How Wall Street calculates those big bonuses

/ Source: The Associated Press

Wall Street has long operated by one simple pay rule: To the victor go the spoils. If a firm does well, its people do well, getting splashy annual bonuses sometime in December or January.

Checks go to everyone from the CEO to the 21-year-old junior analyst straight from college. In good years, the money can be eye-popping, the subject of wide speculation and envy.

This, however, isn't a good year.

It's been a year of panic on Wall Street, as banks' stocks and profits plunged. Only two large investment banks — Goldman Sachs Group Inc. and Morgan Stanley — are left standing, after Bear Stearns Cos. and Merrill Lynch & Co. were bought by competitors and Lehman Brothers Holdings Inc. filed for bankruptcy.

Goldman announced Sunday that its seven top executives won't get bonuses for 2008, a sharp switch from 2007, when Goldman's CEO alone had total pay of $54 million.

With sums so huge, you may wonder how those bonuses are calculated and who decides who gets what. Here are some questions and answers.

Q: How much money do Wall Street firms devote to pay?

A: Compensation has long been the largest expense on Wall Street. Nothing even comes close.

For instance, in 2007, 44 percent of Goldman's revenues were devoted to paying its employees, with roughly 30,000 people splitting a total compensation pool of more than $20 billion, for an average of $575,000 each.

Goldman's compensation total was nearly twice its fiscal 2007 profit of $11.6 billion.

Of course, not everyone took home a half-million. CEO Lloyd Blankfein's $54 million payday and comparable amounts paid to other top executives left less for midlevel managers. Still, Goldman made plenty of workers millionaires last year — some earned far more than that $575,000, while some earned much less.

It's likely to do the same, very quietly, this year, as it strives to keep its top performers.

Q: Why are bonuses so large?

A: Base pay on Wall Street is a modest portion of total pay, with senior executives earning salaries from $250,000 to $450,000 — an amount that can more than quadruple during a good year, when bonuses are high.

The argument for rich pay on Wall Street is that investment banks are, in some respects, like law firms: They're only as good as their teams. Because employees are the firms' greatest asset, their pay is the firms' largest expense.

Investment banks make money through "relationship business," like representing companies in negotiations to buy other companies and arranging loans for those deals.

They also charge fees for a wide swath of services: Companies pay the banks fees when they go public, issue additional stock or take on debt. Hedge funds pay fees when they trade stock, debt or other securities and wealthy investors pay fees for money management.

In addition, the banks make their own investments; in good years, they lead to profits from their stock and bond trading teams, and in bad years lead to losses.

Banks argue that if they didn't pay so well, their brightest employees would flee for other financial jobs at private equity firms or at hedge funds, which command hefty money-management fees from their clients.

The counter-argument is that Wall Street workers are overpaid, with the emphasis on pay encouraging firms to take foolish risks with investors' money.

"Wall Street is usually described as an industry, but it shares precious few characteristics with the metal-fasteners business or the auto-parts trade," respected financial commentator James Grant wrote in The Wall Street Journal in July.

"The big brokerage firms are not in business so much to make a product or even to earn a competitive return for their stockholders. Rather, they open their doors to pay their employees — specifically, to maximize employee compensation in the short run. How best to do that? Why, to bear more risk by taking on more leverage."

Q: How do firms figure out who gets what bonuses?

A: Banks establish a companywide bonus pool, which is usually some percentage of revenue and profit, said David Wise, a compensation consultant with Hay Group.

Different groups within the bank then get a portion of that pool, based on their contribution to profitability over the course of the year. So, if a team of bond traders added millions to the firm's profit, their bonus pool would be greater than, say, a money-losing team of mortgage traders.

Back-office teams that don't generate any revenue are also included, such as technology, compliance and human resources.

Once the overall pool has been split by group, individuals get their allocation based on their managers' assessments of their performance.

There isn't usually a formula, Wise said. "There tends not to be a lot of formality at any point in the bonus-setting process, but most people will tell you it is a very performance-driven environment and bonuses are allocated based on merit."

Q: How do you arrive at a bonus for someone whose work doesn't directly affect profits?

A: "At the banks, people are working with each other very closely within the same group," Wise said. "Managers have a pretty good read on an individual's contribution to the group's performance. Are there hard measures and metrics? No, there's not. That is different than what we see in other industries."