Explaining Guaranteed Bonuses

The New York Times today has yet another article about the troubles of President Obama's pay czar, Kenneth Feinberg. In it, the Times explains more of the same: that he is going to have an uphill battle in dealing with guaranteed bonuses at the large banks. I've already written several times about Feinberg's challenges in dealing with this problem. I thought it might be helpful, however, to explain guaranteed bonuses, and what banks are thinking in promising enormous sums of money to employees before performance has occurred.

Before delving into a comment about the Times' piece in particular, I think it's important to begin with an understanding of what a bonus means for those on Wall Street. It's not like a Christmas bonus, or other occasional bonuses, that most Americans might be fortunate enough to receive. Imagine, for example, if your Christmas bonus were 50% to 80% of your annual pay. So if you currently make $50,000, that bonus would be $25,000 to $40,000, where your salary would only be $10,000 to $25,000.

The term "bonus" is something of a misnomer on Wall Street. The bonus culture there began as a way in which to encourage people to work their hardest. Linking compensation to performance is certainly not a novel concept, but on Wall Street, they took it to the extreme. Over the past few years, however, it has become clear that bonuses are not nearly so linked to performance. As I pointed out a few weeks ago, 2008 showed healthy bonus levels even though the banks almost all failed.

The reality is that Wall Street jobs have become so competitive that sort of minimum total compensation levels (salary plus bonus) have gotten much higher, but base salaries have not. As a result, sort of minimum bonuses are now generally accepted to be well above zero, despite the counterintuitive result, given the widespread connotation of "bonus."

Consequently, it should not be surprising that so many banks have begun increasing their base salaries. First, it more realistically captures minimum compensation levels in the banking job market. Second, it quells public outcry, as bonus numbers will proportionally decrease. The problem, of course, is that it completely fails to address the problem that bothers so many Americans: that bankers can make millions of dollars despite terrible bank performance.

Up to now, I've been talking more about bonuses in general than guaranteed bonuses, which is what I set out to do. I think that introduction was necessary, however. So now let's go to the Times' lead paragraph, which includes a common misconception:

A guaranteed bonus might strike many people as a contradiction in terms. But on Wall Street, banks have become so eager to lure and keep top deal makers and traders that they are reviving the practice of offering ironclad, multimillion-dollar payouts -- guaranteed, no matter how an employee performs.

This isn't quite right. Many, and probably most, guaranteed bonuses are tied in some way to performance. I can speak from personal experience. When I took a job at an investment bank several years ago, my contract included language that explained that, to earn my "guaranteed" bonus, I had to meet the expectations set out by management. If I were a complete slacker or lost the bank millions of dollars, then they were not obligated to pay out my bonus.

So can't Obama's compensation czar just cite bank losses and say that those bankers didn't meet expectations? Not exactly. The reality is that only strikingly few people at these banks were responsible for the massive losses they incurred. Moreover, most of the bankers and traders who had a hand in causing the crisis have been laid off by now. The vast, vast majority of those left had nothing to do with creating the financial meltdown and are very likely doing a good job. These employees might be energy traders, merger advisors or equity underwriters.

Then, the question becomes whether those Wall Streeters who met expectations should be held accountable for the mistakes of others. That, of course, is a matter of opinion. Atlantic Business readers overwhelmingly think they shouldn't be penalized, as shown through a poll we conducted a few weeks ago:

Finally, banks are dealing with the flight problem. At this point, not all banks are doing badly. Some are doing quite well. As a result, they're in the position where some of the top talent (who, remember, generally had nothing to do with causing the crisis) from the worse-off banks are threatening to flee to healthier banks. Guaranteeing future bonuses is one way to make sure they stick around. Wall Street traditionally has had incredibly high turnover, as most bankers and traders care a lot more about pay than firm culture. They go where the money is.

So if the government imposes pay restrictions, banks are prevented from using this retention tool, which is really the only option at their disposal. This might not bother many Americans on a superficial level, as perhaps those banks are getting what they deserve. After all, they would have failed anyway without our help. But it's important to remember that the failure of these banks now will end up costing taxpayers billions of dollars, since Washington decided to bail them out. If they lose all their talent, the chances of the government getting paid back approaches zero.

So what's the solution? There isn't a very good one. That's why Kenneth Feinberg has such an arduous task ahead of him. I certainly don't envy his job.