Big Bad Banker Bonuses: Part One

For many firms the end of the year means bonus season. Employees await their share of the pool, hoping to be rewarded for hard work and success. While 2011 has been one of the worst years for investments firms across the board, many hard workers are still seething about the over-the-top bonuses given out while their homes were being foreclosed. Like most populist anger there were words like evil, theft, scumbags, assholes, gamblers, and the whole lot directed at the financial industry. I am not going to say that employees at investment firms deserved large bonuses, just explain why they still got them.

1. Benchmarks

If you have a 401k or retirement fund, your money is with a whole load of different money managers. There are two types of money management: passive and active. Passive is cheaper and involves someone just buying into an index such as the S&P 500. Active is when someone tries to beat a certain index. The rules of the game are complex, but in simple terms their goal is to get a higher return than the chosen index without taking on more risk. I use the S&P500 as an example, but there are many indexes that can be used as benchmarks. These indexes follow certain methodologies for selecting their members; the S&P500 uses the top 500 highest capitalization firms in the United States (amongst a few other metrics). Now let’s imagine it is 2008 and you were having your money managed by Dr. Evil. He was actively managing your money against the XYZ Index (If I make it up I don’t need to look up the real numbers!). Now let’s say his contract stipulates that he receives 0.2% of all gains above the return of the XYZ index in addition to a base management fee. At the end of the 2008 the XYZ Index was down 20% as there was an awful crash. But the money he was managing was only down 15%. That means even though it was down 15%, it was still up 5% relative to the index he was benchmarking against. He just got a huge bonus. And you signed the contract at the beginning of the year. And perhaps he even deserves the money; after all, you lost less money than if you had just invested your money in the S&P500 passively. But he just received a performance bonus of millions while the person whose retirement money he was managing was shrinking. It doesn’t look good.

2. Monetary Easing and Bailouts

It should be noted that I only group monetary and fiscal policy together because they both result from government intervention, the first from the Federal Reserve and the second from Congress. Monetary easing is the practice of lending at cheaper rates while bailouts involve buying assets with taxpayer money. In a monetary crisis liquidity dries up quickly, which can grind the economy to a halt. So the Fed pumps money into the system by lowering their interest rates and letting huge banks that are a part of a select group borrow from them at cheap rates. Before the crisis these were called overnight loans. Overnight loans existed only to help banks meet ultra short-term solvency needs despite the fact that they were fundamentally strong. Banks sometimes have fluctuations in withdrawals and the Fed discount window allows them to borrow money to meet these needs if they have underestimated how much would be withdrawn that day. The rate they borrow at isn’t appealing and the Fed gets a ‘good deal.’ However, during the crisis the amount they could borrow was lowered to near-zero and instead of it being overnight it was lent at medium to high durations. The Fed also accepted toxic collateral for the first time instead of just AAA and Investment Grade debt. In short, this means that a select group of 21 ‘primary dealer’ banks could borrow for almost nothing, with worthless collateral, and lend out for profit. This system was necessary to avoid panic and keep liquidity flowing. But it had the side effect of letting banks pretty much print money courtesy of the Fed. Suddenly some executives were getting large bonuses while everything else was falling apart. The government wasn’t happy about this but it is illegal for them to void the bonus contracts in place at the firms.

While the structure was far different, TARP had a similar effect on bonuses. The big financial dealer firms had been making unprecedented levels of money over the past years by leveraging (taking on debt) and buying debt such as MBS (Mortgage Backed Securities), securitizing them, and selling them as highly rated bonds.

This post is short and not meant to be a comprehensive empirical study. Of the 21 primary dealer firms some had large bonuses and others such as Lehman went bankrupt. However, a brief case study of Goldman Sachs can give deep insight into the bonus anger during the crisis. Many of the most famous and outcry- inducing bonuses were awarded to Goldman Sachs employees, of whom 953 received bonuses of $1 million or more in 2008 (The CEO Lloyd Blankfein and six other executives turned down bonuses for image purposes). Even in the financial world there is animosity towards Goldman Sachs. While the firm was part of the creation of the leveraged mortgage crisis, they simultaneously profited from a huge bet against MBS.

As a result Goldman Sachs didn’t do nearly as awfully as other firms, and actually made money in 2008. While the collapse still hurt them in other ways, the MBS crisis wasn’t an existential threat for them. Goldman initially refused TARP money and accepted $10 billion when they were forced to, paying it back April 21st, 2010. So Goldman was forced to borrow money they didn’t want, weren’t in a situation nearly as bad as other firms due to their bet against MBS, and were able to borrow money from the Fed at near 0% and lend it out. They ended up actually not doing that badly given the circumstances. And the benefits they received from TARP, they didn’t even want in the first place. There are still reasons to find fault with Goldman. However, it is incorrect to stay they ‘stole’ from taxpayers or were part of a corrupt government deal.

