The way Wall Street works

The storm over Wall Street pay was back in full force this week as major banks announced multi-million dollar bonuses for their senior managers. This morning's Wall Street Journal trumpets the headline "Goldman Bows on CEO Pay" and goes on to explain that the venerable Goldman Sachs is showing restraint in only paying its CEO and his four top lieutenants bonuses of $9 million each for their efforts in 2009. Yikes! If this is restraint, someone restrain me--PLEASE!

Now don't get me wrong. A person should get paid for the wealth they create. After all, if Steve Jobs has the vision and drive to create products that millions of people want to buy, shouldn't he be free to make billions of dollars? I want as many Steve Jobs in the world as possible. But that is not the way Wall Street works. They don't get paid for creating wealth--they get paid for being in the flow of wealth, and there is a very big difference.

I spent the first few years of my career working for First Interstate Bank in Los Angeles. I was a bond trader for a brief period and then a derivatives specialist. I later worked as a futures & options broker with JP Morgan in London before before managing several billion dollars in mutual funds and institutional portfolios for American Express. When I first got in the business I remember feeling awed by the amount of money changing hands in the markets and by the amount of money some of the bond traders and salespeople made. For the most part, these people were not rocket scientists and for a while I couldn't figure out what they did that made them worth the kind of money they were being paid. (One guy in L.A. made over $1 million in 1986 and he was undoubtedly the least impressive person I have known in business.)

And then it dawned on me. These people don't get paid the big bucks because they are better or smarter or because they contribute more. They get paid like that because they are in the flow. It's like the capital markets are a giant river of money flowing around the world and every trader or salesperson is a reed growing in the river. Compared to the overall flow, very little water sticks to any one reed, but every reed is fully saturated.

The amazing part is that after a while, those reeds begin to believe they deserve what comes to them by being in the flow and the longer they stay in the flow, the stronger the self-delusion grows. Finally, they get to the point where they believe that a $9 million bonus is a sign of restraint and they have a hard time understanding why the rest of us just don't get it. That's why David Viniar, Goldman's Chief Financial officer, could say without any sense of irony, "We really aren't deaf and blind. We see what is going on and we hear what regulators and the world is saying."

Another problem with the way Wall Street works has to do with the time frame used in figuring bonuses. Most people on Wall Street get paid bonuses that are many multiples of their base salary. The amount of bonus is ostensibly determined by how much profit they contributed to the firm that year. That's the theory, anyway.  Unfortunately practice doesn't always reflect theory. The true profitability and risk of a business decision is often unknowable for years into the future--especially when it comes to derivative contracts like credit default swaps. But that doesn't stop Wall Street from paying a bonus on it as if the profits were all realized today. In fact, when you look back at what happened in the credit markets in 2008, many of the people who were responsible for the terrible decisions that led to the carnage were paid hundreds of millions of dollars for those decisions in the years leading up to the meltdown. Were those fat payouts ever recaptured? Forget about it.

Recognizing that this is how Wall Street works is the first step in identifying some clear-headed reforms. Personally, I don't think more government regulation is the answer. Wall Street has a rich history of successfully circumventing Washington's ham-fisted efforts. Instead, we should do all we can to strengthen corporate governance. Shareholders need to step up and demand greater accountability. If shareholders make responsible compensation practices a prerequisite to capital access, Wall Street will listen--after all, if there is one inviolate truth on Wall Street, it's that money talks.