Was I Wrong About Investment Banking Bonuses?

A month ago, I came out strongly against the idea of a government limit on bonuses for investment bankers. Based on the reaction to the article, most readers seemed to believe I was either on the take from the North American Investment Banking Union (an organization I just made up), or heavily intoxicated while writing the article.

I hate to burst any bubbles, but neither is true. In fact, despite the continued stream of bad news from the financial sector, I continue to staunchly oppose heavy-handed, across-the-board government restrictions on bonuses. Perhaps even fewer people will agree with me now than in my first go-round, but before you ready the guillotine, take a second to consider that I may not be as crazy as you think.

We're not talking philosophy of value here
One stumbling block that we're going to have from the outset of this discussion is the amount of money that customers pay for the services that investment banks provide. Whether for stock trading, money management, or M&A advisory services, clients pay these banks through the nose.

But are the services worth it? Pfizer (NYSE: PFE  ) , for example, recently gobbled up its competitor Wyeth; in the process, the two sides spent a couple of hundred million dollars on advisory services from a handful of banks, including Morgan Stanley (NYSE: MS  ) , Bank of America (NYSE: BAC  ) , and Evercore (NYSE: EVR  ) . Or consider the fact that investment banks' captive hedge funds take massive fees that make mutual funds look like nonprofits.

Are these banks creating enough real value through these activities to substantiate such massive fees? That is absolutely a valid question, but one that I'll leave for another venue. The bottom line is that at least as of now, clients are willing to pay those fees, and there are people at the investment banks bringing them in.

Chasing away the talent
There seems to be a lot of furor over the idea that there are people at the investment banks still scoring, and scoring big. But when we break apart the results at many of the major investment banks, some divisions are still very much carrying their weight.

JPMorgan Chase (NYSE: JPM  ) , for instance, reported negative revenue in its investment banking arm in the fourth quarter, but that was driven in large part by a horrendous showing from the fixed-income-markets segment. Meanwhile, investment banking fees for advisory services and capital raising in the fourth quarter still clocked in at $1.4 billion. Goldman Sachs (NYSE: GS  ) told a similar story; though the firm reported a $2.1 billion net loss for the fourth quarter, investment banking fees topped $1 billion, and equity trading revenue was $2.6 billion.

There are some very good reasons for bankers to want to stay with a big firm like Goldman or Morgan -- less personal risk and a good brand name, just to name a couple. But show me a principal strategies trader who brings in tens -- if not hundreds -- of millions of dollars to the firm, and tell me that his or her bonus is capped at $500,000, and I'll show you a principal strategies trader who's going to flip you off and start his or her own hedge fund.

Uncle Sam as a smart owner
The government is now a stakeholder in a great many financial institutions, and we as the American people have good reason to be hopping mad that it came to this. However, rules such as these pay caps -- which, let's face it, are less motivated by solid business sense than by our conviction that these guys are overpaid jerks -- just aren't a good idea.

But that doesn't mean that Uncle Sam, who now owns pretty significant stakes in some of these firms, has to sit on his thumbs. With an economy in disarray, and an investment banking industry in even worse shape, now is the time to cut the fat in a big way. Investment bankers should not be million-dollar seatwarmers, no matter where their MBA degrees originate.

While I have a big problem with putting an across-the-board limit on pay, I think it'd be a great idea to make sure that only the folks who are actually performing get the big bucks. I'm fine with ticking off substandard or non-performing bankers, or traders who aren't cutting it. At the same time, it'd be great to make sure people aren't getting paid for short-term results that could come back to bite the bank. Hedge fund managers are subject to clawbacks when their fund loses money. There seems little reason why a bond trader whose trades go sour shouldn't have to cough up some past compensation, too.

At the end of the day, if we don't end up nationalizing and breaking up Citigroup (NYSE: C  ) , B of A, or any of the others, then don't we want to keep them competitive? At least that way, we'd get the most out of our investment.

