Banker's bonus tantrums

‘Heads I win, Tails you lose’ Culture:

All of us have read enough about the causes of last year’s economic downturn from myriad sources, but the issue of banker’s bonuses was sublime and hitting the news-deck time and again. Bank executives claim bonuses are tied to performance, whereas the real scenario portrays a clear disconnect between compensation and bank performance. All the excessive risk taking by various investment banks in boom times never fetched long term market value to the firm, but earned large bonuses to their executives.
For example, Merrill Lynch (merged with Bank of America in 2009) paid out $3.6 billion in bonuses despite suffering massive losses of more than $27 billion for 2008 and received TARP bailout of $10 billion. Goldman Sachs earned $2.3 billion, paid out $4.8 billion in bonuses, and received $10 billion in TARP funding. (See table below for info on other banks)



Let us discuss few arguments in this regard:

1. Top CEOs often get huge payoffs even if they run their firms into the ground and are fired. For instance, Lehman Brothers CEO Richard Fuld received almost half a billion dollars in compensation in the long financial expansion from1993 to 2007. Stan O’Neill at Merrill Lynch received $166 million as a going away present, Charles Prince, the CEO of Citigroup, was paid $68 million upon his release after the firm’s collapse.

2. Irrational compensation structures and bonus bidding wars were born out of fear of ‘poaching’ of firm’s employees by its competitors. This harmed the entire industry, thereby forcing firms to continually increase bonus levels.


3. Firm’s justify large bonuses in bad years by arguing that new boom will inevitably develop when the crisis is over, and since no one knows which future market segments will be most profitable, it is prudent to pay large bonuses to retain all key employees to make sure the firm is well placed to profit when the
boom arrives, no matter what its form.

4. Employees working in profitable market segments should not be punished by smaller bonuses for the low profits or losses generated by those in other divisions. In other words, huge losses from a tiny number of staff like Merrill blew about $20 billion just on mortgage-related products – more than offset the profits from other successes.

Forbes Bonus ranking - Banking industry CEO's for 2008:



When the subject-matter is ‘bonus’ , as you all know, there is no end to arguments, so also, a rationale concluding remark. Therefore, I feel the reform must be within and not outside – it might sound philosophical but it’s an undisputable fact. I would like to recollect here the statement by present CEO of Citigroup, Vikram Pandit, who said ‘I will take a salary of $1 and no bonus until the bank, which has accepted $45 billion in government bailout money, returns to profitability’


In a NUTSHELL - Real scenario:

An investigation into compensation practices in the American banking system reveals: ‘when the banks did well, their employees were paid well - when the banks did poorly, their employees were paid well - and when the banks did very poorly, they were bailed out by taxpayers and their employees were still paid well.
“Total compensation and benefits at the publicly traded firms analyzed by the Wall street Journal are on track to increase 20% from last year's $117 billion -- and to top 2007's $130 billion payout. This year, employees at the companies will earn an estimated $143,400 on average, up almost $2,000 from 2007 levels”

Cost of Capital

What should be the cost of capital for any investment we make?

All the financial data of the company and the research reports of many investment banks concentrate on some variables to show up the performance, which are not comparable. 

Say for example, you have invested Rs.100/- in a business in the first year the revenue is Rs.100/- and the net margin on the sales is 10%. In later years due to inflation your revenue and thereby your net income would increase, putting the initial capital investment constant. This is illustrated in the below example.

Initial Investment	100.0
Inflation	2%
Year	Sales	Net Income	Return on investment
Year 1	100.0	10.0	10.0%
Year 2	102.0	10.2	10.2%

This shows an increase in the returns per say, but the return are not adjusted for the inflation of the initial investment.
Thereby when calculating the return on assets employed we would be equating one historical figure (Tangible assets and other assets employed in the business) with another which is inflation adjusted (Revenue and Net income e.t.c). Obviously the return will improve over the earlier years as the initial investment is not in the current terms (No Inflation adjustment).
So what can be the basis for calculating the real return on any investment?
The better approach in calculating the return on investment is “Return on the initial investment – Inflation rate” would give a better picture of the actual return.
This is the reason for the importance of opportunity cost in investment and financial management concepts. This gives a better view of the actual return on the investment.
What factors into the Cost of Capital?
There are many factors which would be involved in the calculation of Cost of Capital and they are as follows:

1)      Cost of Equity

2)      Cost of Debt

3)      Risk Premium

Debt is less costly than Equity because, the debt holders will be enjoying only the interest which but not in the remaining profits of the company. But equity holders on the other hand will enjoy the remaining profits and if the business does not do well then they will suffer the loss also. So Return is directly proportionate to risk.
So to take this benefit every company can finance its operations trough debt so that the weighted average cost of capital would be lower. But if the proportion of debt increases that increases the risk of equity share holders which will increase the cost of equity which will offset the benefit from debt financing. So as these factors are relatively offsetting each other the other major driver of the cost of capital is the risk premium. The following chart shows the comparative yields of the 30 and 10 year treasury bonds and the Moody’s Aaa and Baa credit rated bond yields, which explain the significance of risk premium.

