5 Min Read
By James Saft
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.
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.