is simply the tidying up of the worst-performing, hind-end of the sector. The better players and their capital departed those publicly-held firms over a decade ago, the better to ply their trade in stealth and away from excessive governmental intervention.

Though he didn't write that, I believe Mr. Smith would agree with me on that last point.

Revisiting Compensation: Lagging Incentive Comp To Match Long Term Performance

The Wall Street Journal's Scott Patterson wrote a piece in Wednesday's edition entitled "Securities Firms Claw Back at Failed Bets."

Mr. Patterson began his article by stating,

"As securities firms rein in risk-taking that ran amok when times were good, the use of clawback provisions is spreading, with Morgan Stanley and UBS AG rolling out rules that allow them to take back money paid to traders and other employees whose bets blow up later.

But the push to clean up an old problem on Wall Street may create some new ones. By giving themselves the power to reclaim bonuses and other compensation, firms might unintentionally make traders too skittish about taking even healthy risks, nudge some of the best talent out the door or encourage employees to conceal their losses, some observers warn.

"It would be hard for traders to hide losses for more than a year or two, but if we incentivize them to do so, they will find a way," said Frank Partnoy, a University of San Diego law professor who has written about corporate malfeasance.

The clawback "has far too long a memory and makes your most successful traders the most risk-averse," added Aaron Brown, a hedge-fund risk manager who used to work at Morgan Stanley."

I must admit, I have no concept of what Mr. Brown could mean. Isn't most of what has befallen traders, and the companies for which they work, in the last year or so too much focus on short term profits of trades, while disregarding the longer term ramifications?

In fact, in this year, of all years, it is ludicrous to be quoted publicly as saying that traders may not take enough risk in the future.

To me, the following comment in the article makes much more sense,

""We're making what we see as a good-faith effort to more closely tie employee compensation to longer-term performance," said Morgan Stanley spokesman Mark Lake.

I have argued for years, beginning with the application of my proprietary corporate performance research for consulting with CEOs, that incentive compensation needs to be vested some 3-5 years after the year in which it was earned. Shareholders benefit from consistently superior returns, not yo-yoing, inconsistent returns. Thus, Morgan Stanley finally seems to be on a credible, effective track for matching employee incentive compensation with shareholder interests.

Regarding other banks, Patterson continued,

UBS, which announced its clawback provision in November, will hold about two-thirds of eligible cash bonuses in an escrow account from which the Swiss bank will dole out payments based on employee performance and UBS's overall profitability."

"UBS acknowledged that its clawback rule could cut into short-term profits if employees become too risk-averse. Overall, though, the policy is expected to result in more consistent and less volatile long-term gains. Reginald Cash, head of U.S. investor relations at UBS, said the provision could create "some limit to chasing the last dollar on any given strategy." "

Again, this is precisely what shareholders should want. Long-tailed investment positions may be profitable trades in the initial year, but come back to haunt the company. Consider how many of the mortgage-backed securities or CDOs may have performed in their early years, versus their valuation changes in 2007 and -08.

Thus, anyone who argues that traders should not bear the risk of their positions in their compensation for the life of the positions is clearly not paying those traders with their own money. And doesn't care about shareholder interests, either.

This is an idea whose time is long, long overdue. In fact, even the name given the approach by financial services companies promotes incorrect thinking.

It's not 'clawing back' compensation from employees after the fact. It's releasing the incentive compensation in concert with each year's successful earning of the money by an employee, on a lagged basis.

Had this type of compensation approach been in place five years ago, there would have been much less damage from toxic structured financial instruments in the most recent cycle.

Dick Fuld's Miserable Performance On Capitol Hill

I happened to see/hear the first twenty or so minutes of former Lehman CEO Dick Fuld's appearance before a House Committee yesterday morning.

It wasn't pretty.


What's worse, it was entirely preventable.


Think about it. Dick Fuld had been Lehman's CEO since 1994. He possesses a hulking, intimidating physique, along with the reputation for being a fairly demanding taskmaster. You just don't see him as a soft, cuddly, sensitive type of CEO.

In appearing before Henry Waxman's (D-CA) House committee, Fuld must have known he was to be the sacrificial offering from the capital markets to the US voting populace.


Despite losing a large percentage of his personal fortune as Lehman's stock declined in value, and, ultimately, became worthless, Fuld has enough assets to hire a public relations firm.


Didn't Fuld know, as everyone else did, that the lead questions would be about Fuld's multi-hundred-million dollar compensation, relative to wrecking the US capital markets and banking system?


An old friend of mine with some Army training once told me about how soldiers are trained to respond to an ambush.

Attack!


