E. Stanley O’Neal, the former chief executive of Merrill Lynch, was paid $46 million in 2006, $18.5 million of it in cash. Daniel Acker/Bloomberg News
Dow Kim received $35 million in 2006 from Merrill Lynch. Bloomberg News
Brian Lin is a former mortgage trader at Merrill Lynch who lost his job at Merrill and now works at RRMS Advisors. Patrick Andrade for The New York Times
By LOUISE STORY Published: December 17, 2008
“As a result of the extraordinary growth at Merrill during my tenure as C.E.O., the board saw fit to increase my compensation each year.” — E. Stanley O’Neal, the former chief executive of Merrill Lynch, March 2008
For Dow Kim, 2006 was a very good year. While his salary at Merrill Lynch was $350,000, his total compensation was 100 times that — $35 million.
The difference between the two amounts was his bonus, a rich reward for the robust earnings made by the traders he oversaw in Merrill’s mortgage business.
Mr. Kim’s colleagues, not only at his level, but far down the ranks, also pocketed large paychecks. In all, Merrill handed out $5 billion to $6 billion in bonuses that year. A 20-something analyst with a base salary of $130,000 collected a bonus of $250,000. And a 30-something trader with a $180,000 salary got $5 million.
But Merrill’s record earnings in 2006 — $7.5 billion — turned out to be a mirage. The company has since lost three times that amount, largely because the mortgage investments that supposedly had powered some of those profits plunged in value.
Unlike the earnings, however, the bonuses have not been reversed.
As regulators and shareholders sift through the rubble of the financial crisis, questions are being asked about what role lavish bonuses played in the debacle. Scrutiny over pay is intensifying as banks like Merrill prepare to dole out bonuses even after they have had to be propped up with billions of dollars of taxpayers’ money. While bonuses are expected to be half of what they were a year ago, some bankers could still collect millions of dollars.
Critics say bonuses never should have been so big in the first place, because they were based on ephemeral earnings. These people contend that Wall Street’s pay structure, in which bonuses are based on short-term profits, encouraged employees to act like gamblers at a casino — and let them collect their winnings while the roulette wheel was still spinning.
“Compensation was flawed top to bottom,” said Lucian A. Bebchuk, a professor at Harvard Law School and an expert on compensation. “The whole organization was responding to distorted incentives.”
Even Wall Streeters concede they were dazzled by the money. To earn bigger bonuses, many traders ignored or played down the risks they took until their bonuses were paid. Their bosses often turned a blind eye because it was in their interest as well.
“That’s a call that senior management or risk management should question, but of course their pay was tied to it too,” said Brian Lin, a former mortgage trader at Merrill Lynch.
The highest-ranking executives at four firms have agreed under pressure to go without their bonuses, including John A. Thain, who initially wanted a bonus this year since he joined Merrill Lynch as chief executive after its ill-fated mortgage bets were made. And four former executives at one hard-hit bank, UBS of Switzerland, recently volunteered to return some of the bonuses they were paid before the financial crisis. But few think others on Wall Street will follow that lead.
For now, most banks are looking forward rather than backward. Morgan Stanley and UBS are attaching new strings to bonuses, allowing them to pull back part of workers’ payouts if they turn out to have been based on illusory profits. Those policies, had they been in place in recent years, might have clawed back hundreds of millions of dollars of compensation paid out in 2006 to employees at all levels, including senior executives who are still at those banks.
A Bonus Bonanza
For Wall Street, much of this decade represented a new Gilded Age. Salaries were merely play money — a pittance compared to bonuses. Bonus season became an annual celebration of the riches to be had in the markets. That was especially so in the New York area, where nearly $1 out of every $4 that companies paid employees last year went to someone in the financial industry. Bankers celebrated with five-figure dinners, vied to outspend each other at charity auctions and spent their newfound fortunes on new homes, cars and art.
The bonanza redefined success for an entire generation. Graduates of top universities sought their fortunes in banking, rather than in careers like medicine, engineering or teaching. Wall Street worked its rookies hard, but it held out the promise of rich rewards. In college dorms, tales of 30-year-olds pulling down $5 million a year were legion.
