What Does a Bonus Really Cost?

Consider this fable.

You’ve decided to invest $5 million in backing a champion at the new World Champion Poker Standoff. The rules are simple. Two players will play a winner takes all game of Texas Hold'em. Each player will come to the table with a $5 million stake. You might ask why you would consider such an “investment”, but this is not all that different from the game the big banks have played in recent years.

Once in the game, you win a flip of a coin and are given first choice on hiring one of the two champions who will play in the tournament. The only information you are given is the following:

• Player A wants an upfront cash salary of $400,000 plus a bonus equal to 50% of salary.

• Player B requires no salary, but demands a bonus equal to 20% of his winnings.

Admittedly you’re missing some fairly important information such as who has the better track record and whether one of the players is a drunk or cocaine addict. But this is a fable after all so you’ve got to play by fable rules.

Given no more information than this, which player should you choose and how much will each player cost you if chosen. I would posit the following:

Player B is the only rational choice. Player A doesn’t have the courage of is convictions. Player B does. While this could be based on a totally unrealistic optimism on Player B’s part, it is more likely based on Player B’s realistic confidence that he will win. Assuming this is the case then the odds favor Player B and the likely cost of each player is as follows:

• Player A costs $5,400,000 (Salary plus 100% loss of capital)

• Player B generates a net profit of $4,000,000 ($5,000,000 winnings less $1,000,000 bonus)

The major banks in the U. S. (and the world for that matter) have participated in a hardly restrained speculative orgy for the past five to ten years. Under the new stimulus bill, bonuses of top earners at the major banks will be capped at 50% of salaries and must apparently be paid in restricted stock in institutions widely considered to be hopelessly insolvent and in which the equity and the options are likely to be worthless. In a culture where top performers have traditionally had the ability to earn bonuses of tens or even hundreds of millions of dollars, this is going to cause some problems.

It’s easy to debate the merits of the old bonus plans, where even marginal performers have apparently been lushly rewarded, even when the institution itself lost money. On the other hand no one can argue that, if the banks are going to continue to put massive financial positions (debt, derivatives, FOREX, etc.) at risk on a daily basis, billions of dollars at a time, there’s a pretty big premium on having good people in place to do the trading.

The big banks have ten of trillions of dollars of credit default swaps and other risk positions on their books. It’s not hard to picture recruiting calls going out from hedge funds and other trading firms not subject to the new law offering the best and brightest traders highly incentivized deals to move from the big banks to begin trading for these non-regulated firms. These traders will come armed with extensive knowledge of their former employers’ investment positions and will have every incentive to take advantage of that knowledge at the expense of their former employers and ultimately at the expense of the taxpayers who will likely soon own the big banks. And they’ll be trading against bank employees happy to take a comfortable salary and a 50% stock option bonus.

The stakes in this game aren’t millions, but trillions of dollars of taxpayer money. Odds are we just bet on the wrong champions.

Comments

[Publicliter...:]

I don't think you would like the outcome of following your logic. So, since most of these banks are insolvent, shouldn't all the bonuses be clawed back since they ended up losing the "game" at the end of the day? Banking is a "team" sport, and if your "team" loses, like most US banks and investment companies, why should the "team" receive ANY bonus. I think there are plenty of individuals that will play less risky, make less returns in the short term but not blow up the entire system during the process. These are the people that should have been hired to begin with. I wouldn't really argue that any single institution including GS or JPM did well.

Feb 16 04:01 PM

[Leftfield:]

"Top performers have traditionally made" tens or hundreds of millions of dollars. So did Bernie Madoff. Maybe many of those "winners" deserve the same fate.

In any case, they gamed the system. Tilted the board. Paid off the politicians of whom at least some should also be investigated.

Impressive how they worked the system to double down on their ultimately losing bets with taxpayer trillions. Perhaps by staying around collecting bonuses from the resulting carnage, they finally lose.

I hate government regulation. I am a rather low-income earner and the lax regulation of the rich and influential doesn't apply to me. I know about procedures, fees, steps and trapdoors. Maybe the hedge funds need some of those.

Since the game was (is) so rigged, I don't think your fable applies to the bonuses on Wall St. Don't forget, Goldman and probably JPM are the most connected with Washington. We've used these alleged brains too long on financial engineering. How about fixing healthcare or any number of societal ills? That would be awesome and impressive.

Feb 16 04:15 PM

[SingHash:]

Slater's analogy is a good one, as it cuts to the heart of the matter -- though perhaps not quite as he intended.

I do not WANT a gambler handling my finances; I want an investor with plenty of time and resources to eliminate as many variables as possible. The system, as it begins to topple, appears to have been built by INCREASING the number of variables to the point where money was divorced from any underlying value.

If the cap means that the gamblers go elsewhere, then some bright and hungry people of a different sort will step up to fill the gap. Considering the dismal performance of the gamblers, I can't see that as a bad thing.

Feb 16 06:44 PM

[John Slater:]

I totally agree with your logic. I'm part of a traditional investment banking partnership. Last fall when it became obvious that things were going to be tough, we passed the hat to add to our capital base. No bailouts here. The point is that now we have the worst of both worlds: (1) vast amounts of speculative capital at risk in very speculative trading businesses and (2) a system that assures that the people best equipped to deal with the environment are incentivized to move out of the system to rape, pillage and plunder the "peoples" banks. By all means if we object to the banks paying compensation at levels that enables them to get the best traders, the banks should get out of trading. But I haven't seen that suggestion on the table.


On Feb 16 04:01 PM Publicliterature.org wrote:

> I don't think you would like the outcome of following your logic.
> So, since most of these banks are insolvent, shouldn't all the bonuses
> be clawed back since they ended up losing the "game" at the end of
> the day? Banking is a "team" sport, and if your "team" loses, like
> most US banks and investment companies, why should the "team" receive
> ANY bonus. I think there are plenty of individuals that will play
> less risky, make less returns in the short term but not blow up the
> entire system during the process. These are the people that should
> have been hired to begin with. I wouldn't really argue that any single
> institution including GS or JPM did well.

Feb 16 08:16 PM

[norom:]

If people paid as much attention to their accounts as they did the news they wouldn't be in half the trouble their in.

Feb 18 08:07 AM

[yawtlam:]

In a poker game, when there is a winner there has to be a loser. When every bank exec hires your player B, who is the loser?

Feb 22 12:46 AM

[John Slater:]

Under the rules of the game as outlined in the article, one player chooses B and the other player has to choose A. In the real world there are only so many B's and it's hard to imagine the best wanting to stay around at Citibank to figure out whether they're getting a bonus at the end of the year.

Feb 23 11:26 AM