The reasoning is, ambushed soldiers are probably going to die anyway. So they may as well immediately counter-attack the enemy, hoping for surprise, disorganized resistance, and confusion.

Fuld should have realized he was walking into an ambush. And, thus, attacked immediately.


Since Fuld had the initiative, because of his opening statement, he was in a perfect position to begin with something like these hypothetical remarks,


'Good morning Members.


I'm Richard Fuld, former CEO, since 1994, of now-defunct Lehman Brothers Holdings.


Rather than go into detail about my firm's role in the current financial markets turmoil, I want to address the issue which, I am quite sure, is on everyone's mind. And one with which you will, no doubt, wish to paint me as the lead villain in this drama.


"How can I justify my total compensation, while CEO of Lehman for 14 years, of nearly $500MM?"

I'm sure that to many Americans watching this hearing, I seem to be a prime example of what many call 'greed' and 'excess' in the US financial services sector. They, and you, will ask,

"How can anyone possibly be worth that much money? How could anyone do something that merits him earning nearly half a billion dollars over 14 years?"


Well, Members, and fellow Americans, let me start by saying I am not ashamed of earning that money. And I emphasize EARNING that compensation. I EARNED every penny of it.


I worked as CEO for Lehman Brothers Holdings. Not the Federal government, the Red Cross, or a small local retail shop in a neighborhood shopping mall.


Lehman Brothers was a publicly-traded company with many shareholders. A board of directors- not me- determined my level of compensation. The shareholders elected that board.


Over my term as CEO, I increased the value of Lehman shareholders' investment in my firm from $3/share in 1994 to, at its peak, $80/share last year. The market value of Lehman Brothers rose from $__B to $____B during that time.



The team I built at Lehman created that value for our shareholders. Much of my personal wealth was either paid in, and/or remained in Lehman stock.



On a percentage basis, of the $__B in shareholder value we created at Lehman, the total pool of bonuses over 14 years was $__MM. My own share of compensation, as a percentage of the increase in Lehman's market value, was __%.



In short, Lehman was in a business which allowed us to borrow money from banks and make a lot of money for people- institutions, pension funds of union workers, teachers, municipal workers, and others- who owned our stock. As such, our board of directors saw fit to pay us a small percentage, but, in actual dollar terms, large amounts of money, for doing so.



We, my team and I, and I, personally, were paid a small share of the value we created.

I feel very strongly that I, and my executive team and all the employees of Lehman Brothers, are a fine example of the American economic system. We were well-paid when we created value. We made money for those who invested in our company.



Does anyone begrudge a Hollywood director for making millions of dollars from a movie? Is Steven Spielberg here being cross-examined for making a huge fortune while directing and producing movies for which millions of people pay to see?



How about Steve Jobs, the CEO of Apple? Are you going to bring him in to face scrutiny for being a highly-paid CEO who created massive wealth for his shareholders?



I represent the successful pursuit of the American dream. I worked hard, built a good team, made money for my firm's owners, and was highly-paid for doing that.



That's supposed to be what a person with ambition, skill and luck can do in America.

I won't apologize for that.



Members, I made nearly half a billion dollars over 14 years because I worked hard and created value for others.



That is, I submit, much more than any of you have ever done in your jobs. I made more money than you do because I worked hard making money for others.



Who are you to judge, let alone ask, whether I made too much money? You are members of an institution- Congress- with an approval rating so low- 10%- as to be embarrassing to even BE a member.



Now, I will take your questions....."



In addition to this, were I Dick Fuld, I would have had my public relations consultant obtain whatever embarrassing and incriminating information available on Waxman and the other Democratic House members on the Committee. Republicans, too, for that matter.



Sadly, pathetically, Fuld began by reading from a dry, uninteresting history of his career with Lehman. He approached the Committee almost apologetically, meekly, and timidly.

Predictably, after his meandering opening statement, Waxman launched his first salvo in the form of a slide with Fuld's annual compensation, a recounting of the current situation, and the question,

"Is this fair?"

The video of this appears below.





What was Fuld thinking? He reduced himself to tentatively acquiesing to the correctness of the numbers, and argued that he had to exercise options. It looked bad. Really bad.

Granted, he made some of the points I make in my hypothetical speech. But it would have been so much more forceful had Fuld gotten there first with his own framework.



I don't particularly like Fuld. From yesterday's Wall Street Journal article detailing Lehman's summer activities- both public and hidden- it sure looks like Fuld and his team misled the investing public about Lehman's true health.



If it were up to me, Fuld and his senior managers would be charged with fraud, because they privately doubted their firm could survive, but publicly made statements otherwise.



