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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.
News and Related Story Links:
- CNNMoney.com:
Smaller Investment Banks Jump Into Equity Capital Markets - Wikipedia:
Partnerships - Amazon.com:
Liar's Poker - Wikipedia:
Michael Lewis - All Movie Guide:
Risky Business - Wikipedia:
IPO - Answers.com:
Proprietary Trading - Wikipedia:
Carried Interest
Unless you own over 50% of the stock, your individual share holders don't have the power
to curb bonuses. Yes, I could exercise my power by selling my stock but is it worth taking
a loss? Share holders have sued board members for wrongful acts, but fundamentally
corporations don't care about individual investors. The board members aren't in it for
their investors, instead they are lining their pocket books.
Finally, someone really seems to understand the problem. When Wall Street firms were true partnerships, sharing the gains were usually limited to a small portion of the the trading gains because they understood that it in someways is a zero sum game. The big gains today are likely followed by big losses tomorrow.
That is why, during the 60s, 70s and part of the 80s, investment banks and commercial banks restricted the amount of capital available for trading.
You are exactly right that the bonuses are really the profits due the investors who take all of the risk. Under the present system, the traders take little or no personal risk and trade other people's money and keep a large share of the profits. It has been going on for a while and needs to stop. Someday institutional investors will wake up.
I have voted against companies increasing the amount of stock outstanding for some
50 years. Been attending stockholder meetings for some 40 years. I thought when the USA passed a law (a company paying over one million to a employ) could not deduct the over million payment from the income tax, would help stock holders. This caused all kinds of stock options. Thusly deluting shareholders holdings and lining the pockets of company
officers. It seems to me, that every time a rule is made, the smarties figure a way around the rules meaning
Who are these "shareholders"? The average Joe and Jane who have 401ks and IRAs are diffused and scattered across the country, even overseas. If you can unite them, and through the internet you probably can, you have my vote.
i find your points are all self conflicted. Shareholders are part of the wall street too. They are all no less greedy and may be more so if giving the chances. This is including all the new letter writers who are giving investment advices. All such e-mail I received so far bombard my head with greedy bombs. You guys are the Greedy bunch.
The whole structure seems wrong. Individual investors are providing the capital for these traders to "gamble". If they win the trader keeps 50%. If they lose big enough (causing the company to go bankrupt) the investor loses it all. The trader really has no incentive NOT to gamble. GS management has pulled their money out and are now making money gambling. If they lose, they can just go start another company. Why are investors putting up with this?
One way of looking at this is that the shareholders of a larger entity called the United States are excercising their right to curb banker bonuses through their elected government. The banks have the privalege to operate within the domain owned by those shareholders but have acted in a manner that most shareholders of the US have found reprehensible.
When I studied economics (long ago) we were told that Directors are supposed to represnt the shareholders, set policy, and hire managers. Management was to run the day-to day business. The only way I can see to break the incestuous conflict of interest created by permitting selecting director candidates and voting proxies for them. The maximum conflict of interest is the Chairman/CEO! Individual shareholders are powerless, so the fix will have to be:
Active involvment of institutional shareholders/mutual funds in selecting directors with
fiduciary responsability to share holders, or;
LEGISLATION: to prohibit management from soliciting/voting proxies or serving as directors and,
clearly establishing the binding fiduciary responsability of directors to shareholders.
last year when things went to hell in hand basket , I stated they should only bail out the banks & wall street if the return was worth it , meaning that the banks , wall st etc , should have to pay a large portion of any profits made over the next 5 years back & the curb/lower their pay scale back to reality , instead we bailed them out and they are doing the same #$#@&%%$ sh-t now tha t they did before …
While it is a great idea that shareholders control compensation and particularly bonuses, It is incredibly naive to even suggest that the individual investor who owns at most a few hundred shares can have any influence whatsover on those items. Maybe an institutional investor with a large number of shares (or better yet a group nof institutional investors) can exert some influence. What are they doing aobut this?
I agree that it is dangerous precedent to allow the government to influence compensation and bonuses for privately held businesses. But please, a small individual investor like myself and many others has, and I submit never will have, any influence on this issue. I choose not to buy stocks in companies that operate as we see most large banks now operating. This is one small investors influence, but it does no good whatsoever. The corporation doesn't care if I own the stock or not.
You'll find fewer market participants dumber than bankers who THINK that they are traders. Those are the ones who would load up on oil at $147/barrel, silver at $20/ounce, and gold at $1200/ounce. We'll probably see them selling at $10/barrel, $3.50/ounce, and $250/ounce, if they aren't forced to liquidate sooner by margin calls. And if they aren't using your money on outright gambles like those, then they lent it to somebody with a job at McDonalds to buy a $50,000 house for $800,000 on credit, or lent it to Dubai to build an indoor snow ski slope or artificial islands. Some day we as a people are going to decide that banks once again risk exclusively their own capital and nobody else's.