Allen Wheat, president of CS First Boston, took home an excellent pay packet last year: $9 million. Some would say he deserved it. In 1995, though not the firm's best-ever year, CS First Boston recorded net income of $207 million, 33% better than the $156 million it made in 1994.
With an annual salary of that magnitude, Wheat must have built up enough personal wealth to keep him in comfort if he ever grew sick of his present job and decided to walk away from it. It would be more than enough to start up his own derivatives trading boutique. Why might Wheat entertain such thoughts just two and a half years after becoming president and why do CS First Boston staff gossip about the possibility?
Wheat is now striving to stabilize the firm following its first big crisis since his tenure began. This March, dozens of senior bond dealers left CS First Boston in New York, outraged by poor bonuses. Although most parts of the bond business had been profitable in 1995, a weak performance in mortgage-backed securities - that business lost around $70 million - lowered profits for the fixed-income group as a whole. Many traders and bankers in areas associated with mortgages judged it unfair that their bonuses should be cut, and headed for competitors.
"With the asset-backed people we didn't get it right," Wheat now concedes. "We didn't pay them enough and I take full responsibility for that." He adds that many bond traders gained the false impression that their bonus cheques were insulated against the mortgage problem. In fact, a large proportion of traders' pay was linked to the performance of wider groups within fixed income and to bond trading as a whole. "Last year, all people heard was: 'We're doing great, we're knocking the ball out of the park,'" Wheat says. "One or two of them asked about mortgages and were told: 'Don't worry, it's not your problem.' Not surprisingly, the traders' response was: 'I like that music.'" But the firm's shareholders could not turn a blind eye to that mortgage loss. "We should have addressed it sooner and discussed it more openly," says Wheat.
It was hoped that such spats over pay, once a regular occurrence at First Boston, had been consigned to the past when Wheat took over as chief operating officer in 1993. Wheat brought a new approach and more up-to-date management disciplines. He began tracking the allocation of the firm's capital to its different businesses and returns made on it, so as to measure more accurately the profitability of each business. Supposedly, that helped to make the firm's compensation system fairer and more transparent. For the first time, staff would have a clear idea of the basis on which their bonuses were being calculated.
But the system failed spectacularly this year. Some departing bond traders complain that their aggregate pay for 1995 was 15% down on 1994's, even though most bond businesses made more profit in 1995 than in 1994.
The firm's overall after-tax return on equity, excluding special items, was 15.5% for 1995, compared with 11.1% in 1994. Within fixed income, global government bond trading and the foreign exchange and emerging market businesses enjoyed record years. The traders didn't mind slim pay packets in 1994, when many desks made losses as interest rates rose, but they refused to accept disappointing rewards after a much better performance in 1995. Many traders left within days of receiving their 1995 bonus cheques early in March.
The firm's bonus pool for 1995 was $455 million, compared with $350 million in 1994, but it didn't spread far enough. Traders say that there were three big problems. The firm lost money in its mortgage bond business. Partly this resulted from one bad trading position, the liquidation of which cost the firm dear. Annoyingly for the firm's remaining mortgage traders, the individuals responsible for this had already left the firm long before February and March, when bonuses for 1995 were paid.
The second problem relates to CS First Boston's rebuilding of its mortgage business. Costs had fallen over 40% from their peak, but even though revenues were returning, profits were still not flowing. Oddly, mortgage traders were among the most bitter about low pay for 1995. Some thought it unfair that their pay should suffer during this restructuring and add that the likelihood it would suffer was not explained to them. Other traders, for example in the asset-backed securities division, felt they suffered unfairly by being associated with a loosely defined mortgage bond group. Their own areas had been highly profitable. "Over-all CS First Boston's fixed income area had a record year, with the exception of one department," says Marc Hotimsky, new head of the bond division.
Strategic mistake
In the first quarter of 1995, CS First Boston also took an $88.4 million charge arising from lay-offs made in 1994. The firm says this explains the high component of deferred stock in this year's bonuses: another cause of resentment among managing directors.
