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To Bonus, or Not to Bonus? That is the Question
A commenter on a prominent internet financial site posed this
hypothetical (I actually doubt it was that hypothetical, actually):
As
a muni trader, my bonus is derived directly from my P/L which is
accrued over the quarter and kept in a separate account. It does not go
into the firms bottom line and then back out to me. Also, like most
traders, I accrue 2% of my gains in a loss provision account in case I
have a major write-down in the year. My bonus is 10% of my profit for
the year. If I make $50mm for the year my bonus is $5mmWhat
does my bonus have to do with the MBS trader who's sitting on losses?
Did I or did I not show a profit of $40mm to the firm’s bottom line?
I
am very happy this was put up for debate, and I also believe this
anonymous commenter to be a big firm trader or banker. After all, it
honestly does seem that many of the bankers and traders actually do not
understand exactly what the issue is over this bonus thing.
The
"mythical" muni trader above, assuming he works for Goldman Sachs,
would not be entitled to a $5 mm bonus if he made $50 mm for the year.
Why not? Because he generated that 10% return off of taxpayer capital,
not firm capital. Goldman Sachs would have had the drawdown from hell
had they not been rescued from that bad AIG deal. Let's assume that AIG
would have negotiated a 40% payout (if I would have been at the helm,
I believe this is about where we would have settled for the litigation
with an insolvent company that had many more contingent and direct
claims probably would have resulted in lower net receipt). That would
have been a 7.8 million dollar hole. Combine this with the TARP of $10
billion that Goldman said they didn't need yet had to raise capital to
repay (that tells us all we needed to know about whether they needed it
or not) and it is clear to see that Goldman was severely
undercapitalized.
Now, Mr. Muni trader now would not have had
$50 million to trade with if Goldman didn't get bailed out (twice). It
really is as simple as that, thus there is no need to speculate whether
he deserved his 10%. The issue is 10% of what. He could have been paid
10% of his own capital, but he is relying on a 10% vig of tax payer
capital, and that is where the great misunderstanding lies. Even if
somehow one could justify getting paid from taxpayer capital in lieu of
one's own capital or the firm's capital, that capital would have (or at
least should have, as a product of prudent business - if we can call it
that) been pegged with a cost of capital that had a very, very high
hurdle rate that the trader would have to earn over. In other words,
management should say this $50 million cost 14%, thus you will not have
positive ROI until you break that 14% mark. A simpler way of looking at
this is just that Goldman wouldn't have had the $50 million to allocate
to him in the first place, but more along the lines of $1o million. If
the broker earned his requisite 10%, he would have made $1 million, not
$5 million, and with the 14% hurdle rate, would not have received a
bonus at all, and actual would have been negative 4% (clawbacks,
anyone?). Of course these are random, nominal figures, and the cost of
capital could have been 10%. To be realistic, the cost of capital
should have been what Warren Buffet charged Goldman plus the firms own
"vig", which sounds like it would have amounted to 14% anyway.
You
see, not only has the government totally negated the concept of the
"cost of capital" when handing out TARP (hence they got bent over when
it was time to get repaid, and I warned several well placed politicos
personally before the fact), but Goldman Sachs and the rest of Wall
Street (not to pick on GS) fails to take this basic precept of business
finance into consideration when paying bonuses as well. This capital
neglect is good for banking employees in the short term, but it is
literal rape of banking shareholders, for they are getting their
capital used without charge.
Anyone who disagrees with this with
argument using perspectives such as "well, each department is charged
for capital" is free to debate this in the comments section.
After
all if firms do charge inter-department, I doubt that charge is very
realistic given they are getting taxpayer capital for relatively no
charge.
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excellent piece
I hope the powers in Washington get this message before the payouts begin..
Reggie-I understand your cost of capital argument. Great point but WFC did not want the TARP money. Govt made them take the TARP money. Reason that WFC went out into the capital markets to raise the money to return is because they did not wish to continue being in bed with the govt with an ever changing rule/play book mandated by the govt telling WFC how to run their own business.
How does it fit those who work at banks who didn't take government money? Say HSBC guys making money and getting smoked by UK government...
