Where Else Are You Going to Go?

Yves Smith returned from book-writing land to catch up on the Andrew Hall story, which is one that I pretty much decided to ignore from the beginning. Hall is the Citigroup trader who, according to his compensation agreement, was due a $100 million bonus. The bonus was so big because Hall and his team were due 30% of the profits from their trades, which is even more than typical hedge fund fees. (This tradition of particular trading groups negotiating a share of their profits dates back at least to Salomon in its heyday; AIG Financial Products also had this type of deal.)

But Smith focused on one element that got me thinking. Hall’s division, Phibro, was bought by Occidental Petroleum. “Oxy paid $250 million, the current value of Phibro’s trading positions. There was NO premium, zero, zip, nada, for the earning potential of the business. Zero. Oxy bought the business for its liquidation value.” Smith infers that no one was willing to pay more because the success of Phibro depended on its being part of Citigroup and benefiting from Citi’s low cost of funding; in other words, the massive profitability of Phibro was in part due to an accounting error — not charging it an appropriate cost of capital given the risk it was taking.

This made me think of something else, though. The typical excuse for paying traders enormous amounts of money is that if you don’t, they will leave for somewhere else. During the boom, it was certainly true that they would have left. (Whether anyone would have missed them is another question — it seems to me that some of the reasons to be skeptical of mutual fund managers apply equally to proprietary traders.) But after the crisis, the options for someone hoping to leave a major investment bank must have declined.

I’ve written so many times that reduced competition has helped the survivors increase market share and margins, but I never realized the other consequence: it gives them more bargaining power relative to their employees. There are fewer banks to go to; some of them (Citi, Bank of America) are in no shape to be paying top dollar; and while some hedge funds are doing just fine, their cost of funds must have gone up relative to the big banks in the current environment. With less competition for talent, compensation should go down, at least a little.

So why is Goldman reportedly on track to pay record or near-record bonuses this year? I imagine they would say something about how, in order to maximize long-run firm value, they shouldn’t take this opportunity to screw their employees. But if I were a shareholder, I would think a small amount of employee-screwing would be in order. This is a company that claims to live and die by the free market, after all.

By James Kwak

29 thoughts on “Where Else Are You Going to Go?

  1. “So why is Goldman reportedly on track to pay record or near-record bonuses this year?”

    I imagine that as the employees can’t threaten any more to got to get a job at a competitor they are threatening to retire into dolce-far-niente or horse breeding or whatever else is the it-thing of today – they certainly should have enough money for it by now and maybe some didn’t quite like it when “mobs” showed up outside their mansions in one of their enclaves and started thinking about a less adversity generating life style.

  2. Maybe the real question here is NOT how much value those employees could offer other firms, but how much DAMAGE the employees could do to Goldman Sachs outside of Goldman. Some tales and secrets to share perhaps………???

    If WSJ is interested in being more than a stenographer for Rush Limbaugh we might find out.

  3. Does bargaining work like that? What matters is your “outside option” – you only need one other bank willing to employ you, so does a reduction in the number of potential employers really cut the value of the outside option?

    Plus, now bankers are the most hated members of society, they will require larger bonuses to compensate for that.

  4. @Ted
    I like that theory because it would explain why governments let them get away with it as the UK seems bent on with RBS

  5. Why are GS employees not treated like every other employee in the country. Did they forget that the cost of labor / talent raises the cost of the product? Did they forget that low employee cost and high employee productivity is good for the economy and the consumer because it lowers the cost of the product?

    Oh wait, I forgot. Their labor is more important than ours… High interest, fees and cost of underlying commodities is good for the economy.

    Wonder where the middle class went? Their earnings went to the employees of GS, banks, and insurance companies because their bonus and compensation packages raises the cost to the consumer.

    A good example of the cost to the taxpayer is Jefferson County AL. Look who really pays for the folly… the taxpayer.

  6. Given that the success of mortgage derivatives was based on the assumption that housing prices would continue to increase forever (profoundly stupid assumption from our “best and brightest”), how is it the that the whole fiasco was not just a huge pyramid scheme? Don’t the folks at the top of a pyramid scheme always make the most money? Wasn’t Goldman’s at the top of the pyramid scheme? Has anyone looked at the underlying assumptions made on the other types of derivatives out there? Has anyone looked at the validity of the ratings on other derivatives? Sorry if these are dumb questions, but I am not an economist, just a systems-type trying to figure out how this whole system works and having difficulty finding answers.

