Wall Street Bonuses Will Cost Us All in the Long Run

Wall Street firms may not be reaping the record-breaking revenues of 2004-2007, but they're paying themselves the lofty bonuses of that lavish era - and they're doing it at our expense and with the government's blessing.

Wall Street's pay packages, including bonuses, are set to total 4% more in 2010 than in the already record year of 2009, The Wall Street Journal recently reported.

I yield to nobody in respect for the investment banking business - having served as an investment banker for 27 years - but these salaries and bonuses derive from U.S. Federal Reserve subsidies, and are mostly being taken out of the hide of the rest of us. 

Wall Street's record bonuses come out of bank earnings that have been pretty robust, though not necessarily record-breaking. This is mainly the result of two Fed subsidies:

The first has to do with the historically low Federal Funds rate, which remains at range of 0-0.25%. Very low interest rates allow banks and investment banks to borrow at 1% or less and invest in government guaranteed mortgage bonds that pay more than 4%. Leverage that 20 or 30 times, and it becomes a highly profitable no-brainer - to hell with lending to small business!

Normally, the risk that interest rates would rise would make this a losing proposition. However, with U.S. Federal Reserve Chairman Ben S. Bernanke committed to low rates for an "extended period" and very likely buying more Treasuries in coming months, the risk of loss in this year's bonus period is negligible.

The second Fed subsidy, which also was contrived through loose credit conditions, is in bond markets. Record volumes of debt have been issued in the corporate bond market, and especially in the more lucrative junk bond market. These represent new attractive investment opportunities for the balance sheet, because with such low rates, the likelihood of default is slight. They also provide Wall Street with a massive amount of issuing and placing fees up front, fattening the bonuses further.

The other big source of Wall Street billions is "high-frequency trading" (HFT) as featured on an Oct. 10 episode of CBS's television news program "60 Minutes." HFT involves placing computers next to stock exchange servers, so that they can pick up the trading flow before the general public. The computers also place false, immediately cancelled orders to stimulate other activity.

This kind of activity is akin to insider trading - except the inside information is of the order flow rather than of a company's next quarter's earnings. And the immediately cancelled orders are arguably fraud.  

These actions are difficult to prosecute, because market makers in all markets have more knowledge of the order flow than outsiders. And Wall Street is exploiting them to make billions, while providing no useful service. Some argue that HFT provides liquidity, but that liquidity dries up rapidly when trading conditions become turbulent.

If we can't make high-frequency trading illegal, we should at least tax the hell out of it, through a "Tobin tax" on transactions. That would make it less profitable and reduce the value being sucked out of the pockets of ordinary investors by Wall Street's computers.

With the exception of high-speed trading Wall Street's exceptional profitability looks at first sight harmless - after all deals get done, and money gets made. But that's naive.

Recall how the crash of 2008 happened. Wall Street - with the help of interest rates that remained low for far too long - invented securitization, credit default swaps and subprime mortgages. Eventually, the house of cards collapsed. (Yes, ordinary people were greedy and foolish too, but ordinary people will always be greedy and foolish if the system encourages them to be.)

Wall Street missed its bonuses for a year, and some of its top people had to survive 2008 on a $1 salary. Still, it recovered quickly and has paid its people better than ever in 2009 and 2010. That hasn't been the case for the rest of us - 2009 and 2010 have been years of grinding recession, with high unemployment and little or no economic growth.

In other words, we are the ones financing Wall Street's profits, and the resultant bonuses it has paid itself.  Yet if we hadn't had the Wall Street bubble, the recession would have been mild and we'd already be back to steady growth by now.

Now we are instead seeing more bubbles, mostly in bond markets. At some point inflation will arrive as a result of the Fed's money printing, and interest rates will rise. When that happens, the banks holding mortgage bonds will lose money and the bonds will decline in value (probably necessitating yet another bailout).

More dangerously, the junk bond companies that have borrowed too much will default, throwing their employees out of work and causing more humongous losses all over the system. Naturally, faced with this further crisis, the economy will collapse again.

And so Wall Street's 2009 and 2010 bonuses, just like its 2004-2007 bonuses, will end up being paid from the losses incurred by everybody else after the inevitable crash. And when we've dug ourselves out from the rubble, we will again be poorer than we were before - the U.S. economy's enormous competitive advantage of capital will have been further eroded.

That would be dangerous, because China now has lots of capital and lots of workers who are just as smart as Americans. So if the U.S. lacks capital there will no longer be any reason why Americans should be paid more than Chinese workers and U.S. living standards will decline drastically.

Fortunately there's a solution to this. And no, it's not to lynch all the bankers and close down the banks. It's to harass the Obama administration, Congress and the U.S. Federal Reserve to shrink the budget deficit drastically, reduce our need to borrow from the world, and raise interest rates to sensible levels - 5% or so - so it's worthwhile to save again.

That will make Wall Street squeal as its bonus pool gets decimated. But for the rest of us, it is our one hope for economic salvation.

Action to Take: Contact your local representatives and encourage them to address the soaring budget deficit and loose monetary policy.  You might also raise concerns about high-frequency trading on Wall Street. Write state legislatures, as well as your representatives in the U.S. Senate, the House of Representatives, and even the White House. You can find contact information for many lawmakers at USA.gov.

[Editor's Note: If you have any doubts at all about Martin Hutchinson's market calls, take a moment to consider this story.

Three years ago - late October 2007, to be exact - Hutchinson told Money Morning readers to buy gold. At the time, it was trading at less than $770 an ounce. Gold zoomed up to $1,000 an ounce - creating a nice little profit for readers who heeded the columnist's advice.

But Hutchinson wasn't done.

Just a few months later - it's now April 2008 - with gold having dropped back to the $900 level, he reiterated his call. Those who already owned gold should hold on, or buy more, he said. And those who failed to listen to him the first time around should take this opportunity to remedy their oversight, he urged.

Well, we all know where gold is trading at today - in the neighborhood of $1,370 an ounce.

For investors who heeded Hutchinson's advice, that's a pretty nice neighborhood.

Investors who bought in after his first market call are sitting on a profit of as much as 78%. Even those who waited, and bought in at the $900 level, have a gain of as much as 52%.

And let's face it, with the U.S. Federal Reserve getting ready to launch "QE2" (and, by that, we're not referring to a luxury ocean liner - but rather a new round of "quantitative easing" that many of us fear will be highly inflationary), gold and other precious metals are likely headed much higher.

But perhaps you don't want just "one" recommendation. Indeed, smart investors will want an ongoing access to Hutchinson's expertise. If that's the case, then The Merchant Banker Alert, Hutchinson's private advisory service, is worth your consideration.

For more information on The Merchant Banker Alert, please click here.]

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