Lehman

I admit that I have written on at least two other occasions (see my posts on Citi and Bear Stearns) about how the separation of executive pay at financial institutions and any measurement of financial risk has contributed to the disaster on Wall Street. But given that my retirement account has lost about 25% in the past week and that decline can be attributed to poor risk management on the part of banks and investment houses, I think I can take the liberty of repeating myself - although it is hard typing out here on a ledge.

So, excuse me as I join Congress and pile on Richard Fuld of Lehman Brothers. I am also going to pile on Lehman's Board for letting things get so out of control.

There are many businesses where financial risk could reasonably be left off a list of key criteria for managing executive compensation. A pharmaceutical is focused on getting effective drugs through the pipeline and into customer's hands. An Oil Company is interested in finding as much oil as it can and getting it safely to market. But if you are in the investment banking business, the riskiness of investments has to be a major factor in measuring performance whether it be of a mid-level trader or the CEO.

If you want to pump up earnings, or return on equity, get your hands on as much borrowed money as you can, at say 5%, and invest it at 8%. Pretty simple formula for getting rich right? Buy low and sell high. Retail banks do it all the time. They collect deposits, pay a smidgen of interest and try to loan it out in a prudent way for mortgages and business loans.

This formula was particularly easy to follow over the past 5 years with easy, cheap credit for loans and a huge pool of securitized commercial and home mortgage loans to invest in with very attractive interest rates.

So back to Lehman Brothers. If you look at their last 10-K, you will see some serious language around the factors that could significantly impact shareholder value. "Financial Risk" appears often in this verbiage recognizing that when you trade financial securities, act as a market-maker and otherwise develop and sell financial products to clients, the risk that markets might move against you is a pretty big deal.

But when we turn to the proxy, there is only one weak, generic mention of risk (executives are tied to corporate risk via equity-related grants) when it comes to executive compensation. The cash and stock incentives are based on areas such as earnings and return on equity. Some of the other areas mentioned for executive performance include: "Strengthening the Company's brand and Improving employee programs".

If Lehman did not go bankrupt within six month's of the Proxy's publication, I like to think the executives would get a "not meeting expectations" in the Brand area.

All these areas are worthwhile. And for non-financial institutions, earnings growth and return on equity would probably be good places to start as measures for executive performance. But for a company like Lehman which can leverage itself to the hilt, take great risks and pump up its earnings and return on equity without breaking too much of a sweat with lots of easy credit going around, these measures will create what they incent - lots of suboptimal risk-taking and an eventual crash.

Okay, I am approaching this after-the-fact. But I cannot understand why a sophisticated Board of a financial institution that's primary job is to effectively manage risk would not make this a key area of executive compensation. Why not simple things, like risk adjusted earnings or an adjustment for leverage?

So Fuld and the rest of the Lehman crew collected some pretty good paychecks over the years (a signficant portion of which was in cash) while the going was good and left the wreckage to bankruptcy. At least in Lehman's case, the primary losers were only clients, equity holders and the poor employees who loaned money to Lehman through deferred compensation plans. With AIG, we are all picking up the tab.