Further Financial Foolishness:

Pfizer and JPMorgan Chase are former Motley Fool Income Investor picks. Pfizer is a Motley Fool Inside Value recommendation. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. The Fool's disclosure policy has never once been caught with its pants down. Of course, it doesn't actually wear pants...


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 05, 2009, at 2:26 PM, mrwizard555 wrote:

    call it what it is, commission, not bonus. pay it monthly or quarterly to get away from the outrage.

    i have no problem with deserved commission/bonuses, for those that deserve them. what sticks in my craw is the tendency for some of the folks to say "I deserve it".

    you only deserve things when you provide value for your employer.

    to go a little further, CEO's deserve bonuses too, sometimes. payable in restricted stock only, and only when the shareholders(owners) get something. beating the market ain't good enough. you have to beat zero.

  • Report this Comment On March 05, 2009, at 2:50 PM, tops1234 wrote:

    There's an easy solution to preventing the brain drain from the financial institutions that Uncle Sam owns: require everyone who engages in finance to work for Uncle Sam, hedge funds, banks, and all. Make what you will, but you only keep a salary.

    This is not as radical as it sounds. In the United Kingdom, all doctors must agree to work for the National Health service a minimum number of hours, i.e., for the State - or they simply do not get their license to practice medicine. Yet, one can hardly say the UK has too few doctors, and one does not hear of low quality doctors killing off patients by their bad treatment.

    Progress is always painful throughout history. We may be living through progress and enlightenment without realizing it.

  • Report this Comment On March 05, 2009, at 2:57 PM, Bot1 wrote:

    Maybe there are a couple of other things that bother people which relate to the reason that a company such as Goldman can pay the bonuses.

    First there is not a company that I am aware of that thinks the fees charged by the large investment banks are fair or reasonable. They think the fees are outrageous. However the big investment banks are the only access point for most companies to the public equity markets. So companies are held hostage by monopolistic control and must pay high fees if they want access.

    Second, when was the last time you saw the Goldman trading group lose money. Can't remember when. Is it because they are so smart? Heck no, they just have the ability to control price through both their specialists and through the large amount of money they control. They can move the price any way they want and do. Want some proof? Goldman and a bunch of other specialist firms just paid a (pittance) $70 million fine for front running their trades ahead of legitimate market customers.

    So the outrage is not only about the bonuses, but the way in which these large investment firms strangle access to the market and manipulate price to fit them. We are supposed to be happy that have to power to take money at will from others with no consequences and that they then reward themselves with the money they take? I think not.

  • Report this Comment On March 06, 2009, at 12:50 AM, TMFAleph1 wrote:

    "Second, when was the last time you saw the Goldman trading group lose money. Can't remember when. Is it because they are so smart? Heck no, they just have the ability to control price through both their specialists and through the large amount of money they control. They can move the price any way they want and do. Want some proof? Goldman and a bunch of other specialist firms just paid a (pittance) $70 million fine for front running their trades ahead of legitimate market customers."

    This isn't an accurate depiction of the way in which the capital markets work. The settlement with the specialist firms is no proof whatsoever that investment banks "can move the price any way they want and do". If that were the case, why would the specialists be struggling to remain profitable?

  • Report this Comment On March 06, 2009, at 6:03 PM, liftbigski wrote:

    I would prefer to see them start their own hedge funds, as you suggest they might.

    There are many more star players ready to step in at a preferable cost whenever any of the names take leave.

  • Report this Comment On March 08, 2009, at 6:27 PM, timjones0674 wrote:

    I have a better idea... Why dont we just admit that CDO's and CDS's were fraudulent entities, and that any personal profits made on this were illegitimate??

    Meaning, why dont we pass legislation to allow people who took losses from these instruments to be allowed to reclaim some of their losses from the high net worth individuals who profited from the scam?? By doing so, it would send a clear message to people in the future that if they build fraudulent instruments, then they will not be allowed to keep profits that are made from them...

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