Saturday, September 22, 2012

Defending the Indefensible

Francie Stevens: “The man I want doesn’t have a price.”
John Robie: “That eliminates me.”

— To Catch a Thief

Lauren Tara LaCapra put up an interesting piece on Goldman Sachs’ declining employee compensation yesterday on Reuters. As part of it she interviewed a “prominent investor” in financial stocks who believes that Goldman is not doing enough to cut pay. He says
management is not seeing things the same way as shareholders because they have fared much better financially, even in bad times.

To illustrate this gap, he compared return-on-equity for common shareholders against compensation as portion of common equity. (For ROE, he divided pretax earnings by common shareholder equity and for the compensation measure, he adjusted pay for estimated tax costs and divided that by common shareholder equity.)

According to his calculations, Goldman employees have done better than shareholders by 10 percentage points, on average, since the firm went public in 1999. That equates to $34.7 billion over those 12 years, he said, not including what Goldman spends to repurchase shares issued to employees.

To put that figure in perspective, Goldman’s current market cap is about $57.5 billion.
But this is just bizzare, like comparing apples and carburetors.

* * *

When it comes to discussing compensation in investment banking, people seem to forget that bankers are a factor of production for the firms which employ them. At base, banking is a pretty simple business; we gather together a bunch of other people’s money and hand it over to employees who we hope will use it to make even more money. Our raw material is money, or capital, our finished product is money, or return on capital, and our primary operating costs are the cost of that capital, the cost of the labor which turns money into more money, and various other lesser doodads we supply our employees to help them accomplish this transformation, like information technology, real estate, travel and entertainment reimbursement, and lobbyists to keep the government and regulators off our backs. Our productive assets are people, highly skilled labor who wear shoes and walk out the door every day. Investment bankers are like the robots and machinery that manufacturing companies use to transform steel and plastic and energy into, say, automobiles. Unlike General Motors’ robots and assembly lines, however—or the loans and common equity in our own industry—labor does not show up on our balance sheets. Labor is simply an operating cost, a cost of doing business.

Common equity, on the other hand, is a residual claim on the profits of a business, after you have paid your operating costs and the claims of other capital providers like lenders and bondholders which are senior to you. Return on equity is an output of your business model; employee compensation cost is an input.1 And, most importantly, the cost of labor in banking, like everywhere else, is determined at least intially independently of the cost (or required market return) of equity. If you want to run an investment bank, you have to hire and retain investment bankers, whether you are profitable or not, and you will pay the going rate in that labor market. Since we are fungible factors of production, if you cannot afford to pay us what your competitors will, we will leave and you will be unable to generate any profits at all. You might as well shut down.

Now of course the price of labor, like any factor of production, is sensitive in the intermediate and longer term to the returns on capital which employs it. If, as we may be witnessing now in finance, the long term returns to capital in an industry decline, there will be fewer capital providers who want to fund investment banks, banks will shrink, and fewer bankers will be employed. Aggregate and average individual banker compensation will decline. But this adjustment is not immediate, and the demands of inertia and wishful thinking will likely keep labor rates higher than otherwise justified for quite some time.

* * *

Another factor comes into play, which commentators, journalists, and investors seem to have trouble remembering when contemplating compensation in my industry. Even before new risk control mechanisms like clawbacks were implemented in response to the recent financial crisis, investment banks paid a very substantial portion of banker compensation in the form of deferred pay. A generic mid-level investment banker might be paid a fixed salary of $250,000 per year and earn an average bonus of $1,000,000 in a decent year. But of that $1,000,000, perhaps as little as $250,000 might be paid in cash, with the rest coming in the form of unvested stock in the company, restricted stock units, options, and other funny money which get paid out over a period of years. A simple such scheme might have the banker getting $750,000 in restricted shares of the bank’s own common equity which vest in equal installments over the next three years. (A few particularly nasty programs use what is called “cliff vesting,” in which the deferred pay vests all at once after three to five years.) The form such pay takes is often restricted stock, with the number of shares determined by the price of the bank’s stock on the award date, when the bonus is awarded. If Bank ABC is trading at $50 per share, for example, the banker in question would have 5,000 shares vesting on each of the first, second, and third anniversary of the award date.

