Bonus Season Dawns

This year's bonus pool

This year's bonus pool

QE powered markets have been motoring to new highs with all the abandon of teenage lovers. I've been promulgating the view for some time that markets are not pricing in the risk of a demand shock, of any scale, but it has had little resonance until recently. Yet a growing number of commentators are beginning to echo the thought and with a deal more intellectual weight. Upside from here is totally dependent on increasing economic confidence and momentum. Without demand that’s not going to coalesce. The pace of human worker replacement by machines is accelerating, the US consumer is still on the rack even before interest rates move, a reduction in Chinese GDP is self evident, Europe remains the mother of all time bombs and the UK is being flattered by selective house price moves and the auto manufacturing business in the West Midlands. There is an end to all this but a deflationary disruption in demand along the way will eventually rock equities. 

So why are stock markets doing so well? One answer might be from a client who said, “I think governments everywhere are strangling their economies with regulation & taxes. It’s easier to put your money into the stock market than it is to build a business or a house on land that you own so equity markets go up and the real economy stagnates.”

Indeed, how many people do you know from the City or elsewhere  who have retired to invest and or trade under their own steam rather than drag themselves out of bed at 5am in the morning? As we roll into bonus season for the banks another challenge is facing managers on trading floors. The near doubling and more of basic salaries in investment banks, rolled out 4-5 years ago to circumvent an expected clamp down on bonus’s after the crisis, has created other unintended but quite predictable consequences.

Unallocated and allocated costs have soared, (especially as other headcount like compliance has mushroomed). One head of a desk told me the “per head,” number to have a member of staff on his trading floor and I nearly fell over; it was more than twice the number we used when last I worked in a bank and even then my bank was at the top end of peer group. Despite this, most operations have been profitable. However, with structural change being imposed on the bond market by Dodd-Frank and the underwriting of markets by QE on the wane, there will be some tough decisions to make when the tide goes out.

Moreover, the CEO of another operation said to me, “Bonuses’ are not what they were and anyway, only a modest percentage is paid out in year 1. That though is stifling ambition because they feel they just have to turn up and do a good job to bank the pay cheque.” Even at Goldman they are ramping up basics even more in response to EU bonus caps. These are the business economics of the madhouse. It won’t end well and yet again the City is lining itself up for another great reckoning.


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Talking of madhouse business principles, in these days of volatility suppression I’m reminded of another bugbear from my days in a bank. Trading books often have to take provisions against their positions. These provisions will be calculated against a number of metrics, mainly volatility but will include average daily volumes in the name, the average bid/offer spread and so on, and they are usually reweighted weekly. Unsurprisingly, when a bad thing happens volatility spikes and after a big fall for example, traders can expect risk control to wander over and say, “don’t forget, your provisions will rise on Friday.” Similarly, after a prolonged period of flatlining volatility, as we see now, provisions will be released back to the trading books and from their perspective, they’ve recovered hard earned P/L and can now walk the floor looking windswept and interesting rather than gaunt and persecuted.  We see then, that after a bad thing the risk geeks decide that it would be sensible to take out an insurance policy in the form of provisioning but when we’re at all time highs with stretched valuations and low volatility they chuck the insurance policy in the bin.

Is that smart?

Barclays; Anyone See an Iceberg?

The hand wringing class warrior liberals, led by Rusty Cable and the Boy Clegg, joined by innumerable Tories who are torn by a deep seated sense of self need and corrosive envy of their contemporaries in the City cannot help but focus on "Bankers Bonuses."

As we have discussed here before, this is the wrong target for legislators and regulators to be aiming at. They need to be closely examining the origin of the "profits," on which the bonus payments are based. In fact, not much has changed since the crisis, which has thrown ordinary decent people into penury, and precious little has been done to stop a reoccurance of a bad thing happening. Some might say the system is even less robust now than before.

Not to worry though, I'm here to help them ask the right questions.