The third problem, which caused the most resentment, was the amount of money sucked out of the fixed-income bonus pool and paid to a few senior individuals: Wheat; Robert Diamond, former head of fixed income; John Costas, head of government bond trading; and Mark Patterson, head of high-yield bonds. Patterson, for example, was hired early in 1994, on what was rumoured to be a contract guaranteeing him an annual $5 million for three years. Costas would hardly take less. Money also had to be allocated to other senior figures at CS First Boston, such as vice-chairman David Mulford.
Critics say that a number of other more junior traders were hired on high guaranteed contracts last year. These further raised the firm's fixed costs and reduced the amount of money that could be paid out to longer-serving staff.
One departing managing director complains: "The firm made a strategic mistake in 1994 by focusing too much on controlling costs and not on improving the quality of its professionals. Contrast that with Morgan Stanley which continued to hire people even in difficult market conditions. The result was that in 1995, when markets improved, we didn't make as much profit as we should have done. We just didn't have enough warm bodies to put in front of the clients," says the trader.
By the end of 1995, CS First Boston employed 5,033 people, down 23% from 6,555 at the end of 1994. The firm closed offices in Miami, Washington and Dallas, and exited businesses, including asset management, municipal bonds and Japanese domestic equity. These expense-reduction efforts allowed senior managers to claim $50.3 million in pay deferred from 1994.
What these broad figures don't show, departing bond traders say, is how, as 1995 wore on, the firm's hiring strategy lurched to the opposite extreme from 1994. In an effort to catch up, the firm began recruiting bond traders and salesmen. For example, in the autumn, the firm announced it had lured from semi-retirement Andrew Stone, a high-profile, ex-Salomon, ex-Daiwa mortgage-bond whiz. Stone quickly brought a group of his old assistants to help run mortgage and asset-backed trading. By reputation, Stone is one of the smartest mortgage-bond traders in the business. But his arrival could not save the division from a poor performance for 1995.
There were 3,321 people in the firm's bonus pool in 1994, yet despite the overall fall in staff numbers in 1995, there were still 3,309 then. The firm is still hiring. It hopes to build staff levels by between 7% and 8% in fixed income in 1996.
In a generally strong bond market, the firm met fierce competition for good staff, and CS First Boston had to offer two-year guarantees of $1 million and $2 million even to average-quality recruits. "I would argue that some of the guys we hired last year would have struggled to get jobs at any but a foreign-owned firm," says one source.
"There's probably a grain of truth in all that," says Wheat. Again he traces the problem to the mortgage area, which lost money in 1994 and 1995. "A lot of people including myself were asking: 'Can we afford this?'" Following a detailed management review, the firm decided it could, and began a major revamp. Heavy investment began in July, before Andy Stone arrived.
Former senior executives also suggest that profits made in the bond division were used to subsidize other parts of the firm, such as the equities division, which was restructured during 1995, under a new head, Brady Dougan. "We had to carry the firm," complains one senior bond executive who suggests that other divisions may have paid their people close to 100% of the profits they generated, while bond traders kept a smaller proportion, closer to 50% to 60%. Wheat denies this: "That's nonsense. Fixed income had one of their highest pay-outs percentage-wise."
Some veterans who had remained loyal through previous bouts of turmoil in 1990 (when Credit Suisse tightened its grip on First Boston following its losses on bridge loans) and 1993 finally rebelled. One senior trader says: "In 1993, I toed the party line to keep my employees in place because I believed Wheat knew how to manage the business. But I was mistaken."
So serious was the affair that CS First Boston's head of fixed income, Robert Diamond, a vice-chairman of the firm, was forced out. Diamond was blamed for failing to manage his traders' expectations for their 1995 bonuses. Several departing staff say this was unfair. One departed trader recalls: "Wheat was saying Diamond miscalculated the bonus pool, which is mind-boggling. He didn't miscalculate anything. From the start of the year, Wheat decided what percentage pay-out fixed-income traders would take. Wheat used Diamond as a scapegoat to protect his skin." Wheat himself only says: "Bob did a good job building things up here. He left for personal reasons."
Clearly, Wheat himself, as president, would have spent many hours deciding with Diamond what proportion of their 1995 profits the bond traders would be receiving as bonuses. Such decisions are made at the very top of the firm. Wheat would have been closely involved in detailed decisions on the amount and form of compensation. The form, as much as the amount, caused dispute.
