If Wall Street bankers are so smart, how can they be so dumb when it comes to paying out bonuses?
Don’t these people read newspapers? Don’t they watch Dylan Ratigan on CNBC or Glenn Beck on FOX News, castigating bankers for their greed and ingratitude to the taxpayers who saved their firms? Haven’t they sat through one speech too many by President Obama insisting that they stop giving million dollar and multi-million dollar bonuses? Have they no idea what it means for the average worker to struggle in an economy with 10% unemployment and another 8% underemployed?
And yet Goldman Sachs is on schedule to give out record bonuses this year totaling nearly $20 billion, or half a million dollars on average per employee. Morgan Stanley is not far behind, and the investment bankers and traders at Merrill Lynch (now wholly owned by Bank of America) and Bear Stearns (now wholly owned by JP Morgan Chase) are going to be treated royally as well. What is it about these people who are supposedly so smart in figuring out the markets but dumb as posts when it comes to judging the larger world in which they operate?
To get to the bottom of this, it helps to know the environment in which these people have been operating, and the history behind Wall Street’s investment banking culture. It is a culture of entitlement, born of the fact that these investment banks operate like private partnerships, even though they are now all public companies.
Thirty years or so in the past, all the Wall Street firms were private partnerships. The partners were the owners, and their personal wealth was held in their ownership shares in the partnership. If it was a profitable year, the partners personally benefited, and their ownership position increased, some of them more than others because shareholdings were divvied up based on a partner’s contribution to the firm. As a Wall Street banker, you could live well enough, but not astoundingly so until you retired, which is when you could cash out your personal shares by selling them for cash to the remaining partners.
This system had discipline to it, because if the firm had a bad year the partners felt it immediately with a hit to the value of their holdings in the firm. Wall Street firms therefore kept a very close eye on risk and return, and for the most part avoided risk by making their money scalping a little bit here and there off each bond or stock offering they brought to the public on behalf of their clients.
Around 1980, this system began to break down. Investment bankers were watching some of their clients in the hedge fund business, or in the leveraged buyout business, make unbelievable fortunes by taking big risks and reaping outlandish rewards. Wall Street knew that their customers weren’t any smarter than they themselves were (the customers were often far dumber), and they realized they could do as well for themselves if they could have access to big amounts of capital in order to take on much more risk.
The public had to be brought into the partnership. In other words, the Wall Street firms had to abandon the partnership legal structure, organize themselves as a public company, sell shares of equity to the public, and use the capital they received to ramp up their risk taking. The secret of making this work for the Wall Street bankers was a fundamental understanding of how public companies in America operate: the shareholders are passive, often indirect investors, through mutual funds especially which don’t pester management with uncomfortable questions and rarely vote against management on any issue brought to the shareholders. This system allows management in corporate America to act as if they own the company themselves, and to run the company in their own personal interest.
This is precisely how Wall Street firms behaved themselves once they went public. The management acted like partners even though they were technically now beholden to the shareholders. They redirected the firms’ focus onto much riskier activity, and added huge amounts of debt to their balance sheets so that like hedge funds or private equity firms, they could begin making 20% to 30% returns on their equity. They began paying out gargantuan bonuses using a formula that paid out in bonuses around half of their revenue ”“ not net income (a much smaller number). Profits that otherwise would have gone to the shareholders as retained earnings were instead paid out year after year in multi-million dollar bonuses.
The shareholders put up with this because, first of all they were passive investors. The average American corporate employee who owns a 401k checks a box saying ”œstock market investment portion”, but they don’t get to say which stocks are bought. This decision is left to some mutual fund manager who may decide to hold Goldman Sachs shares for six months when it looks like the market is rallying short term. If the mutual fund owns the stock long term, it still hasn’t been in a position to complain in the past twenty or more years, because the stock markets were enjoying an unprecedented, extended rally, especially for financial industry stocks.
The only time this system broke down was once last year, when Lehman Bros. was thrown on to the ropes over rumors (largely true) that it had huge losses in its real estate portfolio and it was in danger of running out of liquidity. Mutual funds dumped the stock in a frenzy, pushing the price close to zero. The collapse in value was also helped along by a peculiar propensity of Wall Street firms to engage in naked short selling, pushing shares lower even though the seller doesn’t own or hasn’t borrowed the shares from someone else as would be the case with normal short selling.
