The Striking Correlation Between Wall Street Bonuses and Market Crashes

Wall Street bonuses have grown by over 1,000% in less than 30 years, while the CPI hasn't even doubled in that time -- but some bonuses are down from last year. Banking specialist John Maxfield looks back over the history of the bonuses, when they peaked, and how it's all tied to the market.

Meanwhile, the Fed earned over $100 billion in 2014. Tune in to learn how the Federal Reserve achieved such a healthy balance sheet, and the decisions that will have to be made going forward.

A full transcript follows the video.

Michael Douglass: Wall Street bonuses apparently not where the money is. This is Industry Focus.

Hi Fools, financial analyst Michael Douglass and I'm here with our senior banking specialist, John Maxfield. John, how are you doing?

John Maxfield: I'm doing great. By the way, "not where the money is;" Don't you wish that you were in on some of that, even though they're a little bit lower this year?

Douglass: Yes, I know! Not a bad deal for them, overall. Let's get straight to what I teased; Wall Street bonuses and trading desks down a little bit from last year, at least for Citigroup (C 1.41%) and Bank of America (BAC 3.35%). John, what's the story here?

Maxfield: The story is that, going into the fourth quarter, things were looking pretty good for the banking sector and for trading in particular, but evidently something went on in the markets; there was a lot of volatility.

Typically volatility is good but evidently it was unexpected, at least by a handful of traders at Citigroup and Bank of America in particular, according to The Wall Street Journal. As a result of that, it turns out that year-end bonuses for the entire year of 2014 look like they're going to be down a little bit for Wall Street traders, at Citigroup and Bank of America in particular.

Let's be clear, the bonuses are still probably going to be pretty generous relative to what the average person on Main Street should expect to receive over the next couple weeks.

Douglass: Fair enough. Not just that there's going to be probably substantial bonuses, but those bonuses have, as you've pointed out previously to me, grown a heck of a lot faster than other things, like let's say the Consumer Price Index.

Maxfield: Yes. I think the dataset goes back to 1985. Who knew that somebody collects data on Wall Street bonuses? It turns out that the New York Comptroller's Office can collect this information. They take it back to, I think it's 1985.

From 1985 until I think the end of 2013, Wall Street bonuses have climbed more than 1,000%, whereas inflation has climbed something like 86%, so you have a disparity between how fast Wall Street bonuses have grown, and the Consumer Price Index, of something like 992%.

It's a ridiculous amount, and just goes to show how much money we are pumping through Wall Street right now, and also how they are setting up the incentive structure for Wall Street and investment bankers and traders in particular.

Douglass: Definitely a fair call there. One other point which is highlighted by that chart that you sent me -- and this is a point that you made to me before we started filming -- interestingly, it seems that these bonuses seem to peak right before market crashes.

Maxfield: Yes, isn't that interesting? Isn't that interesting?

What we're talking about, there's a chart that I drew up and it takes us back to 1985; again, I think that's the starting year. It shows the acceleration of bonuses on Wall Street relative to the CPI, and basically the CPI is flat whereas the bonuses on Wall Street are an ascending mountain, and you have two different peaks over this time period.

The first peak is right around the year 2000, which is when we had the Internet bubble. Then the second peak was during the housing bubble -- we had CLOs, CDOs, all these fancy derivatives that were being traded on Wall Street making people a lot of money that eventually caused the financial crisis, or at least played leading roles in creating the foundation that led to the financial crisis -- so you had a spike there.

When I look at this chart, I think it is impossible to not take away the fact that there is a good possibility that we are incentivizing people on Wall Street to do things that lead to market crashes or market failures.

You just can't help but wonder if that is what's good for the United States. I'm saying that somewhat facetiously, because I think that all reasonable people can agree that it's actually not good for Wall Street!

The second thing is just in the absolute value of Wall Street bonuses and how fast they have grown. You have to remember that all Wall Street does -- and when I'm referring to "Wall Street" I'm referring to the investment banks and the traditional banks that have investment operations.

These are not the vast majority of 6,000-plus banks in the country. Those people are just taking loans and taking deposits, for the most part.

These are your high finance companies and vehicles and they have grown so fast, despite the fact that they really do nothing other than to allocate the money that Americans have earned with their hard work.

All of us around here, doing work, trying to make a living, socking some money away every year to save for our retirement; then that money is used by traders on Wall Street to do all of these ridiculously risky things.

You just can't help but wonder, do we have things turned around? Should we maybe be incentivizing the people that are working hard and making their money in more of an honest capacity, more than the people who are taking the hard-earned money and just shuffling it around and making boatloads of money for themselves?

Douglass: Not just thinking of it from a moral perspective, which I think you've very appropriately laid out, but also thinking of it from an investment perspective.

When it comes down to it, some of the key things that we look for in bank stocks that are worth buying -- of course we want to see a cheaper valuation wherever possible -- but we're also looking at things like the efficiency ratio, and the culture that is pretty reasonable about the sort of risks that they take with credit. It seems that these incentives fly a little bit in the face of that.

Maxfield: That is an extremely, extremely important point.

Let's go back even further. Let's go back to the Great Depression. In the Great Depression the legislature got together and they passed an act called the Glass–Steagall Act. One of many things that Glass–Steagall did was it stopped traditional banks from having trading operations where you're acting as a proprietary trader, either trading equity securities, debt securities, derivatives, whatever it may be.

