Goodbye bonuses, hello hedge funds

By J Saft
February 11, 2009

James Saft Great Debate – James Saft is a Reuters columnist. The opinions expressed are his own –

The argument about bank bonus payments is as sterile as it is backward looking; compensation at government insured institutions is going nowhere but down.

The real action will be at those places like hedge funds, private equity houses and boutiques, which will try and trade less insurance for more autonomy and which will capture more market share, take on more risk and offer more reward. The question is how will they be regulated, how will they fund themselves and how will the rest of us be protected from the systemic risk they could easily represent.

The British government jawboned its banks over the weekend after reports of huge payouts at Royal Bank of Scotland sparked public outrage, calling on senior bankers to reject their bonuses.

President Barack Obama took a more head-on approach, setting a $500,000 cap on top executive pay at companies receiving taxpayer funds, though many have pointed out how easy it will be to circumvent and that it only covers the very top of the management tree.

So, will bankers be paid despite individual and collective failure? Yes. But really, it’s last call for drinks on the Titanic. Sign for whatever you like, there will be no reckoning.

For any institution that is inside the TARP or government tent, there is a very good chance that we are looking at something like a wind down; from high leverage to low leverage, from complicated products to simple products, from high compensation to moderate compensation and from many employees to a lot fewer.

That is right and proper. Compensation at these places, which will fall under ever tighter regulatory control, should reflect the fact that they only continue to exist by the grace of government. And really, once you set lower leverage limits for them, most of these compensation problems will solve themselves.

Utility-like banks will require fewer people and those people will need less expensive skills. So by all means put people in banks on longer earn outs and tie their compensation more to how their activities perform over time. But those activities will just be simpler and less profitable. I would also bet that shareholders, having taken a drubbing on their holdings in banks, will demand a bigger slice of those profits that banks can manage.

Now, I am aware that this coming state will not be a utopia. Highly regulated utilities, with the possible exception of the Swiss railways, are slow, suffer from low level corruption due to a different set of misaligned incentives and probably produce a lower ceiling level of economic growth.

IS THERE ROOM FOR A WILD WEST?

Many banks and investment banks now have a big problem, admittedly: having taken government coin and operating under government insurance they have to manage decline, which is never fun. Their best people will leave, though not for their former rivals. Arguments that bonus payments shouldn’t be limited so as to protect the franchise just don’t hold water the way they used to.

The franchise has changed and payment has to follow. The age of the partnership may come again, as people move to advisory boutiques whose lack of a big balance sheet will now be far less of an impediment than before.

Similarly hedge funds and private equity shops will attract talent and may try and move to fill some of the gap left by the investment banks. The crucial thing here though is to make sure that they aren’t eating in the government’s kitchen. If they raise debt via banks or investment banks they by definition benefit from a lower cost due to government insurance and themselves are a potential loss for the public.

A private equity firm that borrows money from a publicly insured bank and defaults on it is a private equity fund begging to be regulated.

The orchestrated rescue of Long Term Capital Management arguably was a contributing factor to the current debacle. It encouraged the ‘too big to fail’ mindset that existed into the very last hours of Lehman Brothers.

So clearly if you are going to allow these off-the-grid firms to innovate, take risks and make bigger bets, you have to make sure that those bets as a whole are not big when compared with the system, though they may be big enough to pull down individual funds or firms.

The irony is that the United States looks set to give hedge funds and private equity a huge push, lending them the money with which to buy toxic banking assets with what likely will be a government-subsidized insurance policy.

Here’s hoping that is the last government insurance hedge funds and private equity get.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click here. –

2 comments

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Hi Mr Saft,

I think what your saying is very informative. I also believe that the financial crisis has been mainly due to mis-calculated and fradulant risks. I believe that safest way to invest would be in investment funds, which are balanced and not direct investments, which can be very limited and high risk, depending on a person’s financial situation.

Best Regards,

Will

Regulation can be avoided. Create a bank and a company that will absorb toxic assets. Make your bank to sell defaulted debts to that company and your bank will look neat and clean, while the same high risk lending continues. Profit creates bonuses, bonuses are an incentive to risk. And regulation is in the middle, so there is a strong incentive to cheat. Nationalized banks belong to government. It has no need to cheat taxpayers about profits.

Posted by Pablo | Report as abusive