Lehman, unlike Bear Stearns which was forced to merge with JP Morgan Chase by the federal government, was allowed to go bankrupt. The resulting systemic crisis was so severe that the government stepped up immediately in support of all the other remaining Wall Street firms, each of which was beginning to experience the same pressure on their stocks as Lehman had gone through before bankruptcy. Goldman Sachs and Morgan Stanley were allowed to become commercial banks, borrow from the Federal Reserve, and receive all sorts of benefits and privileges, including sweetheart deals with the government that provided them with guaranteed profits.
The federal government even took shareholdings in these investment banks, through the TARP investment legislation. So how were you ”“ the taxpayers ”“ treated by the Wall Street firms? Like dirt, basically. You were treated like any other shareholders. You were ignored. Goldman Sachs in particular has gone on doing exactly what it always did, expecting its shareholders to be perfectly happy that the stock price of the firm is rising again, and then paying out 50% of this year’s revenues to themselves as employees. Goldman Sachs is making some small concessions to public pressure; it’s paying a measly $100 million to one of its charitable funds, and it is paying some of the bonuses in GS stock rather than cash. Still, the shareholders are taking it on the chin once again. Money that would have gone into their account as retained earnings is siphoned off into bonuses for management and staff.
You can see what has gone badly wrong here:
a) Wall Street bankers convert to a public corporation from a partnership, but continue to act as if they are a partnership, rewarding themselves with absurd bonuses at the expense of the public shareholders.
b) Wall Street bankers leverage their firms to the hilt, and eventually a highly leveraged financial system hits a wall in 2007 and collapses.
c) The federal government steps in and rescues all sorts of collapsing firms like Fannie Mae, Freddie Mac, and AIG (a company that was neither a commercial nor an investment bank and had no claim on government support other than the risk its collapse posed to the overall economy, or at least to Wall Street).
d) The ”œmarket” ”“ the be all and end all in the world of high finance ”“ is not allowed to work its magic. The weak, the stupid, the greedy, and the corrupt are not forced to face up to their faults and suffer the consequences of their mistakes. Market discipline is squelched by the government in the interest of preventing what is assumed to be a calamitous fall in national economic output.
e) The surviving Wall Street firms have no reason therefore to change their risk taking appetite, nor their avaricious habits when it comes to paying themselves bonuses.
Given this sequence of events, should we all just get used to Wall Street extracting preposterous amounts of personal wealth from the economy? In the short term, yes. Nothing can be done now short of clawing back the bonuses through legislation, which is not going to happen from a Congress bought and paid for by Wall Street.
But note this: Wall Street’s current behavior may be myopic in the extreme. A day may come, sometime soon perhaps, when the credit crisis reasserts itself. Money and credit may once again become hard to get; there is already talk by the government of shutting down many of its support programs. Even if these programs are allowed to remain, the continuing liquidation of debt by American consumers and corporations is on its own likely to bring back credit constraints. When Wall Street turns once again to Washington for protection, this time the door may be closed. This time even a paid-for Congress and a compliant administration in the White House may have had enough. This time Goldman Sachs may be pushed into the pit with Lehman Bros.
One way or another, the day of multi-million dollar bonus payments in the finance sector is coming to an end, not just for Wall Street firms, but for the hedge funds and leveraged buyout firms that are no longer able to work their alchemy because no one is willing to finance them. The global economy can no longer afford to have so much of its wealth siphoned off to such activity. In this respect, if we return to our opening question ”œHow dumb can Wall Street be?” ”“ the answer is very dumb indeed. So dumb that they can’t see that business as usual exists now only because the government and the taxpayers short-circuited the market mechanisms that would have destroyed Goldman Sachs, Morgan Stanley, and probably Citigroup, Bank of America and quite a few other big players as well.
Business as usual also exists because the global bond market is still allowing America to borrow trillions of dollars in new government debt. This too is coming to an end. Long term interest rates have been ratcheting up lately, and something happened last week that was very important but got hardly any notice. Moody’s the ratings agency said for the first time that the US cannot expect to maintain its Aaa rating forever in the face of such deficits. In fact, the firm suggested that the US has about three or four years to begin reducing its deficit or its Aaa rating will be lost.
Is there somebody out there on Wall Street, in the upper echelons of Goldman Sachs or Morgan Stanley or JP Morgan Chase, who is paying serious attention to what is happening to the US credit position? Is there anybody thinking long term? If so, they have to understand that the game is over, and their financial and securitization business model is broken beyond repair. If so, they should be pounding the table in their board room, demanding that the bank or firm change course immediately and exit these businesses.
If so, we won’t hear about them until long after these companies have themselves gone to the wall and finally faced up to the market discipline that should have been imposed last year when the credit crisis first erupted.