Bailouts, Bonuses, and Barack

Who lived here?
He must have been a gardener that cared a lot
Who weeded out the tears and grew a good crop
And we are so amazed, we're crippled and we're dazed
A gardener like that one, no one can replace
-Elton John

The first day of my game theory class in undergraduate school, the professor asked everyone in the room to write down on a piece of paper either an "X" or a "Y" and hand it in. If everyone wrote down an "X," then he would give all registered students an "A" in the class and dismiss us for the semester. If, however, only one person penned a "Y," then that person would receive an "A+" and be dismissed for the semester, but all other students would have to complete the semester as scheduled.

The result was that fifteen of thirty students submitted a "Y," and we all had to complete the regular coursework. The professor obviously was confident he would not have to explain why any student (or certainly the entire class) would be given a high grade without completing the coursework. His confidence was rooted in human nature and the desire for all successful students to strive for the best possible result even perhaps with great disregard for his fellow student.

So it goes in competitive classrooms, same as it goes in the business world.

As a new and significant investor in the financial community, the U.S. government will exert its influence over their management, just as any other investor might. So, when President Barack Obama stated last week in an exchange with reporters that "There will be a time for them to make profits, and there will be a time for them to get bonuses - now is not that time," Wall Street took notice.

Putting aside for a moment the ridiculous idea that a corporation would shun profits, let's look at the question of bonuses in a silo.

Taking a look at the balance sheet of any financial company, it is difficult to find the true value-drivers. The most important assets of any service-oriented business goes down the elevators and leaves the building each evening - its people. Without the brains and brawn of those individuals who have specialty knowledge, a bank's balance sheet would quickly wilt and leave only a "For Lease" sign in front of the building.

In the go-go years of the eighties, much of Wall Street experienced outsized bonuses, and they got used to them. There was a culture shift among the newly minted investment bankers and other financial professionals who came to expect huge bonuses year after year. In order to satisfy this desire and at the same time keep compensation costs under control, employers began to temper salaries in exchange for an understanding that year-end payouts would be larger. The word "bonus" changed meaning from a payment in addition to what is expected to simply being expected.

Indeed, Bank of America announced over the weekend that bonuses in excess of $50,000 will be paid over the next three years, while at the same time announcing 35,000 layoffs. For better or worse and regardless of how we got here, employees, particularly in the financial community, view "bonus" payments as part of their regular pay package.

In addition, this morning Bloomberg reported that UBS hired more than 200 brokers in the fourth quarter by offering huge signing bonuses. Reportedly, these bonuses were in the range of 100 to 260 percent of the brokers' prior 12 months worth of revenue. How well will bailed out Wall Street firms perform without their top earning employees?

Certainly, no sane financial professional expects enormous bonus payouts this year. In fact, according to the New York state comptroller's office, total Wall Street bonuses paid fell 44 percent in 2008 from 2007.

But they didn't drop to zero. If "expected pay" misses the mark by a wide margin, many talented financial professionals will be glad to step across the street and work for a competitor. There is little regard for the "collective good" in our society, nor will there be - at least not at the individual level.

Cutting bonuses to zero and striving for something other than profits is a sure-fire way to drive your greatest asset out the door one evening with no intention of returning at the opening bell. Don't we have enough real estate up for sale already?

Key Developments

Existing home sales bounced in December, rising from a 4.5 million annual pace in November to 4.7 million. During most of 2008, home sales remained steady around a 4.5 million pace, similar to the last economic downturn earlier this decade. Given that downturn was not plagued by a nonfunctioning mortgage market, one could actually rate the housing market's activity in 2008 as positive. However, given recent massive job losses and coming additional layoffs, it will be very difficult for the housing sector to continue treading water at this pace in early 2009.

The advance estimate for fourth quarter's Gross Domestic Product growth brought positive feelings at the headline number of -3.8 percent, which was much lower than economists' average estimate of -5.5 percent. However, diving deeper into the data we find inventory accumulation contributed $35.8 billion in positive GDP for the quarter. Given today's foggy economic outlook, it is unlikely this inventory build was on purpose and quite likely it portends significant inventory drawdowns in the first quarter as businesses cut their investments.

The economic stimulus packaged moved closer to reality even though House republicans voted unanimously against the bill. In its current form, we expect the bill to provide some short-term strength to the economy, although this shot of adrenaline will only create a temporary boost in activity as the government has many longer term problems that need to be addressed.