When I joined the City the compensation system was very simple. Everyone was paid a reasonable basic salary and in good years the bonus pool was distributed by partners. In bad years  the bonus pool was reduced or cut to zero. Typically, the partners went unpaid and perhaps, might have put something together to give the junior staff a modest lift. That culture is dead, gone and buried. Now, individuals are compensated come what may. Their inflated sense of self worth has long ceased to have any correlation to actual profitability.

Indeed, Barclays is a case in point. By their own internal measurements BarCap, (the investment bank), actually made a loss so why they are paying anything is something of a challenge for the enquiring mind. If though, you want one scary statistic to mull over then think about this. BarCap's Gross Notional Derivative Exposure is growing again, up 24% year on year to £48.8 trillion.................................

Our old friend and contributer, Bankvilgilante has been looking under the skirts of Barclays and is somewhat troubled:

"The Barclays stock price performance on results day, and YTD, reminds me of 2010. Surging upwards on rumours of "good" FY 2009 results and then well-crafted FY results that drag in momentum investors. And then a long slow slide as actual results for the year show up a far less rosy, less spun reality. This might well have applied to all Euro-banks in 2010 and is what may be occurring in 2011 for the sector again.

Barclays is not an attractive entity to own. Eighty (80%) of 2010 PBT was from BarCap, £4,780mn. And this is more or less normal situation at Barclays Group these days. Some very high loan losses from something called "Barclays Corporate" led to that unit showing a negative PBT of £631mn and possibly inflated the BarCap relative contribution to group profits, but not by much.

The "Corporate" loan losses came from what was once the Spanish unit inside what was once "Global Retail and Commercial Banking". It's not easy to keep up with the constant re-shuffling of operating units at Barclays, itself a bad sign from any company, especially a bank. What the heavy losses in that unit illustrate is that non-organic, non-BarCap growth at Barclays is very challenging and not such a priority anymore.  There were also losses in Western European Retail, falling Pre-Provision Profits in UK Retail (8% down), flat profits in Barclaycard (quite recently a major growth story) and in ABSA (a recent, expensive acquisition).

So Barlcays is BarCap, and BarCap is Barclays. Mysteriously BarCap has 80% of the PBT but only 35% of the "economic capital". This ratio doesn't seem right, but then the head of BarCap is now officially running the bank and all the best paid, best brained, people are in BarCap. Those BarCap guys effectively run the capital allocation and it is no surprise it massively favours them. Thus, BarCap is the growth pole inside the group as it shows the best return on economic capital, by far.

It's just that no one should want to own Barclays as BarCap's real, market-tested, economic capital would be 2x or more what it gets allocated internally, and the cost of that capital  (COE) would be above the group's own 12% COE calculation. BarCap returns would then be below the COE and,logically, it should shrink severely. Barclays itself showed an "economic loss" for 2010 of £2,488mn an increase from the 2009 "economic loss" of £1,890mn. The loss is calculated by deducting a capital charge at a 12.5% COE from net profits. More "losses" going forward would be a problem, surely, for the group. However, the new CEO, approved by the FD and the Board, is going to lower the COE to 11% in 2011 and 10% in 2012.

This should help.

I note that that old bugbear of mine, the Gross Notional Derivatives volume is growing again, up 24% YoY to £48.8tn (yes, trilliion). Obviously this is not a risk, according to banks, as the positive replacement values (the asset) are just £420bn  and the negative replacement values (the liability) a handy £15bn lower at £405bn. The accumulated, unrealised gain (sorry, positive balance) on derivatives, was up by £1.5bn in 2010. These derivatives are mostly interest-rate derivatives. The £420bn assets is subject to bilateral "counterparty netting" that reduces the net exposure to £80bn, and £37bn of collateral is held for the gap, leaving £43bn of "net exposure less collateral" according to Barclays. There are many risks in all this: the valuation of the gross notional derivatives to get the replacement values only a small minority of the contracts are traded on exchanges or even centrally-cleared; the quality of the counterparty netting, especially its legal enforceability across subsidiaries and jurisdictions in the event of a group-wide default; the quality of the collateral.