Isn't there a more direct explanation to this guy's post? Let's assume the most favourable of conditions where there's a perfectly reasonable cost of capital attached to this guy's trading book and all that jazz, and he makes 50 million profit to which he's entitled 10%, which is 5 million. Simply, these allocations are ring-fenced only to a certain degree. If the whole company fails, then it doesn't matter who's supposed to get what, everyone goes down. Just like when big companies fail, everyone loses their jobs (ahem...Enron, Barings Bank). Under those circumstances, and given that they were very similar when Lehman went under and AIG did a Titanic impression for a while, that assumption of ring-fencing should not apply. So in adverse conditions, you could be the best runner out there, but if the ship sinks, well, diddly,
If everybody had to reserve properly for the risks that they took and paid the cost of capital on those reserves, then their would be a lot less sinking ships.
I realize I'm part of the idiot tube ignorant unwashed masses, yes I do know my place, but I thought all of this trading was being done by Cray computers and algos. Who in their right minds thinks they deserve $5mm a year for clicking a mouse all day.
I'm clicking my mouse all day on the ZH website, so where's my bailout dude?
Here he is involved in the greatest ponzi scam of all time, he clicks a mouse and enters a position and then clicks that same mouse some time later and exits a position and all of a sudden he's worth $5mm a year?
Can't we just get those ten thousand monkeys currently banging out the latest Hollywood movie on their laptops and fed them crack while they click a mouse sitting at Goldman Sachs prop desks? I'm sure the profits would be the same.
Your thesis of the trader being allocated $50m to trade is a little confused. If he's made $50m on that then his return is 100% pre-bonus, which blows the shit out of a 14% hurdle. On that arithmetic he's very good at his job and 'due' a bonus of $4.3m.
If he's trading Munis and has a a $50m P&L he's more likely trading a notional of (say) $250m-500m, where a 14% hurdle would eat most or all of his P&L.
No argument about whether he's due anything from a moral perspective, though. Not until every single taxpayer dollar is off-risk, including FDIC backed issuance.
So, in that case he deserves his bonus. He earned it.
Well then that means that the profit from trading munis does not fit the risk profile of the firms capital. The cost of capital is still the cost of capital. Making everybody responsible for, and pay for the use of capital will weed out the useful activities from the BS, and automatically cause firms to start doing things that make economic sense.
The post is a FAIL because it missed a key and obvious point by about a mile. The implicit suggestion in grounding the critique of bonuses in the fact that the firm in question received goverment money, is that the same bonus structure was fine and dandy in the years before 2008. Which is emphatically not the case.
Under the trader's rationale, he should internalize his profits. But, obviously, he's not internalizing any losses when such losses occur. Hence, moral hazard is pervasive and the ruling philosophy is: risk it all and either win huge or go home with your base salary and zero bonus (or, at worst, get laid off). Since a couple of $5m bonuses can assure comfortable living without extravagance for a lifetime, the consequence of losing your job is never a particularly scary one.
Now, if they required traders to pledge all of their assets to the firm in the beginning of the year as a condition for bonus eligibility in the end of the year (and foreclose on those assets to if the trader loses money), we'd have a completely different conversation.
Thanks for the supportive words. Maybe you missed this paragraph" In other words, management should say this $50 million cost 14%, thus you will not have positive ROI until you break that 14% mark. A simpler way of looking at this is just that Goldman wouldn't have had the $50 million to allocate to him in the first place, but more along the lines of $1o million. If the broker earned his requisite 10%, he would have made $1 million, not $5 million, and with the 14% hurdle rate, would not have received a bonus at all, and actual would have been negative 4% (clawbacks, anyone?). Of course these are random, nominal figures, and the cost of capital could have been 10%. To be realistic, the cost of capital should have been what Warren Buffet charged Goldman plus the firms own "vig", which sounds like it would have amounted to 14% anyway."
Charge employees on the revenue line for the use of capital and clawback funds (full recourse, of course) when they fall below the cost of capital and they are essentially using their own capital, and are just being fronted capital by the firm/shareholder. I can guarantee you that cowboy bullshit will come to an end quickfast!
It is a simple, yet efficient concept. Hey, it's what I do over here - I really have not choice.
Sorry if I missed it. But practically, how do you determine a WACC for a CDS or even a simple swap? Executing the transaction requires very little money. VAR is large - but that's only relevant to the extent that the bank's reserve requirements are tied to VAR. If they are not, as is the case with many off-balance sheet vehicles (AIG, please step up), WACC is basically zero. So you got both the incentive and the means to take on an extraordinary amount of risk. If the black swan materializes - the company goes bust, but who gives a shit: the mythical trader and his buddies have made out like bandits in the few years that the ponzi worked.
