The Bonus Dilemma
Dear All
As we just crown off the first month of our final twelve according to the Mayans, one of the most important events in Finance is upon us. Q4 GDP? Q4 Results? Christmas Sales Figures? No, No and No. I am, of course, referring to the season where individuals from all walks of finance are found in bars across the world either drowning their sorrows or reaping the rewards for another well remunerated year. Bonuses, are by their definition, an extra reward for achieving what can be considered "above the norm" financial results; despite the practices of many of the leading banks throughout 2007-2008. But..But..We had to retain the best talent I hear echoing around the room. A rhetoric that the ordinary Anglo-European finds very hard to stomach.
"Out of Control"
UK Prime Minister David Cameron on Bank Bonuses
The media and public bashing of the bonus culture that surrounds the financial sector and its quantitive nature is nothing new. However, given the events that have unfolded over the last five years, individuals all over the planet have a right to vent there frustration. Whether you blame lackadaisical policies by Governments, extreme risk taking by financial institutions, personal greed or general naivety for the housing crash - the effects have impacted us all in some form or another. A quick rewind of the tapes would quickly remind us of all the soon-to-be pensioners that piled their nest egg into property in the hope of crystallising a long term rental yield or capital gain only to find, in some circumstances, over fifty percent of their net asset value being destroyed during the crash. A very bitter pill to swallow. One, that is made exponentially worse by news that many of the Wall Street and City of London elite are taking home seven figures for their efforts this year.
Last week saw this frustration come to a head when the CEO of The Royal Bank of Scotland (A Zombie Bank), Simon Hester, decided to refuse his $1.6m bonus in light of increasing public scrutiny. The bank, owned 82% by the British taxpayer, has been left limping around the financial realm following what can only be described as some of the worst acquisitions and business organisation that has been seen in British finance since the Barrings escapade of the 90's. So fierce was the public outrage about RBS, since the start of the year, that the former RBS CEO, Fred Goodwin, was stripped of his knighthood by the British realm. More interesting is why he was knighted in first place but that is a discussion for another day. Anyway, back to bonuses.
"I was going to live on my salary or go down swinging"
Gene Tierney
Despite the resentment towards the bonus culture that is smeared across the Finance industry, the bonus system is significantly better for unemployment, shareholders and the state of the finance industry more generally than the pay scheme that has developed over the last three years. Before I explain why, I must note that the singular biggest floor of bonuses within Financial Institutions - especially banks - as strongly advocated by David Einhorn, is that combining performance related pay and leveraged investment in high risk financial products is almost certain to create financial bubbles. However, the current alternative pay structure that is being run within these institutions could very well be their downfall.
"It's not your salary that makes you rich, it's your spending habits"
Charles A Jaffe
The year is 2005, the S&P 500 has just returned 9% in 2004 and winning has become norm. The risk off episode following the Internet bubble has finally cleared from technology, and global risk is most definitely on. Seeing as this time is different, we have been advising our clients to diversify into the Emerging Markets not only to spread risk but also to take advantage of the fabulous opportunities that exist in these "booming" economies. Real estate continues to provide impressive gains and using synthetic derivatives, investors can now diversify their Mortgage Backed Securities risk by purchasing tranches of a revolutionary product called Collateralised Debt Obligations. You get the picture. During this period, the bulk of remuneration was made through discretionary pay that tended to reflect the impressive returns that both individual and institutions were making - albeit with very high leverage. Traders taking home $1m would expect to have around a 3:1 discretionary to salary based ratio for payment so that as long as profit was being made, the bonuses would continue to grow.
What has transpired is that as the media, government and public have scrutinised the sector during the fallout from the property boom, this ratio has changed. To "retain the best talent", these institutions have increased non-discretionary pay to astronomical and unheard of levels, whilst reducing the discretionary element of financial reward. A friend of mine recently revealed that the salary for a Managing Director - at one of the US Zombie banks - was doubled to encourage staff to stay and prepare them for lower discretionary pay. However, the lasting net effect of this across a global business is a huge increase in the fixed cost base from salary expense.
"As long as they are incremental or success-based, incentives work"
Dwain Celistan, DHR International
The effect of this was not properly experienced until the second half of last year when banking revenues failed to meet expected growth assumptions and the banks looked to shred their fixed cost bases to keep shareholders happy. Add in the catalyst of Europe and the implementation of Operation Twist (for its negative carry), and the banks proverbially wet themselves and fired just about everyone in sight. So far, the global fallout has been around the 100 000 mark from leading institutions (depending on your source) and I would hypothesise that a multiple of this number have lost their jobs from subsidiary industries that are supported by the financial marketplace. Both the direct and indirect effects of this in terms of unemployment, spending and subsidiary industry performance within the economy should not be underestimated. In general, an individuals spending of bonus income in comparison to salary income will be far more irrational and spontaneous which actually forms an essential part of economic consumption.
The sheer scale of this issue, until now, has been truly understated; and as the financial climate continues its volatile cycle due to fiscal incompetence, trying to explain this to the public seems to become somewhat of an impossible task. As we will no doubt see, the fallout from government profligacy will see the financial sector become a political scapegoat for a largely anticipated downturn. Still hate bonuses? Think again.
"The Euro has made Europe Stronger"
Angela Merkel
Onto the articles. The first link is to, the now infamous, Things That Make You Go Hmm.. from my friend Grant Williams. In this edition, Grant takes a look at the idea of Inflation targeting and the idiosyncrasies that exist within its rhetoric. Second, is a fascinating graph from Barclays Capital (via Zerohedge) which highlights both the size of Apple as a firm and the distortion that it creates in the tech market. Third, we have a interesting piece from SK Options Trading that looks at the idea of have a Short Intraday Long Overnight Gold fund that is likely to add fuel to the already raging belief regarding manipulation of the precious metals space. And finally, Bill Gross revisits the topic of Zero Bound Interest Rates. Enjoy.
1) Things That Make You Go Hmmm.... - Grant Williams (Click HERE [17])
2) S&P 500 Tech Earnings Outlook With and Without Apple - Barclays Capital (Click HERE [18])
3) Revisiting Our Proposal for an Overnight Gold Fund - SK Options Trading (Click HERE [19])
4) Life - and Death Proposition - Bill Gross (Pimco) (Click HERE [20])
Best Regards
George Adcock
Founder
www.tickbytick.co.uk [21]
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