How to Make Money from Bank Bonuses.....

In my Money Week column this week, I've been looking at how you can make money from other people's bank bonuses. Here's a taster.

Warren Buffett once famously remarked that the airline industry, whilst making it far easier for people to get around the world, had burned just about all the capital investors had ever put into it. “As of 1992, in fact—though the picture would have improved since then—the money that had been made since the dawn of aviation by all of this country's airline companies was zero. Absolutely zero,” he wrote in one of his letters to his shareholders in the 1990s.
Buffett probably doesn’t feel quite the same way about investment banking – he did, after all, help out Goldman Sachs when it was short of cash during the credit crunch and made a lot of money on the deal. But his observation about airlines is just as true of the traders and dealmakers of London, New York and Zurich. The industry has made a fortune for the people working in it. The executives and traders have walked away with fortunes. But, as a general rule, the outside shareholders have been stuffed.
Now, however, that might be about to change. Under political pressure, banks such as Barclays Capital and Credit Suisse are abandoning big cash bonuses in favour of paying their staff in deferred shares, or in bonds linked to the share prices. Whether that makes the banks any safer remains to be seen. But it should be a great opportunity for investors. The one thing we know bankers are really good at is manipulating the price of financial assets. All you need to do is invest in the same piece of paper that bankers bonuses are being paid in, and you can be sure it will soar in price.
Barclays has been making the most noise about changing its bonus scheme. Chief executive Bob Diamond is said to be about to unveil a scheme that would pay his most senior staff in convertible bonds, known as cocos, rather than just giving them wheelbarrows full of cash. The bonds would be freely traded, but would automatically convert into equity if the bank’s capital ratios fell below a required level. The idea is a simple one. If the bank gets into trouble, and runs out of equity the way many banks did during the credit crunch, all those bonuses would be converted into shares.
Credit Suisse has also been forcing its bankers to have more of a stake in the bank. The bank has started paying a far higher proportion of its bonuses in shares, and staff will have to keep them locked up for four years before they can sell them. Other banks are reported to be considering similar schemes, paying bonuses either in shares or else in convertible bonds.
It’s not hard to see the sense in the idea. Whether big bonuses played the part in the financial crisis of 2008 that is popularly supposed is open to question. It’s possible that lax monetary policy and global trade imbalances played just as big a role. What is certainly true is that bonuses have made investment banking a rotten industry for outside investors. The banks may at times make obscene amounts of money for doing very little – but, rather like football clubs, it was the players who walked away with all the cash rather than the shareholders.
The long-term performance of most of the big banks has been terrible. UBS shares are no higher now than they were back in 1993. Morgan Stanley shares are no higher than they were in 1998. The star of the industry Goldman Sachs has been a money machine for its staff, but not nearly so lucrative for its owners. The shares are still down on the 2006 price, and the yield is less than 1%. As a general rule, the people who actually own the businesses have missed out on all the money the industry makes.
No great surprise about that. There was no real need to share the spoils with the shareholders. For much of the last decade, investment banks didn’t need to raise much fresh capital.
The new bonus schemes will change all that. One useful rule in economics is that if you provide people with a big incentive to hit a target, they will do so regardless of whether it makes much sense. A classic example was in Soviet Russia. The Kremlin leadership decided too many people were dying in Moscow’s hospitals. The doctors were told to cut deaths by 50%. So they chucked all the old people out into the streets. Naturally, they quickly died of cold, but deaths in hospitals fell by the required amount. The target was met.
Banks aren’t going to chuck out old people – apart from anything else, they don’t employ any. But they will, just like those Moscow doctors, do whatever they need to do to meet their target. The one thing that we know for sure bankers are very good at is manipulating the price of financial assets. If actually getting their hands on their bonus requires that the share price or its convertible bonds hit at a certain price in two, three, or four years times, then you can be certain that the entire energies of the bank will be dedicated to making sure it happens.
Whether that will actually make the bank stronger or more stable in the medium-term is open to question. The long-term performance of Barclays doesn’t really depend on its capital ratios. The Credit Suisse share prices may or may not be a good indicator of its underlying performance. But none of that will matter. If it is what needs to be done, it will be done.
It is a great opportunity for investors. Just wait until the bonus scheme is unveiled. When it is, look at what piece of paper needs to soar in price for the bankers to collect their bonus. Then fill your boots. The bank may well go bust a few years later – but you can be sure that your investment will pay off handsomely before that happens.