While top executives received the biggest bonuses, what is striking is how many employees throughout the ranks took home large paychecks. On Wall Street, the first goal was to make “a buck” — a million dollars. More than 100 people in Merrill’s bond unit alone broke the million-dollar mark in 2006. Goldman Sachs paid more than $20 million apiece to more than 50 people that year, according to a person familiar with the matter. Goldman declined to comment.
Pay was tied to profit, and profit to the easy, borrowed money that could be invested in markets like mortgage securities. As the financial industry’s role in the economy grew, workers’ pay ballooned, leaping sixfold since 1975, nearly twice as much as the increase in pay for the average American worker.
“The financial services industry was in a bubble," said Mark Zandi, chief economist at Moody’s Economy.com. “The industry got a bigger share of the economic pie.”
A Money Machine
Dow Kim stepped into this milieu in the mid-1980s, fresh from the Wharton School at the University of Pennsylvania. Born in Seoul and raised there and in Singapore, Mr. Kim moved to the United States at 16 to attend Phillips Academy in Andover, Mass. A quiet workaholic in an industry of workaholics, he seemed to rise through the ranks by sheer will. After a stint trading bonds in Tokyo, he moved to New York to oversee Merrill’s fixed-income business in 2001. Two years later, he became co-president.
Even as tremors began to reverberate through the housing market and his own company, Mr. Kim exuded optimism.
After several of his key deputies left the firm in the summer of 2006, he appointed a former colleague from Asia, Osman Semerci, as his deputy, and beneath Mr. Semerci he installed Dale M. Lattanzio and Douglas J. Mallach. Mr. Lattanzio promptly purchased a $5 million home, as well as oceanfront property in Mantoloking, a wealthy enclave in New Jersey, according to county records.
Merrill and the executives in this article declined to comment or say whether they would return past bonuses. Mr. Mallach did not return telephone calls.
Mr. Semerci, Mr. Lattanzio and Mr. Mallach joined Mr. Kim as Merrill entered a new phase in its mortgage buildup. That September, the bank spent $1.3 billion to buy the First Franklin Financial Corporation, a mortgage lender in California, in part so it could bundle its mortgages into lucrative bonds.
Yet Mr. Kim was growing restless. That same month, he told E. Stanley O’Neal, Merrill’s chief executive, that he was considering starting his own hedge fund. His traders were stunned. But Mr. O’Neal persuaded Mr. Kim to stay, assuring him that the future was bright for Merrill’s mortgage business, and, by extension, for Mr. Kim.
Mr. Kim stepped to the lectern on the bond trading floor and told his anxious traders that he was not going anywhere, and that business was looking up, according to four former employees who were there. The traders erupted in applause.
“No one wanted to stop this thing,” said former mortgage analyst at Merrill. “It was a machine, and we all knew it was going to be a very, very good year.”
Merrill Lynch celebrated its success even before the year was over. In November, the company hosted a three-day golf tournament at Pebble Beach, Calif.
Mr. Kim, an avid golfer, played alongside William H. Gross, a founder of Pimco, the big bond house; and Ralph R. Cioffi, who oversaw two Bear Stearns hedge funds whose subsequent collapse in 2007 would send shock waves through the financial world.
“There didn’t seem to be an end in sight,” said a person who attended the tournament.
Back in New York, Mr. Kim’s team was eagerly bundling risky home mortgages into bonds. One of the last deals they put together that year was called “Costa Bella,” or beautiful coast — a name that recalls Pebble Beach. The $500 million bundle of loans, a type of investment known as a collateralized debt obligation, was managed by Mr. Gross’s Pimco.
Merrill Lynch collected about $5 million in fees for concocting Costa Bella, which included mortgages originated by First Franklin.
But Costa Bella, like so many other C.D.O.’s, was filled with loans that borrowers could not repay. Initially part of it was rated AAA, but Costa Bella is now deeply troubled. The losses on the investment far exceed the money Merrill collected for putting the deal together.