In my view, Barclays is operating in something of a fantasy-land, egged on by brokers at similarly structured investment banks and seemingly unconstrained by the regulators. However, market reality does eventually assert itself as all the investment banks compete hard with each other, driving returns down, leading to higher (largely hidden) gearing, and much volatility in results. They can't help themselves while they are able to arbitrage the benefits of sitting in (on?) a core Too-Big-To-Fail retail bank."

Icebergs Ahead?

Bankers Bonuses & January Detox

A friend, apparently with my best interests at heart and mindful of the increased stress levels associated with the January detox thing, kindly sent me a copy of "Falling Down," the Michael Douglas movie about a middle aged man who comes unglued with mounting frustration and anger at modern life. A kind, if not witty thought but given recent events the timing could be better. Maybe I need to get some new friends................. or come off the detox.

There is indeed though, and unfortunately, a simmering frustration and anger across the world which occasionally bursts out onto the streets or in individual meltdowns. Witness the recent food riot by Chinese students in Guizhou over a very modest rise in cafeteria charges, Algerian students rioting over food prices, Bangladeshis rioting over a quick stock market correction after a steep rise, student discontent in the UK and rioting in Greece over austerity measures last year are self evident. Were it not that we are in the middle of a deeply protest unfriendly winter I'm sure the levels of street violence would be considerably higher, both in the UK and abroad.

Guizhou Students Riot Over Cafeteria Price

Voters have much to be angry and frustrated about. Most work hard to provide for their families but are being asset stripped by a combination of growing inflation in the things they need, such as energy and food, whilst seeing deflation in their assets such as their houses, whilst carrying a higher and growing tax burden. Whilst they bear the consequences, most of those who were either at the political levers of power, or those steering the banks onto the rocks, or indeed those charged with regulating the system before and during the financial crisis are either still in place or have disappeared happily into the sunset.

Worst of all, the "had it all," generation who enjoyed years of growth, low inflation, house price growth, full employment and fully funded pensions, (having asset stripped the country at a national level), are now set to retire, put their feet up and leave it to the new workforce to provide the tax income to fund a growing and aging population. Oh, and just to remove any last morsel of incentive, "here's 50 grand's worth of debt to start you off with son." I won't dwell on student financing but it's a fair bet that no one has thought through the structural implications for the economy in 10-15 years time of the proposed loans. It's already created a massive imbalance in applications this year prior to the rise in fees but there will be an impact on the housing market in the future and on emigration rates. I'm not even going to go near the inequity of English taxpayers funding EU students to go to Scottish universities at rates which are far less than their own children can go to university either in England or Scotland.

There is creeping inflation in the system, we see that every day at the petrol pumps and at £6 a gallon of unleaded it's only a matter of time before there are mass protests in the UK. Food inflation is growing too. A combination of harsh winter conditions in North America, the Australian floods and the Russian export ban is sending wheat parabolic. Nothing gets people more angry, or on the streets more quickly, than when they are hungry. Watch this space. For the moment though, inflation in the UK is not running out of control, despite warnings from politicians that interest rates may have to rise. Inflation in the UK ex indirect taxes remains benign; it will change but not yet.

Of course, Westminster has been trying to direct and focus the wrath and indignation of the "people," at the City, but in an unfocused and indiscriminate way. "Billions of pounds," and "bankers bonuses," appear to be the battle cry but insofar as virtually no one in the City understands what they want, apart from money and no spotlight on they own tawdry affairs, the politicians don't appear to understand what they want either. If they do, they've certainly failed to articulate it but they have generated lots of fees for law firms and accountants to whom all the banks have fled to over the past two years in an attempt to get some clarity. Consequently, the governments attempt to increase the tax burden on the City has failed.

Odd though, no one ever mentions the accounting firms, law firms and regulators with regard to their part in the debacle, or indeed their compensation.

If Westminster took the time to educate themselves about the City, rather than turning up very occasionally for lunch and a campaign contribution, they might learn from past mistakes. To date, there is precious little evidence that they have done so.

