Thursday, November 6, 2008

Is Wall Street Pay Falling Far Enough?

(From Calculated Risk) The New York Times, writing from the industry town, tells us "Wall Street’s Pay Is Expected to Plummet," tries to make the case that the calls for scalps deeper pay cuts are overdone:
The first clues are emerging that Wall Street pay will plummet this year — but perhaps not enough to satisfy the financial industry’s critics.

Bonuses, which soared to record heights in recent years, could drop by 20 to 35 percent across the industry, according to a private study to be released on Thursday. Bonuses for top executives could plunge by 70 percent.

But to some, those figures, from the consulting firm Johnson Associates, demand the question: Why should Wall Street executives get any bonuses at all? Banks’ profits have plunged, and the government is spending hundreds of billions of dollars to shore up the industry and prevent its problems from dragging down the economy.

A report on Wednesday from the New York State Assembly said Wall Street bonuses could tumble 41.3 percent next year, which could further widen a budget deficit....

In an interview on Wednesday, Mr. Cuomo suggested that even 70 percent declines for top executives might not be enough, given a financial blowup that culminated in a $700 billion federal rescue for the industry. Many critics, Mr. Cuomo among them, contend that outsize pay encouraged bankers to take outsize risks in the first place. The crisis that followed led to the bankruptcy of Lehman Brothers, the emergency sales of Bear Stearns and Washington Mutual and federal rescues for the insurance giant American International Group and the mortgage companies Fannie Mae and Freddie Mac.

“Given this economic situation, how do you justify any performance bonus at all, is my initial point,” Mr. Cuomo said.

Bankers and traders have been rewarded for taking risks that Wall Street clearly failed to manage. “When you incentivize that type of behavior, you shouldn’t be surprised when you find very risky, overly creative, short-term, highly leveraged products,” he said.

Mr. Cuomo added that he would closely examine the books of the nation’s biggest banks to ensure that no government money went into bonus pools. Henry A. Waxman, the California Democrat who heads the House Committee on Oversight and Government Reform, has asked for similar pay information from banks....

Among different areas of banking, the study suggests that fixed-income traders will see bonuses decline 40 to 45 percent.

Investment banks typically pay out about 50 percent of revenue as compensation, and year-end bonuses can account for a large percentage of employees’ pay. In the past, fat bonuses led to big spending on lavish apartments and other luxuries, and leaner times are expected to hurt New York’s economy.

In previous lean years, Wall Street banks justified large payouts by arguing that top employees would flee for higher-paying jobs. But with tens of thousands of Wall Street jobs disappearing, that argument may no longer hold. “Where are people going to go?” one senior banking executive asked.

I will grant that New York is a horrifically expensive place to live, unless you bought your apartment a long time ago (then it is just expensive). But cost of living has never been a rationale for pay (at least in the US), otherwise artists and writers who live here would be better compensated.

20% to 35% bonus cuts versus the extraordinarily rich payout of 2006-2007 is a complete and utter joke. Let me give you two data points. The first comes from John Whitehead, former co-CEO of Goldman, and mind you, he was raging at the 2006 pay levels:
Nothing in John Whitehead's 37-year career at Goldman Sachs Group Inc. prepared him for the excesses of today's Wall Street.

``I'm appalled at the salaries,'' the retired co-chairman of the securities industry's most profitable firm said in an interview this week. At Goldman, which paid Chairman and Chief Executive Officer Lloyd Blankfein $54 million last year, compensation levels are ``shocking,'' Whitehead said. ``They're the leaders in this outrageous increase.''

Pay packages for traders and investment bankers are soaring as Goldman and its rivals fight the lure of hedge funds, private pools of capital that offer managers a cut of profits on the money they invest. Last year, the five biggest Wall Street firms paid a record $36 billion of bonuses, more than $200,000 per employee.

New York-based Goldman set the pace. Blankfein out-earned all of his counterparts and Co-Presidents Gary Cohn and Jon Winkelried each received $53 million, including cash bonuses of $26.7 million. Goldman employees shared $16.5 billion of compensation and benefits, an average of $621,800 apiece. That's up 20 percent from a year earlier and almost $300,000 more than the firm's closest rival.

Whitehead, who left the firm in 1984 and now chairs its charitable foundation, said Goldman should be courageous enough to curb bonuses, even if the effort to return a sense of restraint to Wall Street costs it some valued employees. No securities firm can match the pay available in a good year at the top hedge funds.

``I would take the chance of losing a lot of them and let them see what happens when the hedge fund bubble, as I see it, ends,'' Whitehead, 85...

Goldman partners in Whitehead's day made salaries of $120,000, compared with $600,000 today. Their cut of the firm's profit was plowed back into Goldman's capital and remained mostly unavailable until retirement. When Goldman sold shares in an initial public offering in 1999, partners with a claim on the firm's book value received five times as much in stock.

The second data point is what normally happens in a downturn, and 20% to 35% bonus cuts is well below normal for a bad industry contraction. Moreover, per Whitehead, past boom periods were no where as rich as the latest one, so one should expect even deeper reductions, rather than the comparatively shallow ones in the works.

Bonus cuts are normally much steeper for middle level and senior professionals than the rank and file. For instance, in the dot-bomb era, I know of investment banking MDs (well regarded, still in the saddle)whose bonuses fell by 70%. They knew they were appreciated because the MDs who weren't were fired. I don't have a sense of the level of the pay cuts, but in the 1990-1991 recession, three quarters of the M&A bankers were fired. The prospects for the industry looked so bad that in an unprecedented move, a record number of Goldman partners went limited (that meant their capital account was valued, and would earn interest at a pre-set rate, and they could gradually pull it out over a long period of time). Why did they do this? Because they expected that the firm was going to take such large losses that they thought their capital accounts (even with high Goldman earnings) would not return to their current levels in any reasonable time period (to my knowledge, the firm had never seen such "every man for himself" behavior in previous tough times)

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