You've got a really perverse situation: the trader shares in the revenues or profits of the corporation without being its shareholder or its creditor (i.e. with no money on the line). This is a situation that cannot stand. Shareholders, unfortunately, lack the means to revolt, so regulators probably should.
Rewarding performance is fine in concept, but disasterous when the job involves playing dice in Vegas.
You're overcomplicating this. Money costs money. It is not free. Money for a high risk endeavor like a prop trading firm costs more money than most endeavors - hard money, high risk money. You simply charge each user of that money that cost of the money, plus the amount the house get's for offering the money. Using your example, for CDS or other swap, you reserve for ALL the risks extant: counterparty risk, credit risk, market risk, etc. That reserve is money set aside in case the shit hits the fan. That money is not free, it costs money. The trader is to be charged for that use of the firms money, even if it is sitting in a side account as a reserve, it is still being tied up. The capital needed to execute the trade is given to the trader and the trader makes the trade. He either makes money on the trade or he doesn't. His bonus does not come into play until ALL of the money that he used for the trade has been paid for. That means that the firm, ie. the shareholders, or in the case of Goldman or AIG, the Taxpayer, has been compensated for the use of their capital. That means if you enter into a swap with $70 million of reserve requirements and $30 million needed to execute the trade, you need to return $14 million to the firm before you start accruing a penny towards your bonus. PERIOD! So if he gets a 5% share of the profits, he will need to make 20% to earn $300k, and that will be split up over the life of the deal. This way, the less risky deals are actually more attractive to traders, primarily because they are less risky. Doesn't that sound like it actually mirrors reality? The more risky deals will need to knock the ball out of the park and be able to carry through the life of the deal without blowing up in order for the trader to think it was worth pursuing. Again, just like in real life. I have no wish at all to cap anyone's compensation. The could make a 200%, which would net over $9 million in bonus at 5%, and nearly $20 million at 10%. Hey, go home and spend happily. Just be sure to realize that your money is at stake like everybody else's.
You will get paid you bonus in an 80/20 or 90/10 restricted stock/cash split and the restriction/vesting period of the stock will depend on the full life cycle of the transaction/deal. For instance, if you wrote a 2 year swap, you have a two year cliff vesting period. If you wrote 5 year MBS, etc.
This cures the loyalty issue that Wall Street has, and it also cures the unnecessary risk takign. Now it is the trader's capital that is at stake when he enters the trade, and it is his capital that is at risk throughout the life of the trade. This also works for salesman (especially salesman), analysts, bankers, etc.
If the deal blows up, then the bank shall claw back whatever capital is necessary to meet the cost of capital hurdle, and it shall do this on a full recourse basis. The employees future earnings and a very significant portion of his salary will go towards filling this hole until the firm (ex. the shareholders) are made whole. Other assets and future revenue streams of the employee are contingently liable and attachable as well.
If the employee does not want to engage in such an arrangement, the employee should not be in a revenue generating position that risks the firms capital. When the firm's (ex. the shareholder's) capital becomes the traders/salesperson's/banker's/analysts/financial engineer's capital and vice versa, you would be amazed at the absence of blowups that occur.
Believe it or not, just 20 or 30 years or so ago, this was how most of Wall Street was run. You never heard of a bank causing the end of the world as we know back then, now did you.
Like I said in the beginning. Let the bank employee blow up his capital first and drive himself into the hole, then the firm's capital, and if a rescue is needed then we can talk about the taxpayer coming in. I doubt it will ever get to that point though.
This is why I subscribe to ZeroHedge!!
"Because he generated that 10% return off of taxpayer capital, not firm capital. "
Bullseye.
Because govt pointed gun at banks and said you must take money(even those that did not want it). We're missing the broader more important point-govt had no business getting involved yet they did and now we have these kinds of debates. Call it the law of unintended consequences when govt got involved but after govt got involved any/everything else is a mere formality as it provides a smokescreen for the govt to do as they wish so we can debate the topic of bonuses. I am not drinking the cool aid and refuse to take the bait hook line and sinker like so many others. Yeah it is taxpayer capital and it sucks yet the govt mandated the allocation of taxpayer capital. The govt intervention should be the real issue not to be glossed over. Let's always remember this when we and so many others have these types of debates.
per my last comment-govt to curry favor with public by teaming up against business. all a facade so govt can get their hands further into business with nobody questioning govt's true motive so the populist can argue over bonuses which isn't the real issue to begin with. wake up johnny public.