  7. The reason there was no premium was simply this: Phibro’s value is not in its systems or algorithms but on successful bets made by one or two guys. This is not something anyone would ever pay a premium for – it cannot be counted on to keep going N years out. What if the guy starts making bad bets because his wife leaves him or he is upset or sick? when the whole business is one guy making wild bets – there never will be a premium.

  8. Since it is Goldman vs. the rest of us, why would they cut compensation? Your question presumes some concern for shareholder interest and maybe even for national interest. Bad presumption.

  9. who do you expect would buy them? the 30% fee structure kills almost any deal.

    for instance, would a hedge fund be interested? if the group negotiated 30% of profits, and if they get to take that deal with them, no hedge fund is going to touch them because no hedge fund would get more than 20% of profits to begin with — so there would be no way for a hedge fund to take them on without taking a huge loss.

    a prop trading shop within a bank domiciled in the US? no, the PR would be terrible.

    my conclusion is that there is very little information here of the form you are suggesting.

    my take on this is that he and his group were fired and that this ‘sale’ was a way of covering it up.

  10. “in other words, the massive profitability of Phibro was in part due to an accounting error — not charging it an appropriate cost of capital given the risk it was taking.”

    That’s not a bug, it’s a feature.

  11. I asked myself the same question about lavish Wall St pay. From the start I answered that the gangsters need to stick together, at first half-facetiously.

    But over time, as I watched how they all follow the same line, how even outcasts like Richard Fuld keep their mouths shut, all sorts of threats and extortion (like how AIG cadres supposedly knew how to intentionally destroy the global economy if they weren’t paid obscene amounts to unwind those CDSs), how supposedly the traders themselves hold all kinds of threats over the heads over the top management (that’s something that Trillin could have mentioned regarding the intelligence mismatch, but I don’t recall that he did), and of course the brazen government corruption…I came to the conclusion that it’s veritably true.

    It is conventional organized crime, with the same pay scheme. Not just the capos but all the “earners” get a fat cut. It solidifies loyalty, enforces the sense of us-against-them, creates accomplices in every crime, and helps enforce omerta, silence.

  12. 1a) Oxy bought it for “book value” which is certainly not carrying value of Phibro’s “trades”. The vast majority of their positions are in listed futures or margined over-the-counterposition. If oxy were taking over the positions alone, they would likely need to get paid, rather than pay for them, due to the expected cost of liquidation. That’s how it works whenever and bank/hf takes over the positions of another
    1a) So what are the components of the 250mm? The goodwill and employment contracts of the 30 or so traders, less the payments owed to the traders for the profits they generated for citibank in 2008. Hall’s is 100mm and there’s probably another 100-200mm spread amongst the other 29. Therefore oxy is really paying 350mm-450mm for the future earning potential, which seems on the cheap side given the groups historical performance.

  13. There was a legendary bankruptcy in my home town, when I was much younger, in which everybody and his dog knew that the CEO had illegally transferred assets to himself and his family while knowing that the company was going into bankruptcy. It was a small enough firm that at least half of his office knew that he was doing it. But when the feds tried to convict him of it, they couldn’t get even one employee to testify against their former boss. Why not? Because his last move, as he went out the door, was to pay off each of them with an equally illegal million-dollar “bonus.” They could only testify against him by admitting that they also knew that their personal million dollars was also an illegal asset transfer, and at the very least having to give the money back.

    Watching the current round of Wall Street bonus scandals, I wonder if I’m really seeing what I think I’m seeing. Are they buying performance? Or silence?

  14. compliance? – obedience?

    and it may even be that they can convince some to convince themselves that compliance is for the greater good and bonusses are honestly earned
    I imagine the argument goes something like when the bomb hits the ground too many get injured so the decent thing is to keep tossing it around …

  15. “Oxy bought the business for its liquidation value.”

    In March of this year there were many decent companies trading on the NYSE at liquidation or net asset value, but I am willing to bet that finding such companies was a virtual impossibility on Oct. 9. I read that “Citigroup…said certain Phibro executives had agreed their 2009 compensation would be deferred and reinvested in Phibro, and paid out in future years.”
    “Occidental said Phibro’s senior management team had agreed to make a significant investment in the business and receive returns dependent on the company’s future performance.”