But Dick Fuld's day in court is a different matter than his being lynched by innuendo in a televised House Committee hearing.



Fuld's performance- if you can call it that- was an embarrassment to himself, his firm and CEOs in general.

Myths About the Current US Financial Debacle

Two days of Congressional hearings have begun to wear heavily on my patience and tolerance for stupidity. The sight and sound of Chuck Schumer, the senior sitting idiot Senator from New York, chairing the proceedings and making statements calculated to play to the crowd, have sickened me.


As I've listened to hours of statements by Treasury Secretary Paulson, Fed Chairman Bernanke, SEC Chairman Cox, and a myriad of Senators and Representatives of both parties, as well as the two Presidential candidates, several incorrect, now-mythical aspects of the current US financial debacle are become frequently repeated and erroneously believed.


Myth 1: American consumers are, or should be, worried about the debacle, and have been directly hurt by CDOs and credit default swaps.


This was patently untrue, at least up until politicians began to keep dragging 'the average, hardworking American' into the fray. Few, if any, 'average Americans,' or 'hard working Americans' bought or hold CDOs or credit default swaps. Those who bought equities in failed institutions knew the risks they were taking by investing in equity markets. The financial services debacle is largely a sector problem, rather than a wide-ranging economic problem.


There have been some follow-on effects due to knee-jerk credit tightening by some financial institutions. And, yes, now that the clear impact of Congress' misguided insistence on the 'mark to market' rule has caused a loss of capital by lending institutions, credit is drying up.

But direct losses by most American consumers from the failure of Lehman, Bear Stearns, Fannie, Freddie, AIG, or Merrill Lynch's sale are non-existent, save for those who chose to work for those firms.


Myth 2: Congress can and should do 'something' about financial executive compensation, especially as taxpayer funds are being considered for buying distress-value mortgage-backed structured financial instruments.


Hard as this is for many people, including Congressional legislators and many Americans, this is not the business of non-shareholders of companies in the financial services sector. Shareholders bear the direct price of excessive executive compensation. Regulators functioned to oversee companies, and their executives. If those regulators saw no illegal activity, then there is no reason for the Federal government, with no proof of illegal activity, to arbitrarily 'take' compensation awarded by shareholders of private, publicly-held companies.

The last time Congress meddled with this, they created the options timing/pricing debacle. Remember when, similarly outraged, a prior Congress limited corporate tax deductions for executive salaries at $1MM? The result was to cause boards to issue generous stock options to executives, instead. When timing of the options pricing became tangled and complicated, Congress then punished that, too. It just never ends.

Perhaps Congressmen, knowing, down deep, how unemployable and inept they really are, harbor a badly-disguised envy and hatred of corporate executives who actually accomplish goals?

Finally, just how would Congress attempt to write a completely ironclad law with respect to executive compensation, in 48 hours, that will not have some overlooked loophole, or lead to some horrendous, unintended consequence. As most of their punitive legislation often does.


The proposed plan by Paulson and Bernanke is more of a 'buy, hold and resell' program, rather than just a straightforward, unrecoverable spending of $700B+ of taxpayer funds. As such, it is not a direct payment by taxpayers to already-richly-compensated financial service sector executives for having ruined their companies, damaged the sector, and general wreaked havoc with US fixed income and business lending activities.


Myth 3: Federal regulators knew that illegal or imprudent actions were being taken by commercial and investment banks, but silently let them continue said activities.


This is not true, per se. In the case of Fannie and Freddie, regulators attempted to raise warnings for over four years. However, Congressmen of both parties, but, particularly, those who received the largest political donations from those GSEs- Senators Chris Dodd and Barack Obama- and Representative Barney Frank, all ignored or otherwise rendered ineffective the regulators' warnings. As for investment and commercial banks, there was a buyer for every seller of a questionable mortgage, mortgage-backed security, or credit default swap.


Nobody put a gun to any buyer's head and forced her/him to purchase a financial asset which is now worth substantially less than it was when purchased.


Our economic system allows for individual action to be free of restraint, unless explicitly prohibited. The notion that the Federal government 'should have known what was going to happen' and, absent a crime, intervened, as Bill O'Reilly and others have harangued, is ludicrous. Millions of transactions occurred to create the current mess. Each was performed consensually by an adult or sophisticated investor. To baselessly prohibit these activities, if they were legal, would have been an inappropriate intrusion of government upon private sector activity.

As I wrote here recently, the ultimate risk management technique in financial transactions is 'investor beware.'