So Much for So Few
By the time Costa Bella ran into trouble, the Merrill bankers who had devised it had collected their bonuses for 2006. Mr. Kim’s fixed-income unit generated more than half of Merrill’s revenue that year, according to people with direct knowledge of the matter. As a reward, Mr. O’Neal and Mr. Kim paid nearly a third of Merrill’s $5 billion to $6 billion bonus pool to the 2,000 professionals in the division.
Mr. O’Neal himself was paid $46 million, according to Equilar, an executive compensation research firm and data provider in California. Mr. Kim received $35 million. About 57 percent of their pay was in stock, which would lose much of its value over the next two years, but even the cash portions of their bonus were generous: $18.5 million for Mr. O’Neal, and $14.5 million for Mr. Kim, according to Equilar.
Mr. Kim and his deputies were given wide discretion about how to dole out their pot of money. Mr. Semerci was among the highest earners in 2006, at more than $20 million. Below him, Mr. Mallach and Mr. Lattanzio each earned more than $10 million. They were among just over 100 people who accounted for some $500 million of the pool, according to people with direct knowledge of the matter.
After that blowout, Merrill pushed even deeper into the mortgage business, despite growing signs that the housing bubble was starting to burst. That decision proved disastrous. As the problems in the subprime mortgage market exploded into a full-blown crisis, the value of Merrill’s investments plummeted. The firm has since written down its investments by more than $54 billion, selling some of them for pennies on the dollar.
Mr. Lin, the former Merrill trader, arrived late to the party. He was one of the last people hired onto Merrill’s mortgage desk, in the summer of 2007. Even then, Merrill guaranteed Mr. Lin a bonus if he joined the firm. Mr. Lin would not disclose his bonus, but such payouts were often in the seven figures.
Mr. Lin said he quickly noticed that traders across Wall Street were reluctant to admit what now seems so obvious: Their mortgage investments were worth far less than they had thought.
“It’s always human nature,” said Mr. Lin, who lost his job at Merrill last summer and now works at RRMS Advisors, a consulting firm that advises investors in troubled mortgage investments. “You want to pull for the market to do well because you’re vested.”
But critics question why Wall Street embraced the risky deals even as the housing and mortgage markets began to weaken.
“What happened to their investments was of no interest to them, because they would already be paid,” said Paul Hodgson, senior research associate at the Corporate Library, a shareholder activist group. Some Wall Street executives argue that paying a larger portion of bonuses in the form of stock, rather than in cash, might keep employees from making short-sighted decision. But Mr. Hodgson contended that would not go far enough, in part because the cash rewards alone were so high. Mr. Kim, for example, was paid a total of $116.6 million in cash and stock from 2001 to 2007. Of that, $55 million was in cash, according to Equilar.
Leaving the Scene
As the damage at Merrill became clear in 2007, Mr. Kim, his deputies and finally Mr. O’Neal left the firm. Mr. Kim opened a hedge fund, but it quickly closed. Mr. Semerci and Mr. Lattanzio landed at a hedge fund in London.
All three departed without collecting bonuses in 2007. Mr. O’Neal, however, got even richer by leaving Merrill Lynch. He was awarded an exit package worth $161 million.
Clawing back the 2006 bonuses at Merrill would not come close to making up for the company’s losses, which exceed all the profits that the firm earned over the previous 20 years. This fall, the once-proud firm was sold to Bank of America, ending its 94-year history as an independent firm.
Mr. Bebchuk of Harvard Law School said investment banks like Merrill were brought to their knees because their employees chased after the rich rewards that executives promised them.
“They were trying to get as much of this or that paper, they were doing it with excitement and vigor, and that was because they knew they would be making huge amounts of money by the end of the year,” he said.
Ben White contributed reporting.
---
The Reckoning
Articles in this series are exploring the causes of the financial crisis.
Market Cop | An Agency Handcuffed By Zachary A. Goldfarb Washington Post Staff Writer Monday, June 1, 2009
The five enforcement officials caught a morning Acela train bound for Washington. Based at the New York office of the Securities and Exchange Commission, the team was seeking agency approval to impose tens of millions of dollars in fines on a drug company, Biovail, which had allegedly used the crash of a truck hauling depression medicine to cover up financial losses.