Fast forward to 1999 and there is a big deregulation movement that hit all the industries, but the financial industry in particular. One of the things that did away with was this prohibition of depositary institutions, which by the way are backed by the taxpayer of the United States via the FDIC because it insures all deposits under a certain amount; it stopped those types of banks from doing it.

Then in 1999 it allowed them, through that deregulation measure, to then start proprietary trading again. One of the things, and this is one of my main hypotheses over the past few months, is that if you look back over the past decade and you see how these banks have been treating their customers, they've been rearranging deposit transactions, they've been ostensibly fixing neutral credit card arbitration forums where people can go in and dispute charges on their credit cards ...

They've been doing all these different things to their customers, and you can't help but wonder why would a bank treat their customers in this way?

I can't help but think that by letting these trading operations -- and traders think of everybody, not as a customer who you owe some type of duty, whether it's fiduciary or a lesser standard, but they look at everybody as a counterparty; that is, as an adversary. Not only are you not on the same side, but you are actually on opposing sides when you adopt that trading mind-set.

I can't help but think, as we've seen these trading executives move up to the top of these banks -- we see it at Goldman Sachs (GS 0.22%), we're seeing it at Bank of America, we've seen it at Citigroup -- we've seen it at all the major banks.

You can't help but wonder, are these people allowing that adversarial treatment of counterparties, or customers if you will, to influence how these traditional banks are treating just your mom & pop depositors and borrowers on Main Street?

Are these banks treating them poorly because of this trading culture? I think it's a really good question. I think it's difficult to prove, but I think the anecdotal evidence is very powerful.

Douglass: Yes, that's a very fair point and definitely something anybody who's interested in the financial industry needs to be keeping a very close eye on.

Moving from banks to The Bank, let's talk about the Fed briefly. The Fed recently reported their profitability, and the numbers look pretty good.

Maxfield: Yes, the Fed is doing all right for itself! In 2014 the Federal Reserve earned $101.5 billion.

Now on this show, it used to be called "Where the Money Is," we talk about numbers and money and all that stuff all the time, so sometimes it's easy to lose track of how large some of these numbers are, but $101.5 billion, that is a ton of money.

We've seen a couple of different things, but one of the reasons they have earned so much money is because their balance sheet just exploded in size during the financial crisis, through QE1, QE2 and QE3, through which the Federal Reserve was just purchasing massive amounts of Treasury securities and mortgage backed securities that are backed by Fannie Mae and/or Freddie Mac.

They're just collecting all of this interest on this money, and it's just a phenomenal amount. I think they remitted something like $98 billion in "change" to the federal government, so you can't help but think that the federal government is probably really appreciating that contribution right about now.

Douglass: Yes, I would imagine. Certainly I could use a $98 billion check. John, how about you?

Maxfield: Yes, just the change! The change I think is like $500 million.

Douglass: Yes! That would be absolutely lovely. Looking at the Fed, any warning signs or concerns there for you?

Maxfield: Really no warning signs or concerns. I think what I found most interesting, is to the point that you brought up at the very beginning of this second issue, is that the Federal Reserve really is just a big bank. We think of it as a governmental institution, which of course it is, but underlying all of that is a huge bank that holds a massive amount of assets.

A couple of different points; if you go through its income statement and you say, "How is it possible that it earned so much money?"

Basically, it has this huge asset portfolio that it's collecting interest on, but unlike a traditional bank -- a traditional bank will go out and borrow money from depositors or through warehouse lines of credit or things like that, and use that money to then buy assets, and then the interest rate that it pays on the funds versus the interest rate that it earns on the assets, you take the difference between those two and that's the money that a bank earns, its net interest income.

If you look at the Fed what's so interesting is that of course the Federal Reserve doesn't have to borrow any money whatsoever. What does it do? Figuratively speaking, it just turns on the printing press. It just creates money and then buys assets with that.

That's the reason why the Federal Reserve is able to be so profitable, because it doesn't have that expense that all these other banks have. In fact, the return on assets is 2.2%. Take this from somebody who thinks about, reads about, writes about banks all the time; that is just simply unheard of in the banking industry.

The big question going forward is this. You have this huge asset portfolio at the Federal Reserve; I think it's like $4.5 trillion in assets. The question now is what will the Federal Reserve do with that? Is that the new normal, or is it going to go back to, say the $800 billion in assets that it held on its balance sheet before the financial crisis?

I can't help but think that because of the huge contribution the Federal Reserve is making to the federal government in a time where the federal government is not in a surplus by any stretch of the imagination ...

It's hard to say because the Fed is ostensibly independent, but you can't help but think that perhaps there's going to be some political influence on the Fed to maintain the size of that balance sheet, not only to continue making money but if it starts selling those assets, if it becomes a net seller, that will presumably drive up your long-term interest rates, which will weigh on the economy.

Douglass: Right. Definitely a very fair question for us to ask, and one that we'll want to watch moving forward.

John, as always, a pleasure to talk with you. Folks, check back to Fool.com for all of your financial and other investing needs, and stay tuned to the Industry Focus podcast tomorrow. Thanks much, and Fool on!