New Compensation Plans Good for Wall Street

There's an uproar on Wall Street over widespread changes to bonuses that are hitting employees of big banks this year.

Morgan Stanley (NYSE: MS  )  has been the most aggressive in changing bonuses with the intent to align long-term personal goals with those of the company. Instead of getting lump sum cash bonuses this year, employees from trading to investment banking who make over $350,000 will get four equal installments from May of this year to January 2015. 

Barclays  (NYSE: BCS  )  capped cash bonuses last year at $103,000, the most aggressive I've seen at a big bank, and paid some bonuses with convertible bonds. The concern now is that bankers will start to leave if bonuses stay that low. 

Other banks have been less aggressive in tying long-term shareholder interest to employee compensation. Goldman Sachs (NYSE: GS  ) started its own deferred compensation plan for high-level executives in 2009 after being criticized for paying huge bonuses during the financial crisis. But the five-year restricted stock program only applies to a handful of executives, as opposed to the broad reach that Morgan Stanley's new program has. 

Investors should be cheering the news of deferred compensation. For years, traders had incentive to make big bets that may pay off in huge bonuses with little worry about downside risk. Just look at JPMorgan Chase's London Whale fiasco as exhibit No. 1 for the reason deferred compensation is good for Wall Street. The bank was able to claw back some compensation, but a plan like Morgan Stanley's may have prevented the massive losses in the first place. 

The loss of "talent"
Some in the industry will argue that deferred compensation will mean risking losing talent to hedge funds or other sectors of finance that can operate without heavy regulatory oversight. That may be true if broad rules are applied to traditional investment banking and asset managers, but I'd like to focus on why this is a good move for the trading side of the business. Is striking out on their own really a risk every good trader on Wall Street wants to take?

The biggest payout I've seen in recent years was the $100 million-dollar man, Andrew Hall, who was at the center of Citigroup's pay dispute in 2009. The company was willing to pay him $100 million per year because it was concerned that he may leave if he wasn't paid such an exorbitant amount. Eventually, Hall did just that.

But the move hasn't been the wild success that would send every trader packing. Hedge fund numbers are hard to come by, but it is reported that in early 2011, Hall had $1.4 billion under management. To make $100 million, he would have to make a $500 million profit, or a 36% return if he had a standard 2/20 hedge fund structure. But Hall's fund lost 4% in 2011, meaning he had to make up ground before making a dime (assuming a standard high water mark). 

He was still able to attract funds, however, and last year, Reuters reported he had $4.8 billion under management and managed to squeak out a 3% return for the year. If the numbers are correct, he didn't even reach his high-water mark, so he likely didn't take home anything more than his 2% fee (still not a bad pay day) in 2011 or 2012. With many of the world's best hedge fund managers falling short of the Dow Jones Industrial Average in 2012, it's clear there's a lot of risk in striking out on your own.

The downside is also far greater at a hedge fund, for both investors and traders. It takes years of great returns to attract billions of dollars, but a few bad bets can sink a fund in a moment. Long Term Capital will live in lore as causing a panic in the late 1980s, and Amaranth Advisors lost $5 billion in one week, and $6 billion of the $9 billion it had in assets in 2006, making it the biggest hedge fund failure on record. If you're still making big bucks on Wall Street, is it really worth the risk just because your compensation is deferred? 

Dealing with loses
Even if big banks did lose a lot of "talent," they could easily restock their stables. Banks have scores of young traders willing to step into big shoes if the headlining talent leaves. Don't think they wouldn't be willing to take deferred payment for a chance at the big time.

Maybe a little less of that risk taking would be good for the big banks since that's what caused the collapse of Lehman Brothers, and nearly the entire banking sector in 2008. Now that shareholder wealth is on the line instead of partners' wealth, it's harder to keep a close eye on these big banks, and deferred compensation is a good way to do it.

Foolish bottom line
Deferred bonuses on Wall Street may not be as attractive as big cash bonuses for those on the trading floor, but it's good for investors. Banks like Goldman Sachs were built with the wealth of partners and employees on the line every day, and now that shareholders' money is on the line, banks should operate with the same kind of scrutiny. This doesn't solve the problems of 2008, but it's certainly a start and a strong step toward aligning the interests of employees and shareholders of the biggest banks in the world. 

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