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Wall Street Deserved Its Bonuses

Marc Hodak, 02.19.09, 06:00 PM EST

The $18 billion paid in bonuses last year is entirely defensible, and losses might have been worse had the banks withheld it.

I would be perfectly happy living in a world where the typical CEO made no more than, say, 30 times the pay of the average worker. I don't think anyone needs more than that to be happy or secure, or deserves more than that as an expression of their value to humanity. I'm also a compensation consultant that shareholders hire to get the best executives at the lowest prices. I don't pay more than I have to, but I often have to pay more than 30 times what the average worker makes. You do get what you pay for.

If we're bent on ridding Wall Street of those dreaded bonuses, banks will have to replace bonus opportunities with much higher fixed salaries than they now pay in order to remain competitive. In a horrible year like 2008, the banks replacing target bonuses with fully competitive salaries would have had far higher compensation expenses. We would have been spared the bold headlines about $18 billion worth of bonuses, but Wall Street's total compensation cost could easily have been another five or 10 billion more than that.

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Most of what we call "bonuses" on Wall Street actually resembles commissions earned by a modestly salaried salesperson, albeit with a very high upside. No one familiar with how salespeople get paid would consider zero commissions in a bad year as a sensible outcome. Even if the salesperson sold only half what he sold last year, he still deserve some commission. That's where the "shameful" $18 billion in bonuses went--to traders whose books did not blow up, investment bankers who squeezed some fees from a desiccated market, and asset managers whose portfolios survived the carnage relatively intact.

AIG (nyse: AIG - news - people ) had over 100,000 employees. It was brought down by about 80 of them. When divided among all the eligible folks on Wall Street, that $18 billion worked out to about $110,000 per person, with some getting multi-million payouts while many others got relatively little.

I know it's hard for someone making $50,000 a year to imagine that anyone can be worth 10 or a hundred times that. But, they well might be. How do I know? Because if I don't pay them, someone else will. When an executive across the table tells me, "The guys down the street are offering $2 million a year," he's not bluffing. The experienced buyer of managerial talent can see the difference between a $500,000 executive and $2 million executive as surely as a home buyer can tell the difference between a half-million-dollar home and a $2 million home.

When we buy a $2 million home, we're on the hook for the whole price--the house doesn't have to prove its worth every time the mortgage payment is due. What works about Wall Street's bonus structure is it means I can offer my $2 million talent a fraction of that in salary, and make them earn the rest.

In the context of Wall Street pay, "bonus" is a bit of a misnomer. Most people think of "bonus" as something extra, for above-target performance. But rather than pay a competitive salary plus a modest target bonus, Wall Street has tended to offer its typical workers base salaries that might keep them in a small Manhattan apartment, then enable them earn a "competitive" level of pay only through additional compensation based on their production. Of course, they can earn well above competitive pay in good years, and often do, but that's not guaranteed.

These incentives matter far more than most people can imagine. Many blame perverse incentives on the financial sector meltdown, which is certainly the case. But not caring about the downside can be just as dangerous as caring too much about the upside. Consider Citigroup (nyse: C - news - people ), which lost about $19 billion in 2008. Would Citi's shareholders have cared if the losses were $22 or $25 billion? Of course, just as they would have welcomed an extra several billion of profits in a good year.

A billion dollars is a lot of money to anyone who isn't a U.S. congressman. But because the vast majority of Citigroup's workers, those who had nothing to do with toxic mortgages or auction-rate securities, still had the prospect of at least some bonuses, they still had an incentive to keep overall company losses from getting worse. Absent those bonuses that caused Wall Street so much grief, Citigroup could have easily lost many billions more, with the shareholders never knowing how preventable those losses might have been.

Difficult as it is to believe, Wall Street's losses can get much worse. How much worse we won't know until we eliminate all remaining incentives to preserve, if not earn, what income one may no matter how bad things get.

Marc Hodak is managing director of Hodak Value Advisors, a firm specializing in the finance and compensation issues of corporate governance, and he teaches corporate governance at New York University's Leonard N. Stern School of Business. He can be reached at mhodak@hodakvalue.com.

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