This gives the view that after the burst of any bubble the spread between Fed Bonds Yield and Moody’s Baa Rated would increase. But during the current crisis this has increased significantly. The risk premium is more almost equal to the 30 year bond yield, which will increase the cost of lending significantly in the bust phase through the recovery phase.
To sum up, while calculating the return on investment we need to take into account, inflation factors and the risk premium into account to assess whether the investment is worthy or not.

Cranky Currency stuff (USD-INR)

It's over a year now, since i started tracking the US dollar index movement in Bloomberg (http://www.bloomberg.com/apps/cbuilder?ticker1=DXY%3AIND). The US Dollar Index (USDX) is an index (or measure) of the value of the US dollar relative to a basket of foreign currencies (weighted geometric mean of the dollar's value compared only with Euro (EUR), 57.6% weight; Japanese yen (JPY), 13.6% weight; Pound sterling (GBP), 11.9% weight; Canadian dollar (CAD), 9.1% weight; Swedish krona (SEK), 4.2% weight and Swiss franc (CHF) 3.6% weight).

Supported by various economic and financial stability programs (like TARP, TALF, etc) by US government; the index hit the peak level of 88.9 in March-09. USDX touched low at 76.4 post Lehman collapse (Sept-08). During the course of the year, a series of quantitative easing measures followed by printing currency must have plunged the index further to 74.8. It is expected to go down unless resurrected by financial stability measures.

Turning to Indian scenario, INR/USD was extremely volatile in the past year. Led by rupee depreciation, the exchange surged to Rs 52 per US $ in March-09. Thanks to the pro-active easy money policy measure by RBI, but for which, the Indian economic experience last year would have been traumatic. INR/USD is tending close to stability levels at around Rs 46 per US $. We must not rule out the fact that dollar depreciation globally improves the chances of INR/USD marching below Rs 46 to as close as $ 40-42.

The bubbling yellow metal

Commodities, especially 'gold' look like a good store of value in the current economic regime, where the interest rates and the yields on government bonds are low. Banks are more willing to support investors and speculators than to lend businesses and consumers.

When money is easy and demand moves faster than supply, prices can explode. In 18 months from July 1978, gold went from $ 185 per ounce to $ 850. That's $ 2400 in today's (Nov 17,2009) dollars. And interest rates were much higher than now. A similar price rise from here would bring gold to more than $ 5000 per ounce.

The price of yellow metal depends on same three factors like Oil or wheat - demand, supply and financial conditions. Since august, it surged 20%, which might be a modest beginning.

Gold production from mines totaled 2,414 tonnes in 2008, worth $ 88 billion at Nov 16 price. There will be more this year, however it is expected to be less from 2010 onwards.

India recently purchased 200 tonnes of gold from IMF, thereby rising gold composition in for-ex reserves to 6% (earlier 4%). If China decides to substitute 10% of its existing for-ex reserves ($ 2.3 trillion dollars) with gold, it might require to buy almost three years' worth of production, at current price.

Forex Movements - What do they say

During the recent past when the financial crisis has started we have seen a lot of ups and downs in the forex movements of many currencies around the world. What actually can we make from them and whether there is any solution for the stabilization of the forex movements in future? The following thoughts are placed to understand the dynamics and finding a reasonable solution to stabilize the forex rates.

Why there is a recent spike in the INR vs USD. INR appreciated approximately 12% against USD. This was mainly due to increase in the flow of US$ in to India (and other emerging markets) which increased the demand for INR. When demand increases the price will increases, which appreciated the value of INR.

What happens when the foreign capital flows into the country?
The inflow of cash will increase the money supply within the economy which will create a boom.
Example: When US is importing goods from export oriented countries (Japan and China), the US$ are going out from US. This decreases the money supply within the US which will increase the interest rates within the country. As the interest rate rises, the debt driven US households would decrease the consumption which affects the export oriented countries.

So what the export oriented countries do to keep the interest rates of US low?
They pump in the US$ back to US through purchase of US Treasury. As the demand for the US Treasury increases, the yield on these bonds decrease.
Going by the Capital asset pricing model, interest rate would be equal to “Risk-Free Rate + Risk Premium”.
As the Risk-Free Rate (US Treasury bond yields) has decreased there would be decrease in the interest rates and so the demand for the goods would not be decreasing.
But this cannot go for long and every thing in this world needs to be balanced. As the foreign capital continued to flow to US, there was a boom which resulted in current crisis.

Note: The two biggest holders of US treasury securities (http://www.treas.gov/tic/mfh.txt) are as follows:
1) China with 799 million (40% of its more than USD two trillion forex reserves) (http://www.bloomberg.com/apps/news?pid=20601087&sid=alZgI4B1lt3s).
2) Japan with 752 million (75% of the more than USD one trillion forex reserves) (http://www.thehindubusinessline.com/businessline/blnus/10071706.htm).

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