Myth 4: Thousands upon thousands of Americans are defaulting on mortgages because of losses in CDOs or swaps at large US commercial and investment banks or insurance firms, and should be 'saved' by interest rate reductions, mortgage loan amount reductions, payment holidays, or some combination of all three.

These two events are unrelated in the way that Congress and other pundits are describing. Yes, delinquencies and defaults by the marginal, risky borrowers with subprime, variable rate and/or alt-A mortgages, will affect the values of the layered-on securities which they underpin.

But causality does not run the other way. The manufacture, sale and purchase of mortgage-backed securities, and their subsequent creation of unmanageable amounts of counterparty risk, does not feed back to current borrowers.

Simply put, the trouble in the banking sector caused by unwise creation and trading of opaque structured financial instruments backed by mortgages in no way argues for forgiving either payments, rate levels, or other aspects of mortgages freely taken on by homeowners.

This is just a fallacy of apparent relationship. Some homeowners borrowed unwisely. Some investors bought securities backed by mortgages, some of which may default.

Hey, let's forgive both of them!

No, it doesn't work that way. Borrowers who borrowed unwisely must pay the price, else the lesson for them, and their children, will become,

'Yes, son/daughter, and if you get overextended on your mortgage, on the too-large home you buy, don't worry. The government will save you by either reducing your loan amount, or your rate.'

Does anyone really want this to be the lasting lesson of this recent overindulgence in residential homebuilding?

Myth 5: We suffering 'the greatest economic crisis in America since the Great Depression.'

No, we are not. We still, as of late September, 2008, are not in a recession, as measured conventionally by consecutive quarters of GDP growth.

Our politicians, beginning with the freshman Senator from Illinois, who, by the way, is apparently too young and inexperienced to know what a Depression looks like, continue to compare the current mess in one part of our economy- the financial sector- with the entire Great Depression.

Nothing could be further from the truth. If a recession is coming, it is going to be far from the Great Depression in severity or length. The current difficulties in the financial services sector are not, in and of themselves, a Depression.

If anything, today's financial services sector mess more closely resembles the late 1980s real estate market collapse. But it is, at root, a financial sector issue, not an economy-wide problem, per se.

How- and How Not To Manage Risk

Yesterday, on CNBC, one of their on-air guests uttered some of the worst ideas yet on risk management and regulation thereof. If I'm not mistaken, the guest was former Clinton-era economic advisor, Laura Tyson.

Ms. Tyson's bright idea was to have more detailed audits of each financial service company's risk management procedures by regulators.

Unfortunately, she seems not to have any working knowledge of how risk is really managed in the trenches of a modern investment, or even commercial bank.

For examples, look no further than Kidder Peabody last decade, or Merrill Lynch several years ago. In both cases, risk managers who dissented from business managers' desires to heighten exposures were either intimidated, as in the case of Kidder, or simply fired, as in the case of Merrill Lynch.

I happen to have actually known the risk manager of the unit which was responsible for the losses which Kidder suffered, thanks to Joe Jett's government instruments trading, while part of GE. His explanation of what happened, between squash games one night, was that, upon discovering positions which exceeded risk limits, he was simply told to shut up, or leave. Being subordinate to the operating unit's management, he had little choice. He looked the other way.

At Merrill Lynch only a few years ago, veterans Jeff Kronthal's and Doug DeMartin's forced departures solved the problems of risk management for business managers in the fixed income unit which was busily increasing the firm's exposure to newly-minted mortgages and their securitized final products.

Laura Tyson's bromides are worthless. It's not the printed risk management policies that matter at a financial institution.

Rather, it's how the risk management organization is structured, and to whom it reports. I don't know the details of Goldman's current risk management organization. But I have read several different accounts which confirm that the company puts a premium on objective, independently-housed risk management challenges to each trading and investment business. Risk and business managers swap jobs, in order to imbue each business manager with a fresh and recent perspective on the importance and practice of the risk management function.

Of course, it helped enormously when investment banks were private partnerships. Never so much as when their own money was at risk have investment banks practiced effective risk management.

However, like their commercial banking brethren, once becoming listed public entities, even investment banks learned that taking on excessive risk paid them, as employees and managers, while leaving shareholders owning any imprudent and, ultimately fatal exposure.

In my opinion, there is simply no substitute for risk managers being equal with business managers, capable of vetoing business decisions, and reporting up through a separate command chain to a Chief Risk Manager who reports to the CEO or CFO. To execute prudent, objective risk management, the function has to be separated, organizationally, from the businesses to which they are assigned.

Anything less will eventually become corrupted, no matter what the former Clinton economic official might see in her visit to an investment bank to audit their risk management policies, procedures and operations.