In Defense of Bankers’ Bonuses and Union Contracts

Over the past year, two groups have been unfairly scapegoated for our country’s economic problems:  (1) bankers and (2) unions.  In particular, many people have blamed the incentives embedded in bankers’ compensation scheme for the near bankruptcy of the entire industry.  Many people also blame unions for the down fall of the auto companies.  But I believe both positions are misguided at best and flat out wrong at worst.

In Defense of Bankers’ Bonuses

Full Disclosure:  For two years I was an investment banker at the firm f/k/a ats Lehman Brothers.  My experience was an odd one to say the least.  Four months before I started at Lehman in July 2000, the technology bubble burst and the NASDAQ plummeted more than 60% and has not really recovered since.  In September 2001, across the street from my firm’s headquarters, terrorist slammed two planes into the WTC.  While this event escalated the recession, business actually picked up for Wall Street because the Federal Reserve’s dropped the federal funds rate or the rate that banks lend to each overnight at the Fed to 1%.

UPDATE:  Just to be clear, this post is in defense of bonuses paid by banks to bankers pre-September 2008 and pre-TARP funds.

While there has been much ink spilled over the last nine months excoriating the compensation schemes employed at Wall Street, much of it is wrong.  Much of the anger stems from an essential misunderstanding of what Wall Street means by “bonus” and what most bankers and traders do.

What a Does Wall Street Mean by a Bonus?

For most of America, a bonus is compensation for effort or a result that exceeds expectations.  For example, a casino builder may get a bonus for every day early the casino is built.  For Wall Street, a bonus essentially is a lump sum payment around Christmas time that represents income earned during the year.  Compared to overall compensation, bankers and traders’ salaries are relatively small.  Much of their compensation is paid out in December, January or February in the form of a “bonus” but it is earned throughout the year.

Wall Street compensation schemes are essentially the same as those used by most real estate agents or TV salesmen at Best Buy:  very low salary (as compared to overall compensation) + commission.  For example, if a bank brings a company public through an IPO or an “initial public offering”, that bank is paid a 7% commission on the amount of money raised through the sale of stock (at least that was the going rate when I was Lehman).  The bankers responsible for the IPO would get a percentage of that 7% at the end of the year in their bonus.  For an M&A transaction, a bank would normally earn  between 1 and 2% of the deal value with a portion of that fee going to the bankers involved in the transaction.  This is no different from the 2.5% fee a real estate broker earns on the purchase or sale of a home.  For traders, compensation is no different.  Most traders perform a service for their clients by either selling shares the client owns or buying shares on the open market for the client.  The client pays a commission for this service just as individual investors pay a stock broker or TDAmeritrade for trades executed.  Like bankers, traders receive a percentage of all commissions they generate during the year.

What angers most people is the fact that it is called a bonus and paid in a lump sum, which makes it look very large.  But no one ever complains if a real estate agent earns millions of dollars from commissions generated on the sales of hundreds of millions of dollars of real estate.  I believe that if bankers took their compensation more evenly during the year, a lot of anger would dissipate.    These bankers and traders generate hundreds of millions or billions of dollars in revenue and profit for their employers and are compensated accordingly.  I am not going to get into a moral debate about whether paying a banker thousands of times more than a teacher or a policeman is “right.”  In terms of how much revenue and profit bankers and traders generate, their compensation is usually justified.

What Bankers and Traders Do

Another misconception that has led to a lot of hand wringing of late is that “bankers” and “traders” caused the near downfall of western civilization.  While I would agree that Wall Street nearly led to the end of western civilization in September, it was essentially a handful of employees at Lehman, Bear Stearns, Citibank, B of A and AIG that caused almost all of the problems.

Most bankers and traders on Wall Street generate billions of dollars of revenue and profit with almost no corresponding risk for their employers.  Most of these bankers and traders are paid very “low” salaries and have low overhead.  Essentially the overwhelming majority of “bankers” and “traders” provide a service to their clients in return for a commission.  For example, as described above, M&A bankers advise clients on whether to buy another company or asset, sell itself or part of itself or merge with another company and at what price.  For this service, the bank is paid a fee representing a percentage of the deal.  There is little to no risk for this type of advice.  The only real risk is either the deal that falls through and there is a loss of time and foregone opportunity to work on another deal that might have gone through or litigation risk from shareholders who sue claiming the bank was negligent when it advised the company.  When compared with the amount of money generated by M&A, these risks are negligible at best (and many times, insurance covers the litigation liability and legal expenses, assuming there is no finding of fraud).  When it comes to selling stock or debt for an issuer company, there is some risk that the bank will not be able to sell all of the shares or bonds.  But this risk is usually minimized by banks by talking to major investors for the weeks preceding the coming to market to gauge interest in the deal and at what price.  If during those weeks a bank finds that there is no interest for the shares or bonds, it will not bring the company to market, or cause the company to lower the price demanded.  Unless there is a major event between the time the bank “purchases” the shares or bonds from the issuer and resells them to investors, a bank usually has no problem selling all of what it bought from the issuer. Thus, the fee or commission it earns is essentially earned without real risk.