In 1993, the firm's managing directors were told to expect between 15% and 20% of their future pay in the form of deferred awards of the company's stock. The laudable intention was to promote a wider feeling of ownership among senior employees. Sadly, it appears, they prefer being paid in hard cash. Some managing directors in fixed income found that deferred stock made up closer to 50% of their total compensation for 1995. Even more controversial than this high proportion of deferred stock was that it vests, or pays out, over five years - not three, as many traders had been led to believe.
Some executives say that amid the uproar, the departures, sackings and politicking, the poverty of 1995 pay awards at CS First Boston has been considerably exaggerated. One says: "I think we were underpaid, but not badly. A bonus pool 10% higher might have seen us through."
Part of the problem was that strong bond markets in the latter part of 1995 and the willingness of other firms, including commercial banks, to recruit people on high salaries raised traders' hopes for their cash pay. Senior management underestimated this factor. Meanwhile many traders simply forgot about the loss in mortgages and the first-quarter restructuring charge. "Last year, we didn't talk about compensation until the end of January [1996]. That was a big mistake," says Hotimsky.
The message from Wheat's office was that the firm, for which read Diamond, had failed to manage its bond traders' pay expectations. It is not as apologetic about the actual levels of pay. In a memo dated April 3, John Hennessy, chief executive, and Wheat argued that the fixed-income bonus pool increased 25% from 1994 to 1995. Meanwhile its contribution to profit was 42.9% lower than the banner year of 1993. It was not a memo to heal wounds. The implication was that bond traders had no grounds for complaint. Traders say it is clearly unfair and misleading to introduce a comparison of profits made in 1993, the vintage year for the entire industry. "The whole firm laughed at that memo. It was despicable," says one.
Wild rumours
In the same memo, the firm denied that it had paid out excessively or unfairly to executive board members. They took an average of 57% of their bonus in deferred compensation and stock, a high proportion. Their average increase of total pay from 1994 to 1995 was 18%, whereas the firm's overall bonus pool was up 32%.
Wheat himself scoffs at wild rumours that he took home $35 million - "I wish" - and says his own pay was up 10% on 1994. He also adds that in 1994, a poor year for most divisions, the firm took the largest percentage cut in bonus pool for any group and applied it to the pay of the executive board.
That's still not likely to soothe traders who have seen their pay fall by 15%.
The truth is that at CS First Boston, as at other firms, the disparity in pay, between a few individuals and the herd, is growing. "The backbone of the business is a small number of people who you must pay as much as possible, because you need them to protect the franchise," says Hotimsky. "Maybe some people thought they were part of that group, when they were not."
Bitterness tends to spread quickly at CS First Boston, partly because it lacks the long-established culture and stronger sense of loyalty of a firm like Morgan Stanley. Until 1993, the firm was deeply divided, with competing groups in New York and Europe spitting poison at each other.
Those rivalries have not entirely disappeared, nor has a strong new ethic superseded them. Perhaps none ever will. "There is a conflict within CS First Boston between those who want to build a team and those who care just about their own contribution and their own pay," says one departed source. It sounds as if the latter group is dominant. It's also still a firm prone to infighting.
There is speculation that Diamond may have told Wheat that he was thinking of leaving the firm. So when the pay dispute erupted, Wheat decided that Diamond would make a useful scapegoat, even though 70% of the bond division's profits in 1995 came from businesses such as Asian bonds and emerging markets which had been built up under Diamond since 1993.
When it became obvious inside the firm that Diamond was taking the blame for widespread dissatisfaction over bonuses, competition between senior fixed-income executives, fighting for position, quickly came to the surface. For some time, there had been tension between Diamond and Patterson. Wheat made no obvious attempt to resolve this. One former employee says: "I think Wheat would happily have locked the two of them in a room and then worked with whoever walked out alive."
Diamond's position was already uncomfortable when Costas, the physically big, rough-around-the-edges head government bond trader, made his bid for power. "Costas was going to Wheat and saying 'it's Diamond or me'," claims one departing managing director. "Diamond became the scapegoat, even though there was a limited amount he could do. The bonus pool could only stretch so far."
