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The Problem Isn't Bonuses -- It's Cash Bonuses


And it's the differnece between short-term and long-term greed.

Editor's Note: This article was written by Minyan Kevin Dougherty, a portfolio manager at Pharos Financial Group, a specialist investor in emerging markets. Kevin manages three funds, the Pharos Russia Fund, the Pharos Small Cap Fund and the Pharos Gas Investment Fund. Prior to joining Pharos, Kevin was Director of Emerging Market Equities at Deutsche Bank in London.

The current debate over Wall Street bonuses is missing the point. It's couched as a zero-sum debate over what the "right" compensation levels should be. It's also mistakenly positioned as an issue of interest only to populists, class warriors, and others on the left, and one on which believers in the free market should automatically support Wall Street's "right" to pay their employees as they see fit.

Wall Street is doing a good job resisting calls for pay reform by claiming it's anti-American and anti-free-market to regulate pay. In normal times, they'd be right, but these aren't normal times. Moreover, there's an easy solution to this pay debate that's fully consistent with the best free-market principles and that both sides should find acceptable, although I suspect the bankers will privately hate it even though publicly, they'd have to support it.

Simply put: There should be no cash bonuses this year; all bonuses should be in the form of equity which doesn't vest for at least three years. Equity is normally a large part of bonus compensation. This year it should be 100% of bonus compensation -- and for all bank employees, not just senior executives.

The place to start understanding why this makes sense is to accept that the huge profits generated by the banking sector this year are almost completely due to government support -- which at the end of the day, means taxpayer support. Bankers have done a terrific job of convincing the public that the situation is "too complicated" to understand. But banking -- both commercial and investment -- is a pretty simple business: Banks borrow to fund themselves at one level, then lend or invest at a higher level, and their profit is the spread between these two interest rates, minus operating costs and losses.

Banks' profit is at record levels this year, not because the bankers are brilliant or have precious and rare skills that must be rewarded at extreme levels, but because of three reasons: one -- their borrowing costs are extremely low; two -- their revenues are high, and, crucially; three -- the value of many of their assets is being held at artificially high levels, which means they don't ave to write them down, which would lower their overall income. Government (taxpayer) support is directly responsible for both the low cost of funding and the artificially high value of what would otherwise be distressed assets on the banks' balance sheets.

The low cost of funding for the banks is really at the heart of their high profitability. Is their cost of funding low because the market believes banks to have highly profitable and secure core businesses? Absolutely not. The reason why funding costs are low is because the market knows that the government won't let any more big banks go bankrupt due to fears of a wider systemic crisis. Without this implicit government guarantee, the banks' cost of funding from the bond markets -- if they could get any funding in the bond markets at all -- would be several percentage points higher than they currently have to pay. Therefore the high profits at Goldman Sachs (GS), JPMorgan (JPM), Morgan Stanley (MS), Citigroup (C) and the rest, is due mostly to this government guarantee and subsequent artificially low cost of funding, not to the "skills" of their bankers and traders.
No positions in stocks mentioned.

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