But when the group arrived at SEC headquarters on that winter day early last year, it was barred from the room where the commission was meeting, according to a person familiar with the case. Chairman Christopher Cox and his colleagues reviewed the case inside. When the doors opened, the enforcement officials learned the commission had knocked down the penalty to a small fraction of what they had sought.
The outcome, though discouraging to the team, was not a complete surprise, sources said. After Cox became SEC chairman in mid-2005, he adopted practices that undermined the enforcement division's efforts to investigate cases of corporate wrongdoing and punish those involved, according to interviews with 19 current and former SEC officials.
During Cox's tenure, investigators who wanted to subpoena documents or compel interviews faced an increasingly cumbersome process to win the commission's approval for each case, according to current and former agency officials.
Cox also required enforcement officials to see the commissioners before approaching a company about a civil settlement. In several high-profile cases, when SEC lawyers were ready to ask the commission to authorize lawsuits or approve settlements, Cox postponed the decisions at the last minute, leaving cases unresolved for months, the sources said. At times, as in the Biovail case, the commission eventually weakened the sanctions sought by the enforcement division.
This is the legacy Mary Schapiro inherited when she replaced Cox as chairman this year. Among her first acts, Schapiro freed enforcement officials from getting commission approval before negotiating settlements with companies and established an accelerated process for authorizing subpoenas and depositions. She speaks frequently of taking the "handcuffs" off of the enforcement division.
This effort is central to Schapiro's strategy for rebuilding the SEC and ensuring it has a dominant voice in the emerging debate on overhauling the nation's regulatory system. Since the 1930s, the agency has been the top cop on Wall Street and the primary regulator of financial markets, requiring that firms play fair and give investors honest, timely information.
But a backlog of financial crime cases continues to slow the enforcement division as Schapiro tries to turn more of the agency's attention to abuses linked to the financial crisis, SEC officials said. The agency is still working to reinvigorate its dispirited enforcement ranks.
As grounds for the policies he adopted, Cox cited efficiency and ensuring that commissioners had the chance to review cases. Cox said in a recent interview that he had taken steps that made clear that "corporate penalties are an important part of the agency's enforcement arsenal."
But former enforcement lawyers said the practices had a chilling effect. Several cases, they said, were scaled back or dropped because of anticipated resistance from the commission.
"The presentation of cases is the culmination of the investigative process. When that process is interrupted, delayed or denied, it can't help but have a negative impact on the people who conduct those investigations," said James T. Coffman, a former assistant director of the enforcement division. "Clearly some people wonder, 'If they don't want these kinds of cases, why should I bother doing them even though they're very important?' "
Most former and current SEC officials spoke on condition of anonymity because they were discussing confidential legal matters or were not authorized by the agency to comment. But in a report last month, the Government Accountability Office, after interviewing many enforcement lawyers, concluded that the SEC penalty policies in 2006 and 2007 "led to less vigorous pursuit of corporate penalties, may have made penalties less punitive in nature and could have compromised the quality of settlements."
During Cox's tenure, penalties imposed on companies fell 84 percent, from $1.59 billion in 2005 to $256 million in 2008.
Before and After Cox
Cox's predecessor as chairman, William Donaldson, had pursued hefty penalties against companies accused of wrongdoing, often despite dissent from other commissioners. But when Cox took office, there was a growing concern within government and the financial industry that the United States was losing business to less-regulated markets overseas, and Cox wanted to achieve consensus among the commissioners.
One commissioner, Paul Atkins, was particularly skeptical about corporate penalties. He argued that these ultimately were shouldered by shareholders -- the very people most frequently hurt by fraud -- and he often asked for more time to review cases.
"It's important that commissioners have a fair opportunity to fully understand the cases before they vote on them," Cox said in the interview.
Cox defended his enforcement credentials and pointed to the agency's aggressive pursuit last year of financial firms that misled investors into buying the exotic bonds called auction rate securities. Billions of dollars were returned to investors.
