Kill or Tax Wall Street Bonuses?

Henry Blodget and Aaron Task of Yahoo tech ticker had a very interesting interview on Tuesday with MIT's Simon Johnson:

Bashing big banks is all the rage this week, with White House officials and New York Attorney General Andrew Cuomo scolding Wall Street fat cats ahead of the Financial Crisis Inquiry Commission, which gets underway Wednesday.

At issue is what level of bonuses are appropriate for publicly traded firms that posted record profits in 2009 thanks to the government's largess and after being rescued in 2008.

Simon Johnson, professor at MIT's Sloan School of Management and former chief economist of the IMF, says there's a simple solution to this seemingly complex problem: "People working at our largest banks - say over $100 billion in total assets - should get zero bonus for 2009."

Looking back, all the big firms were saved by the various government programs, including Goldman Sachs and Morgan Stanley were allowed to convert to bank holding company status in 2008, Johnson says. "There were unconditional bailouts for all our big banks - it was a decision made on the fly in the crisis. Let's not second-guess," he says.

"But no way that strategy implies, requires, or is consistent with the banks then paying all that money out to their employees."

By contrast, when the government instituted a similar "recapitalization" strategy for banks after the Latin America debt crisis of the early 1980s, the banks retained the money to help rebuild their balance sheets, he recalls. "In this case they're going to pay out 40% [of profits] - that's not good economic policy."

But, let's put our selves in the (expensive) shoes of the bankers for a moment. Henry points out in the accompanying clip, on Wall Street it's a 'bonus' in name only. Most bonuses are part of a guaranteed pay package negotiated when employee contracts are signed. The Wall Street Journal notes limiting bonuses after the fact will create some high class problems. "Since many people plan their household budgets around bonus expectations, they may need the cash to cover mortgages, school tuition and other expenses." Of course, firms that limit pay always risk the threat of a brain drain.

Johnson discounts these arguments wondering, if Goldman Sachs paid no bonuses this year, would employees really leave? Where would they go?

If the "too big to fail" banks insist on paying bonuses for "retention" purposes or other reasons he deems fallacious, Johnson says they should be subject to a "steeply progressive windfall income tax" -- paid by the employees and not the firms, as is the case with the U.K.'s recently announced 50% bonus tax.

Professor Johnson is absolutely correct. You can watch the whole interview below. U.S. government officials should stop pooing on bankers on Sunday talk shows and start implementing windfall taxes on these outrageous bonuses.

Government officials should also read Dean Baker's Big Bank Theory and think about structuring regulation in a way that advances the public interest, not in a way that allows the financial sector to profit at society's expense.

And the banking industry better wake up and smell the coffee or else they're going to get socked with more regulations than they can possibly conjure up in their worst nightmares. Stop paying bonuses based on short-term speculative calls. Start taking into account the risks that your prop desks are taking to deliver those spectacular returns.

[Note: I heard of one Canadian bank where more than half of the profits last fiscal year came from capital markets. It's much worse in the U.S. Are you banks or hedge funds (with no skin in the game)?]

The same goes for public pension fund managers here in Canada. They too want to get paid like Wall Street or Bay Street titans but their bonuses do not take into account the risks they take to deliver their "alpha" targets.

If you sit back and go over the major trading scandals in history, you'll find that behind every rogue trader there was a weak operational environment that allowed them to mask enormous losses. But the culture of bonuses at the major banks and even some of the larger pension funds here in Canada also promotes excessive risk taking with little or no regard to downside risk.

If governments do not nip this bonus bonanza in the bud, then the next financial meltdown is only a matter of time. How long will we allow the rest of the economy to be subservient to the reckless arrogance and greed of a financial sector gone rogue?

***UPDATE***

A buddy of mine who trades currencies told me that this fiasco is the fault of regulators. He told me that if they did their job properly, setting stringent controls on leverage and off balance sheet manipulations, we wouldn't have seen anything resembling this mess. For him, the problem isn't bonuses, but regulators.

A consultant that works with me thinks the problem is both social ("why do we pay sports athletes ridiculous compensation?") and economic. He thinks that tax treatments have to target bonuses at the corporate level because if you target individual bonuses, they'll find a way around this by demanding higher fixed salaries or by leaving to join an unregulated hedge fund.

One thing he told me is that for years, the US refused to join Basel I and Basel II. He also told me that one easy solution to control these "hired guns" is simply to place clauses with caps on bonuses. "This way the hired guns do not take stupid risks to maximize their bonuses and the banks limit their downside risk."

Professor William Black was interviewed on Yahoo tech ticker discussing the bonus controversy and what needs to be done. Among the fixes, he proposes:

• Independent boards
• Full clawback provisions.
• Paying bonuses in stock. Black says employees should be restricted from selling stock for years.

The former regulator during the Savings & Loan Crisis also recommends reinstating mark-to-market accounting. Until that's done, he says, there's no way to tell whether 2009 paper gains won't be wiped out in the near future if the market sours again. Black argues "people are being paid bonuses when the company, the bank has actually lost tens of billions of dollars. That's an obscenity." Hmmm, where have I heard that before?