A little thought will show you that such a scheme is far less favorable to the banker than it appears at first blush. While the banker gets headline pay of $1,250,000, she only receives $500,000 now and must wait to collect the remaining $750,000 over the next three years. Furthermore, she is exposed to the rise or fall of the bank’s stock price: she receives 5,000 shares on each anniversary whether the stock is trading at $50, $25, or $100 per share. Also, unlike the favorable carried interest capital gains treatment her former brethren and occasional nemeses in the private equity world enjoy, she gets taxed at full ordinary income tax rates immediately upon vesting, calculated on the value of the shares at the vesting date.

From the banker’s perspective, she is being forced to advance her employer a three-year interest-free loan for 60% of her nominal compensation, with the added disadvantage that she is exposed to the potential decline of her employer’s stock price, over which she individually has almost no control, to anywhere below $50 per share up to and including zero. From the bank’s perspective, this is a great deal: they have acquired zero-cost financing for 60% of their current year labor costs with no mandatory repayment risk. It is forced equity investment, the cheapest capital you can find. And, unlike true common shareholders who can take their money and run at any time, the banker cannot sell or hedge her stock prior to vesting. Lastly, if she leaves the bank voluntarily for a competitor, most banks automatically cancel her unvested shares; she only gets paid for past years’ work if she still works for the bank. Captive, costless, non-recourse capital. The true mark of my industry’s genius.2, 3

* * *

This also means that the published financial reports of investment banks are practically indecipherable when it comes to understanding what is happening to current compensation policy and practice. Each year, the employee compensation expense line item on banks’ income statements reflects a combination of current cash compensation and the vesting of deferred compensation from up to three to five years previous. Goldman Sachs’ reported compensation expense in 2011 included pay from 2011, 2010, 2009, and perhaps even 2008 and before. There is a terrific lag to the data, and the reported number tells you almost nothing about current pay practices. In fact, if awarded pay is in fact declining, you can be certain that reported compensation ratios significantly overstate how much of the pie is being allocated to bankers now.

All of which is to say that the headline compensation ratios, and the ubiquitous average-pay-per-employee numbers that get bandied breathlessly about in the press—usually with a healthy helping of outrage, natch—tell you little about how banks are trying to control one of their biggest operating expenses. I cannot tell you what transpires in the executive suites of the biggest banks, but I guarantee you that investment banks have made a study and a science of squeezing their employees as hard as possible over pay for decades. The stated goal is to pay everybody the smallest number that will be sufficient to keep a dissatisfied banker from throwing up her hands in disgust and walking across the street to a competitor. The science comes in when designing the form such pay will take that will be the most advantageous for the bank itself while numbing the employee with reams of complex, one-sided terms and restrictions.

In my view, it is undeniably true that most investment bankers would accept significantly lower pay if it were paid 100% in cash. I know I would.

Which is not to say I’m a cheap date, mind you.

1 This is not entirely true of investment banking, since the majority of our awarded pay depends in large measure on the current year profits we generate for the firm. But this is an ex post perspective; ex ante, to employ an investment banker, you have to budget the going rate. Read on.
2 Just imagine if General Motors paid 60% of the money it owes its current vendors—robot manufacturers, power utilities, assembly line workers—with GM stock. Stock it would not have to deliver if it didn’t employ those vendors in subsequent years. The auto industry might even become profitable again.
3 And lest you think I am placing excessive emphasis on the cash-conserving nature of this practice, please note that non-cash deferred compensation in the form of restricted stock units and options at Goldman Sachs alone represented $2.8, $4.0, and $2.0 billion of total reported compensation expense of $12.2, $15.4, and $16.2 billion in 2011, 2010, and 2009, respectively. Those are some pretty sweet interest-free loans to the Squid from its squidlets.

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