His was a spectacular fall. Diamond was regarded by many as de facto second-in-command to Wheat. Diamond arrived at CS First Boston in 1992 from Morgan Stanley, where he had headed European and Asian bond operations. He did not come into the firm as one of Wheat's old lieutenants from his days at Bankers Trust and later at CSFP. Nevertheless, the two potential rivals seemed to think and work in similar ways. In 1992, when Wheat was running bonds in Europe and Diamond headed the firm's Asian operations, the two men informally agreed to increase integration and cooperation between their regions - something previously unheard of at a firm notorious for internal warfare.
"Diamond was a Wheat friend," says one former CS First Boston managing director. "When this blew up, Wheat put business above friendship, which was the right thing to do." Others are more sceptical. "Wheat has few professional friends," says one. "He has a few lieutenants like Brady Dougan, head of equities, Chris Goekjian, head of CSFP, and Marc Hotimsky [now promoted to head of global fixed income]. But everyone else is an outsider." Now departing veterans of First Boston in New York say that Wheat has overdone his promotion of these.
They joke that the firm is to be renamed Wheat First. Meanwhile, rumours inside the firm are circulating once again that John Hennessy, chief executive of CS First Boston and nominally Wheat's boss, is preparing to stand down.
Ironically, when Wheat became president of the firm, he and Diamond talked often about what they called "the soft issues", how to retain people's loyalty by offering them the prospect of career development, of equity-linked compensation and not just fat annual bonus cheques. But the two men come from different cultures. Diamond is a veteran of the high-volume, low-margin bond business; Wheat of the high-margin, transaction-based and marketing-heavy derivatives business.
Behind the scenes, relations between top executives became strained. According to insiders, long before the bonus problem blew up, Diamond was growing disillusioned at the direction in which Wheat was leading the firm: while Diamond's vision was of a fixed-income division operating within a broad, fully-integrated investment-banking business, Wheat's instinct is to manage CS First Boston as a group of profitable niche businesses.
This last is a charge which the firm's senior executives regularly deny but never quite shake off. The firm has for example, taken the strategic decision to build market share in corporate bond underwriting and this will require some subsidies from elsewhere in the fixed-income division. But the firm is limiting such subsidies between units. It also prides itself on its ability to redeploy capital where it sees the best opportunities for return on equity.
"It's the nature of investment banking that regularly you have to shrink one group and build another," says Hotimsky. For example, he is thinking of allocating capital for an expanded proprietary trading group to take market risk and is developing appropriate risk limits and ROE goals.
In fact, the firm's financial performance compares reasonably well with its peers'. Morgan Stanley's return on equity for the 12 months ending November 30 1995 was 13.6% compared with 15.5% for 1995 at CS First Boston, excluding one-time items. Merrill's was 20%, Lehman's 7%. Staff worry more about the firm's comparative size. Morgan Stanley's equity capital is $5.2 billion and its net income last year was $609 million, compared with CS First Boston's $1.8 billion of equity capital and $207 million of net income. "We cannot afford to be any smaller," says one manager.
Some departing sources suggest that the management style and structure of CS First Boston is dictated by its relationship with Credit Suisse and its chairman, Rainer Gut. and that this ultimately limits its size. "In parts of the world, like Russia, and certain businesses, such as foreign exchange, CS First Boston and Credit Suisse still compete," says one. "It's not like Barclays, which has even put corporate lending into BZW. Gut likes separate little businesses, under CS Holding, each with their own boards."
Confusion and mistrust
Following Diamond's departure, attempts to reorganize the fixed-income division became rather messy. First, a committee was formed to run the bond business. It included Costas, Hotimsky (then the firm's head of global emerging markets and foreign exchange), Craig Foster and Tony Iliya (co-heads of fixed income for Europe and Asia).
Then Costas dropped his bombshell. Throughout the rumpus, he had been negotiating a move to UBS, a firm keen enough to continue building up its bond business to offer Costas a lucrative three-year contract.
On March 21, the firm announced that Hotimsky had been appointed head of fixed income and a member of the executive board of CS First Boston. The business will be organized into three product groups, or clusters, as CS First Boston calls them. Hotimsky will continue to run emerging markets and foreign exchange, Patterson and Iliya will run corporates and capital markets, including high-yield and investment-grade bonds and asset-backed securities. Foster will run government bonds and futures and mortgage bonds.
