Why bonuses should not be curtailed in banks

There is a flurry of law-making activity in the US House of Representatives and in the US senate to impose upto 90% taxes on large bonus payouts to individuals. AIG's ill-timed bonuses have outraged the entire nation and have led lawmakers to to use this blunt blow to root out bonuses in all sick companies supported by taxpayer money. But the move is a populist one, and one that may have far deeper consequences than recovering a few hundred million in bonus money. I am afraid there is a lot to lose with this last minute decision of making a law limiting bonuses. The taxpayer will actually end up loosing much more in the long run.

In many companies bonuses are given across the organization to all employees. A bonus for a good quarter, a bonus for Christmas, etc. But in knowledge-intensive fields bonuses are disproportionately distributed and given a small subset of employees who create exceptional (significantly over the average) value for the company. Knowledge-intensive fields include finance and banking where a talented person can create a lot more value than another lesser talented person. The distinction between employees is easily measurable in banks (earned profits) and therefore banks can easily reward better-performing employees. The reason for the reward is the hope is that a better performing employee can be retained in the company if she is paid a bonus.

A modern bank's success is almost wholly dependent on its employees. Banks are no longer armies of clerks following a rule book and doing the same thing every single day. Instead, banks are participating in a very sophisticated knowledge-based global game where bankers make decisions on how to invest their depositor's money. They employ some of the brightest minds to compete with other bright minds of other financial institutions, all of them trying to maximize returns on invested money. Quite naturally, the financial institution with the most creative, innovative, smart, and industrious people will take it all away.

Not all minds are equal. Hence all bankers cannot be paid the same income. Its a mind game, and intellect is not equal across the board in every employee (perhaps unfortunately, but certainly by natural design). Bankers are men and women like the rest of us. They will gravitate to financial institutions which pay better. By removing the bonus incentive for bright people in ailing financial institutions we are clearly reducing the chances of these institutions recovering taxpayer money as the brightest will leave or be less motivated.

Bonuses have been wrongly maligned in this whole saga. They are one of the best tools to improve worker productivity, commitment, and a company's bottom line.

Where is all that Wall Street money?

You've all heard the news - investment houses going bankrupt, being sold off to retail banks, large insurance companies being nationalized - all within the span of a couple of weeks. What amazes me the most is the sort of numbers floating around. A year ago the market capitalization of these busted companies was 100s of billions of dollars. They employed 10s of thousands of people, including ivy league-educated finance jocks and MBAs. Their stock prices seemed to go up, up and away - a complete endorsement of their magical money making ability. Then, ignominiously, they went broke.

Monetary circulation is a closed entity - dollars don't just float away into outer space. So I am thinking - where did all those loaned dollars go? To understand that, lets look at Mr. John Doe's 4-bed/3-bath home in suburban San Diego that was built ca. 2004 and bought by Mr. Doe at a hefty price via a loan. Say Mr. Doe has fallen behind on his payments in 2008, therefore adding to the toxicity of the CDOs - Collateralized Debt Obligations - that wrongly counted Mr. Doe's mortgage as AAA+ reliable. But all this happened in 2008. Where did the money go to in 2004?

The developer bought the land from the state. Therefore a part of the loan capital went to the state. The house itself was built using superior building materials (expensive house) and therefore, part of that capital flowed into the pockets of the building material company shareholders - the glass company, the wood company, the lighting company etc. A big part of the house price was profit for the builder/architect company and therefore, it went to these companies' shareholders. There was Latin American labor to built the house, and so some of the money went to Latin America via Western Union transfers. Some more must have flowed to China for building materials, or perhaps to Italy for the Italian marble.

Now the key point is that the value of the asset handed to Mr. Doe was supposed to rise as time went by, because this house was in the San Diego area, with the beautiful Southern California climate, the wonderful, peaceful, and happy society, the good public school in the neighborhood, and consequently the never ending demand for housing as people from all over the world came looking for a piece of this beautiful part of the world. In fact, Mr. Doe bought the house factoring all this into the future equation to pay back the hefty mortgage. In the worst case (he thought), he could just sell the house and pay back the mortgage, making a neat sum for himself. And until he sold, he could live a good life in the expensive home.

Unfortunately for Mr. Doe (and everyone else), the price of his house actually fell, and this voided the whole argument of the previous paragraph. Now if Mr. Doe's house goes into foreclosure, Mr. Doe's lending bank will only recover the reduced price of the house. The notional and fluffy value described in the previous paragraph could not be converted back into hard money when it was needed in 2008. Money has been lost, and this fact bubbles up to all those CDOs on Wall Street. Until the value of the asset -that house - rises again, there is no way to fix the problem.