For a trader, the commissions earned on the purchase or sale of assets for clients is also done with virtually no risk.  The only real risk for a bank on these transactions is that the client will not or cannot purchase the shares or bonds they requested the trader buy after the trader has already executed the trade.  However, this occurrence is very rare and usually the resulting damage can be minimized by simply reselling the shares or bonds into the market.  While there is a risk that the bank will take a loss on the transaction if it cannot resell the stock or bonds at the same price it bought them for, this risk is usually minimal (especially in comparison to the amount of fees generated from all trades processed).  As soon as the buyer of the shares pays for them (or has their accounted debited) the bank’s risk goes away.  Therefore, like the bankers described above or a real estate agent, traders earn money for the banks by providing a service to clients with almost no risk.  And they only earn money on actual revenue generated.

So How Did Bear Stearns and Lehman Brothers Collapse?

At its root, these institutions failed because they got away from their core competency.  For Bear and Lehman, instead of just providing advice and other services for clients—their bread and butter for decades–they started to invest their own money and capital in assets in the hopes that the assets would increase in value.  Apart from the bankers and traders who serviced clients, these banks started what has come to be known as “Prop Desks,” short for proprietary trading desks.  These groups invested their employers own money and capital in various assets.  Instead of earning a “small” commission providing a service to a client, the banks stood to earn all of the upside from their investments but also to suffer all of the downside.  Lehman invested heavily in real estate, especially in California, and in mortgage-back securities.  Bear also invested heavily in mortgage back securities.  To further exacerbate the problem, these prop traders were compensated for the paper profits the investments generated.  In other words, they were paid bonuses based on how much the investment was worth on paper, even though no actual money was made until the investment was liquidated.  Therefore, bonuses were paid out but the risk still existed that the bank could take a severe loss.  Furthermore, the value of many of these investments had to be estimated because the asset did not “trade” regularly.  Thus, had the prop traders only been paid when the investment generated actual profits, as opposed to paper profits, much of the problem could have been avoided, because less risk would have been taken, and banks would only have paid out bonuses when they actually earned money.

I would wager a decent amount of money that inside Lehman and Bear, less than 100 people at each firm, out of tens of thousands, were responsible for these investments and for the banks’ downfall.  While Lehman had survived and prospered for more than 150 years providing banking and trading services (and being compensated handsomely through commissions), a few people over the last decade brought down the whole firm by investing the firm’s capital in real estate and real estate related assets.  It is those people and the people who were or should have been supervising them and those who should have been monitoring the amount of risk they were undertaking that are responsible; it was not thousands of “ordinary” bankers and traders.

Why We Should not Blame Unions for Detroit’s Problems

This is a follow up to a question I posted on this blog asking whether companies were obligated to agree to a contract with their unions.  Full Disclosure:  As my previous post makes clear, I am not an expert on labor law and do not practice in that area.  This post is based on my cursory reading of the National Labor Relations Act.  I have NOT read through the NLRB regulations nor case law interpreting the statute or regulations nor have I read labor law treatises.  If you do practice law in this area, and believe I am wrong on a point of law, I would love to hear from you.

Much of Detroit’s problems have been laid at the feet of the unions and the contracts they agreed to recently.  While some of the provisions of these contracts do seem somewhat egregious, the blame should be placed with management and the boards of directors.

According to the National Labor Relations Board,

Congress enacted the National Labor Relations Act (“NLRA”) in 1935 to protect the rights of employees and employers, to encourage collective bargaining, and to curtail certain private sector labor and management practices, which can harm the general welfare of workers, businesses and the U.S. economy.

The NLRA provides (29 USC 158(d)) provides:

[Obligation to bargain collectively] For the purposes of this section, to bargain collectively is the performance of the mutual obligation of the employer and the representative of the employees to meet at reasonable times and confer in good faith with respect to wages, hours, and other terms and conditions of employment, or the negotiation of an agreement or any question arising thereunder, and the execution of a written contract incorporating any agreement reached if requested by either party, but such obligation does not compel either party to agree to a proposal or require the making of a concession.

Therefore, although GM, Ford and Chrysler had obligation to bargain with the unions, according to my cursory reading of the NLRA, none of the companies was under any legal compulsion to make a deal.  This reading is bolstered by the fact that one of the provisions of the Employee Free Choice Act, that unions are pushing in Congress, would require binding arbitration where a third party could dictate terms to unions and their employers.  If the NLRA already required an agreement, as opposed to only requiring negotiations, this provision of the EFCA would be superfluous (while this type of reasoning does not always lead to the correct reading of a statute, many times it does).   Thus, the Big-Three could have hired non-unions workers if they could not agree with the unions on a contract they thought was in their best interest (if I am getting a point of labor law, someone please correct me).

The unions and their leaders have a responsibility to their members, not to the car companies.  Their obligation is to get the best deal for their members.   Management and the Big 3’s Directors have the responsibility to get the best deal for their company, not the unions.  While this may not have been a feasible political or PR option, that was the auto companies’ problem.  Blame should lay with their management and boards, not with the unions.  The car companies had options and the right not to agree to the agreements that bind them now.  If they did not like the terms, the companies should not have agreed to them.  Just because the unions were successful at the bargaining table, does not mean they should be blamed for Detroit’s predicament.  This might be a different story, if the unions had imposed the contracts by fiat.  But this was a negotiations and a contract that both sides agreed to.  The car companies only have their management to blame for their position.


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