Wall Street's Season of Excess

It's bonus season on Wall Street and there's plenty of holiday cheer this year. The New York State comptroller yesterday said the securities industry will distribute envelopes stuffed with about $24 billion -- a sum larger than the gross national product of many countries. If you were to add in the hedge funds arrayed along the Connecticut gold coast and the private-equity firms scattered around the country, the number could easily top $50 billion.

Near the top of this year's list is Lloyd Blankfein, who, we learned yesterday, will take home $53.4 million in his first year as chief executive of Goldman Sachs. That's a record for the head of any Wall Street investment bank and reflects another year of record trading volume, record fees for mergers and acquisitions, and record profits in Goldman's proprietary accounts.

And get this: Blankfein probably isn't even the highest-paid Goldman employee. The word is there is a handful of hot traders who will earn even more than the boss.

Who says Wall Street isn't a meritocracy?

Actually, I do. Nobody who is hired help and who plays with other people's money "deserves" to earn $100 million. That's certainly true in a moral sense. But it is also true economically. For despite what you hear from all the apologists about the "market" for financial superstars, this is a highly imperfect market.

Let's start with the fundamental asymmetry of risk in the investment business.

If you were putting your own money at risk, there's the possibility of making lots more, but there's also the possibility you could lose it all. The same, however, can't be said if you are an investment banker, a hedge fund manager or a trader in credit default swaps. In that case, if you do well, you get a percentage of the winnings or the value of the deal. But if you do poorly and your clients lose money, the worst that happens is that your bonus is zero. You never have to give back anything from the bonus you earned last year. And you still get a base salary comfortable enough to keep up payments on the Upper East Side townhouse, the summer place on Nantucket and the tuitions at Brearley.

Wall Street is a classic example of an oligopoly, a cozy club of competitive firms that manage somehow not to compete on price. There are lots of reasons. Because the fees are, even now, a small fraction of the money at risk, clients are less focused on price than on the reputation of the firm and its key employees. Nobody ever lost their job hiring Goldman Sachs. Because of this reality, it is difficult for new firms to enter, while existing firms know they can get more business by bidding up the price of talent than by cutting fees.

To find the evidence of this less-than-robust competition, look no further than the bottom line. In the fiscal year ending in November, Goldman was able to report an after-tax profit margin of 25 percent, and an effective return on equity of nearly 40 percent. Those results are well above the comparable figures for other industries and raise the obvious question that why, in a free-market economy, have they not been competed away over time?

My biggest problem with the rationalizations for Wall Street pay, however, has to do with the widely held misconception that top executives are somehow entitled to some fixed percentage of the profit or a percentage of the gain in a company's market value.

This is, of course, the way we calculate waiters' tips. And it makes sense for small, closely held partnerships. But today's large, global corporations have become so big, the numbers so large, that they provide inappropriate benchmarks when calculating the compensation of a single human being. There's no limit to how big a company can get, but human beings are limited in how much they can eat, or how many homes they can occupy, or how many days they have to take vacation.

Acknowledging that asymmetry, Goldman Sachs used to have a $35 million cap on individual bonuses. Those were tough days, but people could still afford the bare necessities of upper-class life. Last year, however, that cap was replaced with a formula allowing the management committee pay as much as 0.6 percent of pretax earnings to each of its top 25 managers.

Goldman was quick to point out last night that neither Blankfein nor any other executive got anywhere near the $87.4 million bonus that would have been allowed under the formula this year. But where did 0.6 percent come from? Add it all up, and for 25 souls that works out to 15 percent of the profits of a firm with 26,400 other employees and millions of shareholders. Why not 0.4 percent? Or a sliding scale? Or better yet, why not set executive salaries the way salaries are set in just about every other labor market: paying as little as you can get away with while still attracting and retaining key employees.

Why should we care about Lloyd Blankfein and his millions? The answer is that excess compensation in one area leads to excess compensation in others.

A couple of summers ago, I played golf with a fellow who turned out to be a director at Tyco International. At one point, I casually asked him why Dennis Kozlowski, who got a big salary and bonus, was so piggy that he had to have a New York apartment and artwork paid for by the company. His reply was fascinating: Kozlowski, he said, was resentful that while he was masterminding Tyco's growth strategy, arranging for acquisitions and creating value for shareholders, he was still making less than the investment bankers he hired to do the deals.

And that, in the end, is how this arms race in executive pay comes about. It's more about envy than economics. The corporate executives complain they should make as much as the investment bankers, the bankers are upset if they don't make as much as the private-equity guys, the private-equity guys demand to make as much as the traders, and the traders won't sit still until they are paid like hedge fund managers. If you dare to criticize any of them, they'll quickly point out that they still make less than Madonna and A-Rod.

But don't get too exercised about the Wall Street bonus orgy. It turns out that these big paydays are not quite as big as they appear. For residents of New York City, the marginal rate for federal, state and city income taxes is 51 percent (although I doubt very many pay that amount). And because all these masters of the universe are competing for the same Park Avenue co-ops and sailboats and reservations at hot restaurants, a portion of the rest is lost to above-average inflation in the price of things people crave rather than the things they need.

What we have, then, is form of rough economic justice. The beneficiaries of an arms race in compensation are themselves the victims of an arms race in the price of luxury goods and services. It couldn't happen to a nicer group of folks.