What to do with Goldman's Bonus Billions
By Jeffrey N. Gordon, Alfred W. Bressler Professor of Law
In apparent affront to the spirit of Pay Czar austerity, strong profits and bonus pool set-asides at Goldman Sachs may well produce near-record compensation. The resulting outcry has drawn from two strong currents: first, concern about the perverse incentives of the “bonus culture” that fed the financial mania of the recent past; second, the cruel juxtaposition with darker economic news of near double-digit unemployment and the fall of supposedly “sticky” wages for the first time since the Depression. How should we think of Goldman Sachs’ profits and what the firm should do about them?
The bottom line here is: let Goldman pay its bonuses but insist that the payout be made almost entirely in restricted stock, not cash, because that’s the way to fortify the bank and the overall financial system against the foreseeable bumpiness as the government withdraws its credit market support. Obtaining a fair return to the taxpayers' implicit investment in the financial sector generally and in Goldman specifically is important, but the best form of such a return is in systemic risk reduction which can be achieved in this way.
Here is the argument. First, Goldman’s profits are not illegitimate, even though they are heightened by today’s unusual economic circumstances. One of the consequences of financial sector distress was to reduce the number of competitors in the fixed income and other financial markets where Goldman commonly has made its exceptional profits. Bear Stearns, gone; Lehman Brothers, gone; Merrill Lynch, gone. Morgan Stanley and the banks that took over the remains of the failed securities firms are pursuing different economic models. With fewer competitors, Goldman can charge customers higher fees and take advantage of wider spreads in trading markets. Its customers, by the way, are hardly powerless consumers hit up with astonishing “late charges” and overdraft fees.
There is no moral case that Goldman should give hedge funds, institutional investors, and other sophisticated counterparties a break against what the market will bear. This means that Goldman can earn Bubble-era profits with Sober-era risk. These profits, the proverbial $20 bill on the sidewalk, will draw new competitors, meaning new capital, into the financial sector. A key challenge for the regulators in the next period of financial sector recovery will be to constrain risk-taking to systemically-safe levels.
Second, the division of Goldman’s profits is appropriately handled by ordinary corporate governance including customary relations with bondholders. Goldman set aside 50 percent of its profits for the bonus pool, consistent with prior years. There is no evidence that Goldman’s management has overreached shareholders in making this decision, or that bondholders have any basis for objection in light of their covenants or other expectations. Nothing about the financial crisis means that this quarter’s profits should be specially dedicated to increasing dividends, nor to giving bondholders more than contracted-for interest payments.
Third, nevertheless, the government’s role in the financial crisis affects in crucial ways the appropriate form of bonus compensation if not necessarily the amount. Let’s understand who benefited from the bailout. The big winners were the shareholders of the financial firms and the bondholders and other creditors, not the employees (except insofar as they were shareholders). Unlike the shareholders of Lehman Brothers, the shareholders of Goldman are doing quite nicely now, thank you. Its stock currently trades around $180 a share, almost a four-fold increase over last fall’s $47 low and much better than $0. Goldman’s market capitalization is approximately $94 billion. In an important sense, that value comes as result of the government’s intervention.
The bondholders and other creditors also benefited hugely. Because of the government’s bailout, Goldman was able to avoid default on any of its credit obligations. The Lehman creditors were paid on average roughly 65 cents on the dollar, even after the government saved the financial sector. Before that intervention, the credit default swap market estimated the Lehman bondholders would get 8 cents on the dollar. Goldman’s balance sheet in August 2008 showed $1 trillion in liabilities, including $240 billion in unsecured borrowing. How much of that would have been lost without the government’s intercession?
The shareholders and the creditors faced those losses because their investments in Goldman were “sunk,” irrevocably made. A shareholder or bondholder could get out of its investment only upon a subsequent sale to someone else. Not so with the managers. Had Goldman failed, they would have gone onto the remaining financial firms (if any) and resumed their money making activity (assuming there was a functioning financial system). Their “human capital” was not entirely invested with Goldman. Many of the Bear Stearns and Lehman Brothers employees, for example, have done quite well with firms that have picked up the pieces. So thinking of the bailout from a firm-by-firm perspective, Goldman shareholders and creditors were the big winners and there is no particular reason that they now have some special entitlement to Goldman’s current profits.
This is obviously not the whole story. In a very real sense, Goldman’s profits are attributable to the government’s many actions, meaning taxpayer investment in the financial sector generally and in Goldman specifically. Goldman received and paid back its $10 billion in TARP money on contracted-for terms, to be sure. But it still benefits from prior FDIC guarantees of its post-crisis credit issuances, nearly $30 billion in total. Moreover, the Federal Reserve has supported the credit markets that Goldman so profitably trades in through an alphabet city of credit and liquidity support programs that have put $1.3 trillion on its balance sheet.
So the taxpayers are major implicit capital suppliers to Goldman. What should be the return on their investment? Should Goldman substitute for the FDIC in bailing out Citibank? Should we impose a special tax on banking profits? On “trading profits?” On “excess profits?” Such measures would be distortionary. They are not the “deal” the government usually strikes with profitable business enterprise and they would create uncertainty that would reduce the flow of new capital into the still under-capitalized financial sector. Moreover, the chance of adoption of such measures is not high. Large charitable contributions? A worthy use of some profits but not really a solution.
What can be done and what should be done is this: Goldman’s bonuses this year should be paid out almost entirely in stock subject to appropriately long restrictions on resale. Paying out bonus cash (like paying out dividends) subtracts capital from the firm. Paying out stock locks capital inside the firm. Imposing sale restrictions gives employees incentives for long term value-creation in the firm as a whole, a reason to blow the whistle on excessive risk-taking in any part of the firm. It also operates as a form of claw-back. Existing shareholders, who might complain that their returns are diminished by “too much” capital, have no standing as major beneficiaries of the government’s bailout. Current Goldman employees should appreciate the current political and economic environment, in which long term thinking is important.
In particular, Goldman’s turning its current profits into more capital is good for the financial system as a whole. Bonus payments of this sort create a “public good.” No one really knows about the next stages of financial recovery. As the Fed and the FDIC try to wean financial firms from their unprecedented financial support, the ride could well be bumpy. Goldman’s bulking up with capital makes it a pillar of strength, meaning in particular a more reliable counterparty and a more willing participant in choppy credit markets. This approach, which serves the public interest – which provides a systemic return on the taxpayers’ investment -- is the way to solve Goldman’s bonus conundrum.