We know bad things happen to common shareholders of companies blighted by greedy management. Companies like Enron, Tyco and Worldcom. Eric Fry at Rude Awakening says you can add the names Lehman Brothers (NYSE:LEH) and Merrill Lynch (NYSE:MER) to this list.”Greed and capital preservation don’t seem to mix very well,” says Eric. And the bonus system on Wall Street ensures that greed is the numero uno driving force driving the system…

More from Eric:

No automatic connection exists between greed and poor stock market performance. But bad things just seem to happen to the common shareholders of companies that greedy managements oversee. Names like Enron, Tyco and Worldcom come to mind.

In this context, names like Merrill Lynch and Morgan Stanley do not yet come to mind. But the big brokerage firms of Wall Street have veered perilously close to the shoals of excessive greed. And this course endangers shareholders because it squanders capital that could be funding productive activities, or providing a balance sheet buffer against future unanticipated “adverse outcomes.”

As long as the financial markets remain robust, however, no one will care how many billions of dollars might slosh into the brimming bank accounts of elite traders and top Wall Street insiders. But financial markets are not always robust. The same Citigroup (C) that is today lavishing billions on its top employees was once the Citibank that flirted with bankruptcy in the early 1990s.

Bank and brokerage stocks are already risky enough, thanks to the perennial risks of falling financial markets, rising interest rates and exploding derivatives books. Avaricious management teams do not lessen these risks.

The owners of brokerage shares, therefore, do well to remember that Wall Street is forever and always about money. It is about making as much money as humanly possible, in as many different ways as legally defensible. Wall Street is not about charity or altruism or the “greater good.”

Wall Street is also about survival of the fittest – the ‘fittest’ being those who maneuver themselves into obscenely overcompensated positions. Do these alpha-bankers and alpha-traders deserve their millions? In a primal sense, yes…just like a great white shark deserves a slow-moving harbor seal…or a falcon deserves a hapless bunny…or a coyote deserves the neighbor’s dozing Pomeranian.

But these metaphors become a bit sinister when one realizes that the “hapless bunny” and the “dozing Pomeranian” are the common shareholders.

The big brokerage firms make most of their money by speculating with capital that does not belong to them, or by levying fees and commissions on capital that their clients put at risk in the financial markets. In other words, shareholders and clients bear most of the risks. Yet whenever any form of success arrives, Wall Street’s elite always garner an outsized share of the rewards. That’s asymmetry. And in this case, asymmetry might just be another word for greed.

Consider the case of Morgan Stanley. The firm posted net income of $7.4 billion in 2006 – an impressive $3.7 billion more than 2003 earnings. But at the same time, total compensation at Morgan Stanley last year topped $14.3 billion – a whopping $5.8 billion more than in 2003.

Does it not seem odd that employee compensation is nearly twice the firm’s net income? And does it not seem odd that employee compensation has jumped 60% more than net income since 2003, even though the number of employees has barely increased at all? In fact the employee count has DROPPED since the end of 2002.

Most of the individual recipients of year-end bonuses are not to blame, of course. They are simply blessed. And as blessed individuals, they enjoy the privilege of sharing their wealth in altruistic and charitable ways…or not. Likewise, the stockbrokers who toil for these firms deserve no scorn. They earn their keep like entrepreneurs, and must conduct their activities in a very open and competitive marketplace.

But the leaders of Wall Street – those who perpetuate the status quo – might consider taking a minute of “quiet time” to consider the propriety of their practices. Do these folks honestly believe that they deserve their multi-million-dollar bonuses, simply for presiding over bull market trading activity? And do they honestly believe that “star” traders deserve their multi-million-dollar bonuses, simply for speculating with someone else’s capital.

To re-phrase the question: Isn’t it possible that Wall Street’s elite employees should receive a somewhat smaller share of corporate cashflows than they do currently…and that the common shareholders should receive a somewhat larger share?

“Nobody who is hired help and who plays with other people’s money ‘deserves’ to earn $100 million,” gripes Steven Pearlstein in a terrific article for the Washington Post. “That’s certainly true in a moral sense. But it is also true economically…Let’s start with the fundamental asymmetry of risk in the investment business.

“If you were putting your own money at risk,” Pearlstein continues, “there’s the possibility of making lots more, but there’s also the possibility you could lose it all. The same, however, can’t be said if you are an investment banker, a hedge fund manager or a trader in credit default swaps. In that case, if you do well, you get a percentage of the winnings or the value of the deal. But if you do poorly and your clients lose money, the worst that happens is that your bonus is zero. You never have to give back anything from the bonus you earned last year. And you still get a base salary comfortable enough to keep up payments on the Upper East Side townhouse, the summer place on Nantucket and the tuitions at Brearley.”

No one cares about over-the-top compensation schemes when business is booming…and when share prices are rising. But on the downside, everyone cares. During the Great Bull Market of the late 1990s, almost no one bothered to question the exorbitant option grants that Silicon Valley companies lavished on their employees (and on their board members!)

But once the Great Bull Market ended, and the Nasdaq imploded, a new bull market in recrimination and litigation began. Class-action shareholder lawsuits erupted from the smoldering remains of former Wall Street darlings, as desperate shareholders tried to recover some small fraction of their losses.

Would it not have been much better for these abused shareholders to sell when the selling was good? Would it not have been better to have raised a skeptical eyebrow toward the questionable corporate practices of the era and headed the other way…even though questionable corporate practices were producing rising share prices?

“Excess compensation in one area leads to excess compensation in others, “Pearlstein concludes. “And that, in the end, is how this arms race in executive pay comes about. It’s more about envy than economics. The corporate executives complain they should make as much as the investment bankers, the bankers are upset if they don’t make as much as the private-equity guys, the private-equity guys demand to make as much as the traders, and the traders won’t sit still until they are paid like hedge fund managers.”

Excess compensation also leads to sub-optimal shareholder returns. Greed and capital preservation just don’t seem to mix very well, especially when the greed belongs to someone else and the capital belongs to you.

Source: Bonus Envy