Where the Payoffs Are Big, So Are the Paychecks By Steven Pearlstein Friday, July 17, 2009 http://www.washingtonpost.com/wp-dyn/content/article/2009/07/16/AR2009071604161.html The rest of the country may be stuck in a nasty recession, but on Wall Street, where it all began, business is booming. This week, Goldman Sachs reported a record profit for the latest quarter while J.P. Morgan Chase weighed in with record revenue, and other banks are set to exceed expectations. Compensation levels in some areas are returning to 2007 levels, and firms are once again offering big salaries and guaranteed bonuses to lure away top traders and investment bankers. Good news or bad? Certainly we're all better off now that some banks are healthy enough to remove themselves from government life support and pay back the Treasury loans. And if well-run banks can again earn an honest profit by taking smart risks and restoring the flow of capital into the markets -- well, that's what capitalism is all about. Then again, it seems outrageous that the geniuses whose excessive risk-taking brought on the crisis, and who had to be bailed out by the rest of us, are the first to recover and could soon be earning what they did before. It's the pay, of course, that gets everyone up in arms. Most firms are already revamping their compensation strategies to require that bonuses be earned over the long run. However effective this restructuring proves to be at dampening excessive risk-taking, it probably won't reduce overall pay, which explains why Wall Street has been so quick to embrace it. The real problem with Wall Street pay is that these firms simply make too much money relative to the economic value they create. If other industries were to enjoy such excessive profits, these would be eroded fairly quickly by competition as firms sought to increase market share by cutting prices. But in many segments of the financial services industry -- investment banking being the best example -- a natural oligopoly has developed in which a relatively small number of blue-chip firms dominate the market. These firms compete fiercely against one another in every way except price, which allows them to earn those extraordinary profits. There are several reasons for this less-than-perfect competition. The most obvious is that, in this market, the relative reputation of the firm matters a whole lot more than price. If your company is floating a $10 billion bond issue, having a dependable lead underwriter sends a signal to most investors that you are a borrower who can be trusted, and so it's worth paying an extra $10 million to get Goldman Sachs to do it. Or if your company is trying to fend off a hostile takeover by General Electric, you probably are willing to pay a premium to get Bruce Wasserstein as your investment banker. There may well be banks or bankers just as smart and capable as Goldman and Wasserstein who would do the job for less. But getting it wrong could prove very costly. This is also an industry in which size and scope matter a lot, meaning that the largest players have a big advantage. At Goldman Sachs and J.P. Morgan, for example, much of last quarter's profits were made by trading desks that bought and sold huge quantities of stocks, bonds, commodities, derivatives and other securities for their customers, as well as for their own accounts. Because so many trades pass through their hands, these large trading desks have the best real-time information about where markets are heading than anyone in the world, and they use that information to great competitive advantage -- not only earning a little more than everyone else on each trade, but learning when to get into and out of markets. Being big and having a good reputation don't guarantee success on Wall Street-- just ask Lehman Brothers, Bear Stearns and Merrill Lynch -- but they surely help. That's why a Wal-Mart hasn't emerged and crashed the Wall Street party by offering lower prices. In fact, what new entrants there are tend to be boutique firms started by industry superstars who trumpet their superior skills by charging more than the industry norm. There is one other reason for Wall Street's extraordinary profits -- the safety net provided by the federal government. Most firms would have to pay a considerable amount of money to ensure a reliable source of liquidity in the midst of a financial crisis. But as a practical reality, big banks and financial houses have always gotten their liquidity backstop at a huge discount, courtesy of the U.S. taxpayer. Just because an industry earns outsize profits, of course, doesn't mean that those profits will necessarily go to employees in the form of outsize compensation. But that is often the case. That's what happened in the auto and steel industries in the 1960s, when unions successfully captured most of those industries' profits. It also happened at nonunion companies such as IBM and Microsoft, in the form of stock options and above-average pay. On Wall Street, much of the surplus is captured by superstar bankers and traders who generate a disproportionate share of those outsize profits, just as superstar actors have done in the movie business or superstar athletes in professional sports. And because these superstars work side by side with colleagues with similar skills doing similar work, firms tend to offer higher-than-market pay to everyone else to assure a modicum of workplace harmony. For a brief moment, the financial crisis interrupted this compensation arms race as profits dried up. But now that profits are returning, there is no reason to believe that the inflated pay packages won't be far behind. Because the government's pay caps apply only to the firms that have been unable to pay back their loans from the Treasury, the effect of these rules won't be to reduce pay levels at Goldman Sachs or J.P. Morgan, but to weaken the weakest firms even further as their top talent is lured away. In truth, the best way to restrain Wall Street pay is to restrain Wall Street's profits, either by increasing taxes, reducing leverage or inducing more robust competition. Trying to cap industry pay is like trying to cap a volcano. Steven Pearlstein can be reached at pearlsteins@washpost.com.