Wall Street bonuses are back in the news again, as the Obama administration scores cheap political points by bashing bankers.
Wall Street's investment-banking houses correctly claim that they are paying out a much-lower-than-usual percentage of their profits in the form of bonuses – in some cases, less than 50%.
After all, Wall Street earned the money legitimately (aided and abetted by foolishly lax monetary policy, which will come back to bite us). So these firms should have the right to pay out lots of those profits as bonuses – so long as shareholders don't object.
The problem is that shareholders ought to be objecting – and objecting loudly.
You see, the money that Wall Street is using to pay those big bonuses rightfully belongs to the shareholders.
Banking and investment-banking businesses have grown substantially during the last 30 years.
They've also changed a lot.
Thirty years ago, almost all the investment banks were partnerships, with the partners putting up all the capital. Naturally, having put up the money, the partners got the profit. They also took the risk of something going wrong; when a slew of investment banks went bust in 1970, after a horrendous back-office disaster, it was their partners who took the losses, not outside shareholders and certainly not the U.S. taxpayers.
Starting in the late 1970s, investment banks moved increasingly into trading. Before that time, they had been almost purely advisory houses (For instance, Morgan Stanley only established its first trading desk in 1971).
The firms very quickly discovered that – in order to trade as aggressively as they wished to – they needed more capital. So led by Salomon Brothers in 1981, the partners began selling out to other public companies, or raising money (and taking on shareholders) by conducting initial public stock offerings (IPOs). The last true large-scale partnership was Goldman Sachs Group Inc. (NYSE: GS), which did its IPO in 1999.
Initially, the intention was to use the outside capital only to supplement the partners' capital. Starting with the 1980s, however, the business focus became more and more aggressive – and increasingly focused on short-term results. (This trend was again started by Salomon Bros. – and if you've read the investment classic "Liar's Poker" by Michael Lewis, you'll understand the atmosphere that held sway at the time).
Naturally, partners didn't want to have all their money tied up in such a risky business, so they increasingly sold out and relied on stratospheric bonuses to supplement their already substantial fortunes.
As a result, top Wall Street management came to own less and less of their institutions. Even at Goldman Sachs – where as recently as 11 years ago, right after the IPO, management still owned 48% of the company's shares – management's stake in the company is today a puny 5%.
Institutions and mutual funds – now the ultimate "dumb money" – own 80% of the stock.
It used to be that most of an investment bank's profits came from deal fees and from processing other investors' transactions. But as they've grown in size and market stature (or, like Merrill Lynch, have been bought by commercial banks), more and more of their profits are being created by taking "proprietary trading" positions with outside investors' money.
That tendency is likely to continue because of the conflicts of interest involved. If you're a big corporation planning a new deal, the last thing you want is your investment bank trading the hell out of your stock and playing games with your credit. So the advisory business is moving to such "boutique" investment banks as Greenhill & Co. Inc. (NYSE: GHL) and Evercore Partners Inc. (NYSE: EVR).
There's a term that describes a huge institutions whose business is dominated by trading. And it's not an "investment bank."
It's called a "hedge fund."
But hedge-fund management doesn't take anything like 50% of the income in "carried interest" – the hedge fund equivalent of bonuses. In fact, the typical carried-interest percentage is a mere 20% of the firm's profits, and that ratio is actually going down, not up.
It's a logical trend: No matter how skilled the trader or investment manager, institutional money pools won't give away more than 20% of the profits made with their money. These investors have learned from their own experiences that their investment returns after doing so are grossly inferior: Hedge-fund returns are only a little better than those of the broader market, and after the 20% carried-interest charge is backed out, market returns often trump their hedge-fund counterparts.
These days, that should be true for Wall Street also. By all means, allow the corporate-finance types who make the fees to keep, say, half of their net profits – after expenses. After all, transaction fees are now only a modest piece of overall Wall Street profits.
For the traders and investors who manage the capital – the vast bulk of the profits for a modern Wall Street investment house – the bonus percentage should be no more than 20%.
The bottom line here is clear: Both the Obama administration and Wall Street are wrong. The government shouldn't be meddling with Wall Street's bonuses. It's the shareholders who should be meddling – and demanding to keep 80% – not 50% – of the profits being made with their money.
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