    Does this mean that OXY actually paid significantly less than $250 million for Phibro because of the investment agreement?

    It was reported that Phibro does not trade in exotic derivatives but that does not rule out the possibility that OXY may have purchased derivatives directly from Citigroup.

  16. perhaps i’m the only person on wall st. that reads this blog and feels compelled to post something. I hate to say but big contracts are out there again, without being specific there are banks (foreign and domestic) that are paying size 2yr g’teed deals $$$ left and right and some firms have been severely damaged on the talent scale as a result. as for the hall thing, deals a deal and if they guy made you $300-odd million pay the guy.. its not his fault the rest of your firm sucked.

  17. For any lawyers or aspiring lawyers in the group:

    Is not antitrust law intended to confront those entities that threaten competition or monopolize commerce? Does not TBTF imply that Goldman has the ability to destroy the economy? Why not too big for the antitrust axe?

    Could the answer be that Goldman was the second largest contributor to the Obama campaign with a contribution of $994,795. ($230,095 to McCain who never lead in the polls) and we cannot forget the $3.3 million Goldman spent lobbying our esteemed public servants in 2008 or the $2.7 million in 2007.

  18. Nothing would do more to clean up Wall Street and the TBTF
    financial industry than to convene some special grand juries. The sight of having people in handcuffs being led in groups to the federal lockup with indictments for violations of federal
    RICO/fraud statutes would both sober up Wall street and improve the spirits of Main street. Employing another 1000
    FBI agents to investigate financial crimes would be money well spent. The financial industry doesn’t need the best and the brightest; it need the most ethical people for its next generation of employees.

  19. Or the damage they could do INSIDE Goldman. If you piss those boys off, do you think they will give their 2 weeks notice and then get escorted out by security prompty with severance pay? Don’t you think they’d rather trash the company and then go out with a shrug of their shoulders saying they had a bad day.

  20. I think that´s what they´re trying to do with Raj at Galleon, but I think it smells like a fish. So he´s made $5 million on Hilton stock and he´s managing 3.7 billion. Even if he made the full 20 million, and not some of the other people who have been arrested, that´s mice nuts percentage wise, especially over a couple of years. I don´t know, there´s something about it I really don´t like. Hey, if he did something illegal, then fine, but no one is willing to touch the big boys at GS, etc.

  21. My question: what would we expect GS mgmt, etc. to be doing with its profits, other than paying themselves off.

    As J.B. Hicks suggests, it does look suspiciously like asset stripping.

  22. It’s likely management really doesn’t know what’s going on at the trading desks, and is unwilling to upset the apple cart.

    What management does know is that it’s raking in billions, and buying loyalty from traders. Shareholders aren’t about to complain, because they don’t want to rock the boat either.

    Management’s job is to keep the taxpayer on the hook, and the regulators in the dark.

    The traders’ job is to rent-seek, gamble, and take advantage of the near monopoly on trades that management has given them.

    The shareholders just need to shut up and be happy with what they get, because they could have gotten wiped out last year. I’m sure they realize that now.

  23. I’m missing one point in the list:

    media tell me that management’s job description includes that it is responsible for the whole operation and that that is the reason it needs to be “adequately” paid

    so whether they knew or didn’t know is irrelevant, they took cash for a job they didn’t deliver and that is fraud, (whether it is fraud that can be prosecuted is probably another matter)

    same as if I go to the market wanting to buy tomatoes and the guy takes my money and refuses to hand over the tomatoes

    btw what about religious leaders condemning them? or are those busy praying for their souls to remain unharmed by the havoc they wreaked?

  24. You touch on two important issues: one is that the ridiculous profits of some of these trading groups have clearly been partly due to getting cheap capital from their large corporate parents (meaning from the taxpayers, due to their implicit too-big-to-fail credit rating), and the other is that all this talk of needing to pay huge bonuses to retain talent is ridiculous. There are tens of thousands of bankers on the street who would kill for any job at GS, JPM or other surviving firms. Or will the traders move to Europe to get higher pay? Not likely.

    I posted something similar a couple of months ago: http://thoughtbasket.com/2009/08/18/bankers-moving-for-higher-pay-go-ahead/

  25. Maybe OXY knows that all traders are one step away from ruin. Example: Boaz Weinstein. One year he’s the highest paid employee at DB $40 million); the next he is the firm’s single largest all-time loser ($1 billion). And no clawback.

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