Reggie-I usually agree with your commentary but I would argue otherwise on this one. Let's beware the lynch mob mentality prevalent on this issue. For starters, banks like BB&T and WFC did not want the tarp money but they were made to take the tarp money. Granted, GS and MS both additionally lined up to get away from the investment bank charter to become a commercial bank and thus enable them to further line up at the window to get interest free capital. That as a backdrop and now to the more prevalent issue in your commentary-if this hypothetical muni trader made this amount of money with the taxpayer money then your argument forgets to take the other side of the coin which indicates the trader made 40 million for the taxpayers and therefore still affords the profitable trader the bonus. Department allocation deparment schmallication-you earn what you earn and this hypothetical trader earned it regardless of the source. When the govt tells you you have to take the tarp money or else then we have already slid down the slippery slope of a non free market system. Perhaps more importantly lets consider that this was govts backdoor attempt to get their hands intermingled and even control over banking and henceforth business itself. Not as subtle as fabian socialism but you get my drift. The lynch mob mentality we are seeing towards bankers/traders is little more than govt engineered populism to hate the bankers/traders while simultaneously trying to make the govt look like the good guys in this war against wall st and therefore let the govt look good and the bankers look bad when the whole tarp issue was a govt backdoor approach to gain more control. by the backlash we are seeing it seems the govt engineered this beast just right so nobody would question the more important issue as to why the govt would get involved to begin with and everyone would be focused on the populist issues of bonuses. just my opinion.
If WFC didn't need the TARP money, they would not have had to go to the capital markets to raise funds to return it. The fact that they did shows that they DID need the money.
That's the way it should have worked, but it didn't come out that way.
We can't say the trader is profitable if we aren't charging him market rate for the cost of capital. Trading capital was extremely expensive at the time the banks got bailed out. Look at what GS paid to Buffett (someone who knows how to count). The muni trader would have had to overcome the total costs paid to buffet, and break an economic profit above that to be considered profitable. Then we can start talking bonus.
Tell that to all of the REAL businesses out there. The small and medium sized business tht have debt service, payroll, taxes, accounts payable, benefits and insurance to pay out of their net revenues before they see a dime of net income for the owners. That is how business is truly run in America, or at least how it use to be run.
Imagine if you lent money to me to trade at 6% interest, and I made 5% for the year, and kep 10% of that. You come to me asking for your money at the end of the year and I say "Department allocation deparment schmallication-you earn what you earn and this hypothetical trader earned it regardless of the source." What would be your reaction before you call your lawyer? :-)
The other parts of your comment will require an entire post unto itself, and I don't have the time...
with interest rates near 0 and the willingness of the bondmarket to provide 10 year money, for example, at a few percentage points over LIBOR does this not lower the cost of capital appreciably ?
No Bonuses til all loan losses realized! Period!
+1, as this basically equates to no bonuses from here till endgame
Just like the godfather movies, the gangster got legit and stole the money the old fashion way.....bribing corrupt officials for our money
How much of that profit was derived from a steep yield curve? What was the average p+L for similar traders at other firms? In other words, how much was YOU and how much was the seat worth? I would argue that that for most street people -especially senior management - it is about the market, not the person. Rising tides!!. That is why paying majority of bonus in stock that does not vest for several years makes sense. I have no problem for large bonuses for OUTPERFORMANCE - not for the average trader or banker who happens to be in a hot seat in any particular year. After all, they are not risking their OWN money - that is what hedge fund guys do .
How much is HAL's bonus?
The question that has to be answered is:
If there were no bail-out, would you still have a job trading funny pieces of green paper?
If you are that good in making money, then make it yourself with your own dime.
Reggie,
Thanks for your evaluation.
I'm wondering how much free money these people are capable of losing. It doesn't matter to them, they will have already banked what is actually a liquidating distribution of capital.
Bank profits need to go back into the capital base when balance sheets are horrendous and propped by imaginary accounting until the capital levels are sufficient to offset loan losses.
the bonus is a boner up the american tax payers orwellian brain,, ring ,, dog at gruel bowl..
f these people.
support freedom in Iceland
http://tarpley.net/2010/01/07/a-call-to-the-people-of-the-world-to-suppo...
This is brilliantly put, and by far the best thing Reggie Giant Ego has ever written.
Bonus, I got your bonus. As Clint said, "hang em high". This is treason and warrants a death penalty, we can begin alphabetically beginning with R; ...rokefeller, rothschild, etc.
We can outsource the entire lot of these fcukups, I hear there's a pretty competent group in Iceland for example.
...hey, just sayin'.