Toomre Capital Markets LLC

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Top Traders Still Expect The Cash

As many readers of the Toomre Capital Markets LLC ("TCM") no doubt are aware, there is an on-going populist revolt on-going against the "fat cats" of Wall Street. The national politicians are responding to the deep-rooted anger of their constituents about how the $700 billion TARP program was urgently needed to "bail out" the major American global and investment banks. Hence, there is considerable rhetoric about "Main Street" vis-à-vis "Wall Street".

Much of the populist anger has centered on the large amount of pay and bonus compensation that the Wall Street investment bankers and traders receive, which is multiple times what professionals in other non-finance industries receive. The general thrust seems to be "What work exactly do these investment bankers do that is so special that these professionals are 'entitled' or 'deserve' to receive bonuses that are hundreds of thousands or even multiple millions of dollars?"

New York Attorney General Andrew Cuomo appears ready to proceed to beyond mere populist rhetoric. Using his authority under New York State's fraudulent conveyance legal code, he recently has written to each of the banks that have recently received capital infusions under the TARP program. He has demanded to receive information about executive compensation and how their 2008 bonus pools were calculated as well as information on the 2006 and 2007 bonus pools. He has ominously warned "We will have grave concerns if your expected bonus pool has increased in any way as a result of your receipt or expected receipt of taxpayer funds from TARP."

Partly as a result of this political pressure, the top seven executives at Goldman Sachs recently announced that each of them will be receiving no bonus at all for 2008. UBS quickly followed suit for its top executives as have Deutsche Bank AG and Barclays Plc subsequently. Other banking institutions receiving TARP funds are being pressured to likewise eliminate 2008 senior executive bonuses in the coming weeks.

With senior executive bonuses being eliminated or likely to be, the next challenge is what to do with the bonus pools for the lower levels of each of these banking institutions. Clearly, the bonus pools will shrink in size. However, the key question is by how much? Should they shrink to zero like many populists want? Or should the bonus pools be compressed only to the point where they can hope to retain their most important assets – their people? And if the latter is the objective, how much of a decline will be sufficient to prevent those "star" investment bankers and/or traders from moving to one of their competitors, a hedge fund or an asset manager?

Clearly, if Bank A pays zero percent of previous year's bonuses and its competitors pay about half of the previous year's amounts, the most talented personnel at Bank A will tend to move to competitors with better compensation, thereby hurting the future earnings prospects of Bank A. Likewise, if Bank A pays about half of the previous year's amounts and its competitors are at zero percent, Bank A will receive incredible political rhetoric and potentially legal inquiries by New York Attorney Andrew Cuomo. Hence, the board of directors and senior managements at each of these institutions are in a difficult position.

On Wednesday November 19th 2008, The Wall Street Journal printed the article Top Traders Still Expect the Cash written by Ann Davis. The sub-title of the story is "Wall Street CEOs Are Giving Up Pay, but Hotshots Are Another Story." The gist of this article is that there are a small group of Wall Street traders, primarily trading commodities, currencies and/or interest-rate products, who have had extremely profitable years and these traders expect to be compensated for excellent, if not career, years in terms of profitability.

According to this article, "Even 'best-in-class' front-line employees now face a much darker pay outlook, with bonuses expected to fall by 10% to 20%, according to search firm Options Group. It projects that bonuses overall will drop 25% to 50%. UBS, meanwhile, is crafting packages that withhold short-term pay if long-term bets go sour." In short, "The top traders' final bonuses will be an acid test for Wall Street's once-proud pay-for-performance culture."

"Michael Karp, CEO of Options Group, says he is telling many high-performing traders that if their bonuses 'are flat from last year, they should be pretty excited, even if they've had a much better year.' The best traders at top-tier commodities and currency desks made $10 million to $20 million or more last year, and the next level down, traders who brought in $100 million in revenues, might have made $4 million to $5 million, he says.

"Generally, traders look for bonuses of up to 10% of profits they made for a firm, with adjustments for the performance of the unit and the overall firm. This year, an oil trader who brought in several hundred million dollars or more in revenues to his firm might still get $20 million, but much more of it will be in stock. … star foreign-exchange traders who expected to make $25 million this year after earning the firm $250 million may get less if it isn't clear the feat can be repeated without the use of borrowed money."

The article highlights the quandary senior management faces. "Shaken by the global financial crisis and increasing government oversight, banks are groping with a new way of doing business: Pay out huge sums and risk public ire and perhaps more government intervention. Pay too little, and tempt defections or insurrection from the few people who are driving this year's profits."

Lars Toomre of Toomre Capital Markets LLC earlier in his career was one of those 'best-in-class' front-line employees at Lehman Brothers. Subsequently, he was a middle-level executive at both Smith Barney and UBS where decisions about how to compensate a department's stars and other employees from a finite bonus pool needed to be made. Hence, he keenly appreciates both sides of the argument of what is the trading seat worth vis-à-vis what is the person worth. He has literally lived both sides of that argument and the subsequent fall-out as a result of being willing to have an opinion that differs with more senior managers.

Regarding the current dilemma about what to pay the 'hot shot" front-line employees in 2008, after some consideration, Lars Toomre comes down on the side of those banking senior managers who want to aggressively reduce Wall Street compensation. Generally, many "hot shots" benefit from being in the right place at the right time. Yes, those "hot shots" have good trading skills that help them locally maximize potential trading profits. However, generally they are also presented with far more trading opportunities, for example in the area of commodities, by working for Goldman Sacks or Morgan Stanley.

Just by being employed by such a major financial institution, there is an incredible amount of information flow. First, generally there is a 'best-in-class' research group that helps to put key economic information into context. Second, as a result of the institution's general prominence, institutional customers expose some of their transaction volume to that major financial institution. As a result, a general sense emerges of whether there are better sellers or buyers in a particular product area, and at what levels institutional customer(s) might be induced to transact. After all, as a flow trader, the key objective is to buy at a price of x and to then sell that amount at x + delta x. The key objective of such a flow trader is to make sure that the "delta x" amount is positive. Third, if a trader truly is a "hot shot", his (or increasingly her) opinion about this or that is highly valued by others.

One of the key methods mid-level managers can validate the worth of "hot-shot" traders is to check the sources of both his/her realized and unrealized profit/loss ("P&L"). Assuming that the vast majority of the profits reported are as a result of realized profits (and are not a result from unrealized profits that might for instance result from "mis-marks" that might accrue to that trader's advantage), the next area that one might check is what are the views of the trader's counter-parties? Obviously, if a trader has realized significant profits from closed transactions where the counter-party is a nationally-recognized exchange, there might be good reason to suggest that the true EVA was primarily as a result of the traders activities. However, if most of the counter-parties are regular customers of the trader and much of the "profits" have yet to be recognized, one might want to ask a few more questions than just how the bonus has varied from the previous year.

Toomre Capital Markets LLC also suspects that the general rule of thumb of paying a trader ten percent of his net profits will change. Back in the time before the most recent credit bubble, traders generally were paid a smaller percentage of their net profits. Lars Toomre recalls a time when a payout of five percent was considered the norm. Some of the very profitable traders in the Salomon Brothers fixed-income arbitrage group were paid even less than five percent on a percentage basis. Hence, 'hot shot' traders should likely expect their bonus compensation to decrease both this year and next year. Reader comments and thoughts are welcome.