3. The payment system for bankers

For most Americans a bonus isn’t a part of their paycheck. And for those that it is, it’s generally a small portion of their paycheck. Even the word bonus suggests that it is something above and beyond a salary as a reward for being awesome. In the financial world, however, bonuses are common and are considered an essential piece of an employee’s compensation package. It is really just an incentive payment as well as a hedge by the firms. Investments is, by nature, an extremely cyclical sector. Some years are great and others are awful. As a result payment for employees is great some years and awful other years. For many employees bonuses are traditionally equal to 1-4 times their salary. This way in a great economy, financial firms can pay their employees well, but in a poor economy they don’t need to pay as much. It would be more apt to call them something other than bonuses, which makes everyone think they are receiving a wad of cash on top of their normal salary. This argument is the weakest of all those I have presented as it is based more on my personal experiences than on economic theory.

4. Conflicts of interest.

Most of the rottenness in the system isn’t from corruption. To clarify, I would consider it rotten if a person is receiving lots of money without contributing and creating wealth for society. This situation exists because of poor regulation, lack of regulation, and over-regulation. There are many conflicts of interest at play in the financial system. For example, during an Initial Public Offering (IPO), the investment banking portion of the firm that is putting it together will often give the asset management portion of the firm ‘first dibs’ on shares that they might know with reasonable confidence will increase by 30% in the first hour of trading. IPOs are often underpriced as free publicity for a firm. It sounds good when a firm’s equity rises 30% in the first day, and is even better when the bank putting together the IPO can profit from this bounce. Sometimes investment bankers will also tip off proprietary traders of a firm of a new acquisition that might happen. The Dodd-Frank bill is attempting to dismantle many of these conflicts of interest. The conflicts of interest were made illegal when the Glass-Steagle act was passed in 1932, eliminating big banks and investment firm from being the same entity. This act was repealed in 1999. While there were many good reasons for it to be repealed, it did not accurately deal with the conflicts of interest. While making money off these conflicts appears unethical, I believe it is primarily the legislators fault for not properly monitoring the law. Such conflicts of interest create unique opportunities for bankers to make a lot of money, thereby increasing the firm’s profits and their own bonus pool alike.

5. Corruption: To be continued…

-Simon

Additional reading on Federal Reserve policy: 

Use of the Discount Window during the crisis: 

http://www.federalreserve.gov/pubs/feds/2011/201123/201123pap.pdf

Announcement of liquidity-enhancing measures on September 14, 2008: 

http://www.federalreserve.gov/newsevents/press/monetary/20080914a.htm

2 thoughts on “Big Bad Banker Bonuses: Part One

  1. I’ll be the first to defend GS & banker bonuses.

    While I’ll agree bonuses have become a thing to be expected, rather than deserved, which shouldn’t necessarily be the case. I’ll say that how many other industries is it the norm to work 60-120 hrs a week (Note: No one works just 40hrs… This is America for better or worse…but that’s another discussion… ) ?

    The reason bankers get paid a lot is because they either make a lot in the good times or they work their asses off in the hard times. Now I realize this is up for debate and its part of a broader social movement, but America is built on Capitalism and to to the victor goes the throne. Money management as you described it is a shame and those who don’t know it are either ignorant or blissfully ignorant.

    As for GS, I’ll stand by them and say that they didn’t have a BIG short or were out for anyone. They simply had the best people and intelligence. They hedged correctly and took precautions for the worst. Is it wrong that a firm saw with foresight that a unsustainable problem was escalating and they decided to reduce their risk exposure to it?

    The market has punished those firms who have high exposure to EU markets (MS), wouldn’t this be called prudent risk management? Who at this point is holding a lot of money with EU banks when we know they are still in for trouble..

    Either way I think its wrong to direct anger or even attention to GS & other financial institutions or things in the past. We still face bigger issues such as the majors Bulge brackets are TOO BIG TOO FAIL ( More than a term a policy…Reference Senate Testimony after LTCM), which actually puts tax payers at risk, and the fact that we are likely more at risk than ever due to the Basel Banking rules, (Sovereign Debt is risk free…Tell That to Greek Bond Holders…) have failed to solve many of the fundamental issues at hand.

    All in I get it. I understand the anger toward bonuses. They shouldn’t have been paid. They were contracts though so what do we do now? Finance is though, it’s integral to the economy, but also prone to abuse and crisis. So the only real fix is a better understanding of the problems and also the causes.

    I will finish by saying that no CDO could have been made without willing buyers, willing sellers, willing borrowers, low interest rates, and a false sense of security…

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