At least Hotimsky's promotion is on the back of a good track record. The firm made decent profits last year in his emerging markets and foreign exchange businesses, though cynics point out those were generally strongly performing markets. Hotimsky hopes to expand this business, for example adding research and distribution in emerging market bonds. He is generally well respected even by the firm's bitter departed.
It remains to be seen whether the firm's bond traders will now calm down and pull together. On April 2, Wheat and Hennessy circulated a memo to staff reporting preliminary first-quarter net income of $108 million, the highest in the firm's history. If it keeps running at this pace, the firm will hit an ROE of 23% for 1996. The memo pointedly remarks that this above-budget performance has brought "a corresponding increase in the bonus pool accrual." A senior source adds: "We've had a great four months - way off the charts, even compared to 1993."
The firm's senior management has also been making guarantees for 1996 pay awards to certain key staff. "For some key positions, we've set a floor under people's pay," says Hotimsky. "This has been for staff who had offers elsewhere and who we need to be comfortable with us."
The firm has rehired some of the asset-backed traders who decided to quit. "You hear that the firm's in turmoil, but the problem has been in two specific areas, fixed income in New York, and there have been some issues in the equity department," says Wheat. "We have gotten it cleaned up. In asset-backed we've replaced research, kept all the financing people and a couple of top traders have rejoined. Equity has had a great quarter."
In reorganizing the bond division, Hotimsky intends that in future a poor performance in one area, such as mortgages, will not drag down pay for all other bond traders. The business is being split into more sharply defined units, each of which will have its bonuses more closely tied to its performance. Each has been set goals, either for pure return on equity or for return plus building market share as, for example, with corporate bond underwriting. Each unit's performance against these targets and budgets will be reviewed quarterly.
It remains to be seen, however, whether this will be enough to keep people happy and make them feel they are working at a successful firm.
That sinking feeling Although it is upheavals in the bond division that have hit the headlines recently, the cracks are showing elsewhere at CS First Boston. There have been departures in the equities division, which performed less well than bonds or investment banking last year. Xavier Rolet, whose highly publicized arrival from Goldman Sachs in 1994 was supposed to herald the building of a solid secondary European equity business, suddenly left the firm in April. So too did top-ranked US bank analyst Tom Hanley, who took a six-strong team to UBS in New York. One source at the firm says: "Wheat has let it be known that he is not a research person."
Hanley left for different reasons to the disaffected bond dealers who left en masse in March: money had nothing to do with it. His pay will be the same at UBS as it was at CS First Boston. Nor is he publicly bitter about his former bosses. Hanley says: "I know Wheat has been raked over the coals because of this $9 million pay cheque but I think he's worth every cent. Picture where that firm would be now without him. He put in the re-organization, better management disciplines, proper capital allocation. He has done an excellent job."
But the loss of Hanley, Rolet and others aggravates a concern among many staff at CS First Boston that their firm is falling behind the top global investment banks and sinking into the second tier.
For example, when Hanley arrived at First Boston early in 1992, it boasted one of the strongest teams of investment bankers covering banks and other financial institutions. Richard Thornburgh led this team which included Jack McSpadden, Kenneth McPhail, Mark Monaco, and Michael Martin. Although Martin remains, Thornburgh has moved jobs and other senior bankers have separately left in the last year. That leaves the financial institutions group much weakened at a time when the mergers and acquisitions frenzy in the US banking industry shows no sign of abating. The danger for Hanley and his team was of being left on the sidelines.
At UBS, Hanley renews his acquaintance with former investment banking colleagues from Salomon Brothers. This group is led by Richard Barret, and includes Gerry Smith, Robert Nau and Alan Ginsberg. This team had already shown its worth to UBS by winning the mandate to advise Fleet Financial Group on its purchase of National Westminster's retail banking business in the US.
Hanley considered the move for almost a year, while talking it over with his former Salomon colleagues: "I thought it would be great to put together top-notch investment bankers and top-notch research." He adds: "It's uplifting to come to a group which is being built, from my previous firm where things were getting difficult in the last year or two."
It seems CS First Boston is struggling to maintain the critical mass and to achieve the profitability required to compete as a leading global investment bank. |