The Solution to the Goldman (and by Extension, the Securities Industry) Compensation Dilemma

By: Reggie Middleton | Fri, Dec 11, 2009
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I believe I was one of the first of this new wave of blogger/investors to short Goldman publicly in early 2008 (see Goldman Sachs Snapshot: Risk vs. Reward vs. Reputations on the Street and Reggie Middleton on Risk, Reward and Reputations on the Street: the Goldman Sachs Forensic Analysis). The impetus behind the short thesis was simple. Goldman is an investment bank, just like its bulge bracket brethren, and the risk in its environment threatened all of them the same. Contrary to popular belief, Goldmanites bleed red blood and spend green dollars, just like the rest of us.

As you can see above, Goldman actually tends to move in tandem with the rest of the street.

Their share

Correlation to June 2008
77.95% GS and MER  
84.98% GS and LEH
69.57% GS and MS
Correlation before Securitization Crisis Starts (10/06)
91.26% GS and MER
91.57% GS and LEH
56.19% GS and MS

Bear Stearns went down and contrary to popular belief, it was obvious to see it months before hand as I clearly pointed out nearly a quarter before they collapsed, see "Is this the Breaking of the Bear?"., as did Lehman (who also forcasted their demise through their balance sheet so it shouldn't have been a surprise to anyone either - "Is Lehman really a lemming in disguise?", Lehman rumors may be more founded than some may have us believe, and Lehman stock, rumors and anti-rumors that support the rumors.

Morgan Stanley was next up on the chopping block as the "then" "The Riskiest Bank on the Street", as was Merrill Lynch. Then they all got saved. Merrill was overpaid for by BofA through and apparent extortion deal. GS and MS became government chartered financial holding companies (basically federally insured banks) quick fast.

"Why do you bother to show the similarities between Goldman and the other banks whose demise you forecasted so publicly?" you ask. Because it goes right to the root of this compensation issue. If Goldman were small enough as to not pose a systemic risk, I really wouldn't care how much Goldman pays its employees, nor how they paid them. Alas, they do pose a systemic risk.The dilemma currently at hand is not that Goldman pays their employees too much (although they do, but that is an issue between the shareholders getting raped and the company management, much like the issue of Tiger Woods or Bill Clinton's fidelity issues - it is really between them and their families, not us) it is that Goldman effectively paid their employee bonuses with tax payer monies. It was a doomed company, just like Bear Stearns, just like Lehman, just like Merrill if the BofA deal would have taken a week or two longer to close. Don't think I know what I am talking about? Take a look at the dates of the doomed Ibank links above. I have a pretty good track record. Did you hear any of these banks say that their brethren were going to fail? 'Cause you damn sure heard it from me. It has nothing to do with me being smart, either (I'm actually an average intellect type). It has to do with being objective and observant. I do pay attention.

The taxpayer dove in and saved them in a myriad of ways, including the AIG flow through, TARP, bond guarantees, ZIRP, and the list goes on.

To pay bonuses with taxpayer money is a travesty, and is literally antithetical to the concept of capitalism. To do such is to declare yourself a ward of the state, not an icon of capitalism. Thus the recent stated solution of paying the top 30 executives bonus in restricted stock subject to clawbacks not only fails to go far enough, but also goes in the wrong direction (but it does scrape the surface of holding upper management more accountable for risk). Even that restricted stock was earned using taxpayer dollars. It should not be granted at all without the taxpayer getting paid the "vig". Once the taxpayer is made whole for all of those hard money loans that were given (currently about 16% plus 6 points up front), then we can discuss what is essentially Goldman's return to its partnership days where partners were forced to risk their own capital in lieu of risking shareholder capital. Notice how, when I banks were partnerships and before they had other peoples money to blow up, these occurrences happened much, much less frequently.

In addition (and this is a BIG addition) limiting the restricted stock/clawback provisions to just the top thirty executives fails in that most of the transactional and enterprise risk is generated from the guys who actually create the products and perform the transactions. These guys are significantly below the hierarchical threshold announced by this plan. By limiting the (truly) meritorious pay to their boss's boss's boss, you at the very best are exposed to supervisory error and at the worst collusion. Everyone should be included in this program, particularly traders, financial engineers, salespersons, analysts and bankers.

Lest we not forget, any loan program that allows them to monetize the restricted stock should be FULL RECOURSE!!! That means that if they borrow off of the stock then get busted doing the GSAMP thing to their clients (see Reggie Middleton vs Goldman Sachs, Round 1 and the graphic below), the company goes after them for the capital, regardless of the current situation. It this is unpalatable, then there should be no lending off the restricted stock. That's right, I am even going far enough to presume that Goldman (and all banks) should have a fiduciary duty to their clients!

On a final note, while it is always fun to pick on Goldman, this is not a Goldman thing. It is a Wall Street, City (the Brits, too!) thing. JP Morgan poses much more of a threat to the global economy in case of a blow up than Goldman (see An Independent Look into JP Morgan, please!). Shouldn't those guys' risk taking incentives be reigned in first???

Cute graphic above, eh? There is plenty of this in the public preview. When considering the staggering level of derivatives employed by JPM, it is frightening to even consider the fact that the quality of JPM's derivative exposure is even worse than Bear Stearns and Lehman's derivative portfolio just prior to their fall. Total net derivative exposure rated below BBB and below for JP Morgan currently stands at 35.4% while the same stood at 17.0% for Bear Stearns (February 2008) and 9.2% for Lehman (May 2008). We all know what happened to Bear Stearns and Lehman Brothers, don't we??? Fail to heed my warnings if you want to... (Is this the Breaking of the Bear?).

Well, that's my 90 cents worth. It was my two cents worth, but I levered up 22x!!! For those sharp folk who are wondering, I have the rest off balance sheet :-)



Reggie Middleton

Author: Reggie Middleton

Reggie Middleton

Reggie Middleton

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