Opinion

James Saft

Goldman’s smart move on pay

January 17, 2013

Jan 17 (Reuters) – This is how capitalism is supposed to
work.

Goldman Sachs has cut back sharply on employees’
piece of the revenue pie, taking it to 21 percent for the fourth
quarter.

For long-suffering shareholders, this is the best news out
of Wall Street in, well, maybe forever.

Goldman paid out 37.9 percent of revenues in compensation in
2012, down from 42.4 percent from a year ago. It is the lowest
payout ratio since the firm went public in 1999. The bank did it
by shedding people. Average compensation actually rose 9 percent
to just under $400,000, helped by a 19 percent increase in
revenues.

As such, it is not clear that Goldman has bought into the
notion that the wunderkinds of Wall Street are overpaid, rather
instead into what must be a more comfortable conclusion: that
the ship was carrying too many passengers.

Yet, with continued pressure from shareholders – a given -
Goldman may well find that, even in a recovery, it must allot a
declining share of incremental revenue to employees. In other
words, when investment banking booms again, it may be forced to
staff up but still keep a lid on overall compensation.

If Goldman, the most prestigious firm on Wall Street, takes
this tack, the pressure on its rivals to follow suit will be
intense. Shareholders seem to like the idea, bidding Goldman
shares up by about 4 percent since the news.

Compensation has long been a peculiar institution on Wall
Street, with employees capturing more of the revenue than in
many other businesses employing similarly highly trained
workers. It is also a heads-we-win-tails-you lose arrangement:
Morgan Stanley actually allocated 62 percent of its
revenue to pay in 2009, a year when its stock was trading at
about 40 percent of its 2007 peaks.

High pay on Wall Street drives a variety of ills. Investors
are only willing to value investment banking earnings very
conservatively, partly because they are volatile but also
because of a conviction that they are not getting their share of
the loot. Very high pay also arguably drives excessively risky
behavior among bankers.

NEW REALITY

The incentive to take risk today – heedless of the potential
costs to shareholders – is being addressed across broad swaths
of Wall Street by making deferred compensation a higher
percentage of bonus payments.

Morgan Stanley is reportedly deferring 100 percent of 2012
bonuses for employees making over $350,000 with at least $50,000
in bonus. Half of that bonus is to be paid in cash, the other
half in stock. Payouts are to begin in May and extend over the
next three years.

That’s good news and serves two purposes, cutting the value
of compensation and making employees more likely to have a
medium-term outlook.

The move may be because Morgan Stanley is facing its own
pressure over compensation. Famed hedge fund investor Daniel
Loeb, of Third Point LLC, has taken a stake in the company and
is reported by the Wall Street Journal to be applying heat over
pay, going so far as to reviewing the compensation of specific
top officers.

Morgan Stanley, which reports earnings on Friday, is
expected to still be paying out slightly more than half its
revenues in compensation.

Loeb’s move is a smart one, and I expect others to get on
the bandwagon, pressuring banks over pay. The financial crisis
has likely changed a few fundamental things in the industry.

If a company is one of the lucky in the too-big-to-fail
group, a larger percentage of its value is in its franchise. An
entire team can defect, but they will never be able to beat the
funding costs of an entrenched TBTF bank at their new firm.

Similarly, new regulations are going to force banks to offer
simpler products, and to pursue simpler strategies for their own
balance sheets. That is the clear lesson of JP Morgan’s
London Whale debacle, under which it lost $6.2 billion on a
credit speculation gone wrong.

To the extent that Wall Street products become commodities,
prices fall, and with them falls compensation.

Smart investors need to realize that, far from being a bad
thing, a simpler, lower-revenue-oriented Wall Street will likely
be a far better investment. Banks will be less likely to go
bust, a higher percentage of revenue will flow to the bottom
line. The market will make a far better price for those
earnings, driving shares higher.

Goldman deserves credit for understanding this, accepting
it, and for gaining first-mover advantage.

If this kind of thing keeps up, the next decade might
actually be a good one for investors in financial services, with
stocks enjoying expanding price/earnings multiples.

And maybe even less volatile earnings.

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