Before the last meltdown, most investment bankers were compensated with a basic salary and annual discretionary bonus. The salary level rarely went above £100-120k although there were exceptions, notably one German owned former British merchant bank where salaries were a good deal higher. The bonus pool was then approved by the board contingent on the banks profitability for the year and then allocated by department and then by department heads to individuals. Most, but not all, firms paid a mix of cash and shares and some, including Lehman, had a claw-back if profitability in year 2 went into the red. This meant that when Bear and Lehman went down. thousands of staff collectively lost millions of pounds and much of their savings. The obvious aim was to enfranchise and align the staff with the company and enhance staff retention. On the flip side, it is hard coded in the DNA of investment bank staff to orientate themselves and fight hard for their bonus 365 days a year, both as departments jockeying against each other and as individuals.

So how are bonus's calculated? In short, bonuses should be paid for performance over and above what might be expected as a normal rate of return for the business. Bonuses shouldn't be, and normally aren't, paid for people just turning up. Patrick Hosking discussed this with a shrewd explanation in Saturday's Times and is worth a read, (unfortunately, it's behind a paywall).

I would however, make two points. The first is that such is the compensation culture in the City that as soon as Westminster started talking about bonus taxes then banks immediately started ramping basic salaries. Those salaries that I mentioned earlier are now in the order of £200-300k and in some cases up to £500k. Bonus's are still paid and it remains to be seen if the lower level of expected bonus's that staff were told to expect when these increases were announced transpire. Certainly, fixed costs have gone through the roof and without banking friendly central bank policies they would be unsustainable.  Most people in the City are, anyway, expecting a vicious round of redundancies this year. Nonetheless, the bottom line is that Westminster was out flanked before they even started the debate which they have now anyway lost.

The second and real issue for Westminster however, and specifically for the government, is that it is more important for them at a macro level to learn what the source of profitability in the banks is that creates the bonus pool, how much leverage is involved and what risk remains on the banks balance sheet, and for how long, after the revenue has been booked. These are much more important than how much a trader is paid. Also, and for what it's worth, it's common to blame everyone in banks for a meltdown which they certainly not responsible for as individuals. For example, many banks over leveraged themselves through decisions taken at board level and entered into structures created by corporate financiers that any floor trader would wisely never have touched. As I said earlier, most of those who are culpable got off scot free, yet the entire population must foot the bill not only for the UK but as a result of that supine fool Alistair Darling we must contribute to the PIIGS too; I'd have him in the stocks for a starter. (I still believe we should demand a national audit to find out exactly where and how the last administration managed to get through quite so much money but it will never happen).

Enquiring minds might like to know what happens to a City foot soldier if he comes under suspicion of illicit activity, and we're not talking major fraud here. Well, you can comfortably expect the front door to be banged on at 3am when you're safely tucked up in bed. Your home will then be filled with police and FSA guys clomping around scaring the children while they remove every bit of paper and anything with a chip in it, including the kids Playstation. You'll be arrested, your name released to the press in an all points bulletin and your assets will be frozen. On completion of a short exploratory interview you'll be sent home with a "we'll call you," farewell but won't be allowed to work. So, with no assets, no way of earning an income and with your reputation ruined you can then expect to wait for a year or more to be called back to be told if there is a case to answer. Fred and his fellow bandits got a couple of hours in front of a clueless select committee for blowing up the entire banking sector.

Anyone wishing to hear a pretty good debrief on the financial meltdown could do worse than watch this clip of Charles Ferguson, speaking at MIT which I found at Infectious Greed. It's as erudite an explanation as you'll find.

Where then does that then leave us? Well, the outlook for the summer is decidedly murky and more protests can be expected, both in the UK and overseas. They will come more quickly with warmer weather though, especially if there is no respite in fuel costs. The financial sector will plough on but there are significant economic headwinds ahead. Little has been done since the last meltdown to restructure both over the counter markets and regulators and rating agencies who previously abdicated their responsibility.  Meanwhile, banks accross Europe remain undercapitalised with assets on their books at prices way above market prices. The UK is being strangled by covert tax increases but government spending will be higher this year than last. Our young are being forced to shoulder huge debt to get an education (and face a future of falling living standards which will be lower then their parents and grandparents enjoyed), but without reform of the universities who are the beneficieries of the fees.

Wish I could be more optimistic but then, life is like that when you're on a January detox.