Cox also said he took an important step to modernize the enforcement division and speed cases by introducing a new case-management system. He said staff turnover during his tenure decreased, and he noted that the number of cases brought by the commission has stayed level.
But within months of Cox's appointment, tensions surfaced between the chairman and the enforcement division. Lawyers said in interviews they sometimes waited weeks to appear before the commission to request "formal orders," which enabled them to subpoena documents and conduct depositions. During Cox's tenure, the annual number of these orders fell 14 percent.
"Some investigative attorneys came to see the commission as less of an ally in bringing enforcement actions and more of a barrier," the GAO reported.
But enforcement lawyers faced even greater frustrations once investigations were finished and cases were finalized. In early 2006, Cox outlined nine conditions for investigators to consider when proposing penalties.
On many occasions, former enforcement lawyers said, Cox removed cases from the agenda because of Atkins's concerns. Often, the enforcement team had already reached a settlement with a company. The practice made it more difficult for enforcement lawyers to negotiate credibly, the attorneys said.
"Cases would sit and linger for months while you waited to get a response. . . . There was often a question as to what authority the staff had," said Thomas O. Gorman, a defense lawyer at Porter Wright Morris & Arthur in Washington who specializes in SEC cases.
Cases began disappearing from the agenda shortly after Cox became chairman. Two similar cases against financial firms -- MBIA and RenaissanceRe Holdings -- were plucked from the calendar after the companies agreed to pay penalties. The commission removed the items because of its concerns about the size of the proposed penalties, $50 million for MBIA and $15 million for RenaissanceRe, according to sources familiar with the cases. It took more than a year to close the cases, with penalties the parties had agreed to earlier.
In 2007, the SEC prepared to charge Ingram Micro, a California technology company accused of abetting a "massive financial fraud" in exchange for business at the software company McAfee from 1998 to 2000. But the case was repeatedly pulled from the commission's agenda. In mid-May, the SEC approved the settlement. Ingram, which agreed to pay $15 million, did not admit or deny wrongdoing.
Smaller Settlements
In 2006, an SEC enforcement team forged an agreement with Brocade Communications Systems for the company to pay $7 million to settle allegations it illegally backdated hundreds of millions of dollars worth of stock options. Afterward, Brocade wrote the commission directly, saying the penalty was unreasonable because the company had cooperated with the investigation.
The SEC enforcement team flew to Washington from California to present its case against the company and its executives. On the eve of the meeting, while the lawyers were at dinner, a message from the chairman's office appeared on their BlackBerrys: The commission would hear the case against the executives but postpone the one against the company, a source said.
Ten months later, to the surprise of the enforcement team, the commission met in executive session and approved a penalty against Brocade. The company did not admit or deny wrongdoing.
When subsequent cases were brought against firms for alleged backdating of stock options, penalties often were not sought, several former and current agency officials said. "People openly discussed that if you wanted to get your case done quickly, you didn't put in a civil penalty," a former enforcement lawyer said.
In two cases involving large banks, the commission eased the penalties sought by the staff. Last year, the commission slashed the penalty proposed in a case against J.P. Morgan Chase. The bank was accused of ignoring improper transactions at one of its clients that had cost investors $2.6 billion. J.P. Morgan agreed to pay a $2 million penalty to settle the case.
In late 2006, the SEC enforcement staff sought a penalty of $122 million against Deutsche Bank, which was charged with granting a hedge fund exclusive information about trading by mutual funds in exchange for business. The commission proposed reducing the fine to $17 million.
In paying penalties, neither company admitted or denied wrongdoing.
In the Biovail case, the company had projected earnings that proved too rosy. The company blamed its poor performance on the crash of a truck in Illinois carrying depression medication. But SEC investigators determined the accident "had no impact on Biovail's financial results." Rather, the SEC said Biovail was engaged in a broader effort to defraud investors. The enforcement team sought penalties in the tens of millions of dollars, a source said.
Instead, the commission set a range of $2 million to $10 million. Biovail settled for $10 million, without admitting or denying guilt.
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