One out of ten American workers remain unemployed. Millions have been evicted from their homes. Tensions erupt in state capitals over budget deficits and threats to terminate thousands of school teachers and other public employees. We all suffer a record federal budget deficit. The real economy suffers a brain drain. Major American financial institutions on the precipice of collapse.
What’s the common denominator? Excessive pay on Wall Street.
Union-busting governors dwell on the pay of public sector workers as the root of current state budget problems, but this canard distracts from a real pay problem.
In the last quarter century, pay on Wall Street has escalated. In 1985, with merger activity swelling, the bonuses pool for the New York City securities industry employees amounted to $1.9 billion. A decade later, this figure tripled to $6.2 billion. Only five years later, in 2000, the bonus pool for New York City-based securities industry workers tripled again to $19 billion. Even after the financial meltdown, compensation remains obscene. The New York Comptroller’s office just released its annual report, and it shows that average compensation rose 6 percent for New York City’s Wall Street workers. In 2009, the 25 best paid hedge fund managers earned a collective $26 billion, an average of $1 billion each. David Tepper took in $4 billion, while George Soros made $3.3 billion that year.
Inevitably, these sums attract many of the brightest; the cream of the Ivy League and other top schools apply for work at JP Morgan and Goldman Sachs. Recruiters estimate that an oil trader on Wall Street with ten years experience is likely to earn at least $1 million a year, while a neurosurgeon with similar years on the job makes less than $600,000, according to a survey by the Stern School of Business. An actual petroleum engineer makes $126,000, according to the Bureau of Labor Statistics. How does a Princeton graduate even consider repaying debt from a $200,000 undergraduate degree on a $30,000-a-year teacher’s salary. A Princeton graduate must have a mighty big heart to turn down the golden sums at Goldman Sachs and instead repay $200,000 in undergraduate debt on a public school salary of $40,000.
At the top, the Goldman Sachs CEO Lloyd Blankfein made $17 million during an awful 2009. Meanwhile, the GM CEO was criticized for a mere $9 million pay package.
It’s not simply the suave economics, English, or history majors that nest in Wall Street, schmoozing for deals. It’s the math majors and engineering students. Emanuel Derman left his quest for a Nobel Prize in physics to work 17 years at Goldman Sachs. (He’s since returned to Columbia, but as a finance professor and consults for Prisma Capital Partners.) MIT breeds so called quants for Wall Street. In 1987, 100 percent of the graduating class of Harvard Business School applied to Goldman Sachs.
Once at Goldman Sachs and JP Morgan, these brightest must render banking into an ever more remunerative enterprise. In the 1980s, it was through merger activity, where they extracted enormous fees under the conceit of large numbers; namely that their fees were a small percent of the overall transaction. In 1985, with more than $200 billion worth of transactions, the largest investment banks earned more than $200 million each. Of note, more than half of these deals proved to be failures, with the subsequent stock value ultimately declining. A New York University study of 100 large corporate mergers during the mid-1990s showed that two-thirds triggered negative market reaction and were still underperforming a year later. A KPMG report showed that only 17 percent of mergers it studied added value and more than 50 percent actually destroyed value.
In the 1990s and since then, Wall Street’s brightest devised another counterproductive tool. Since only the real economy produces actual value, products or services that truly sustains us, such as food, clothing, shelter, heat, water, etc., the financial services industry must find ways to extract fees from this real economy. So they addicted us to easy credit so as to attract high interest charges and fees. Check your credit card statement. Since a home is the largest purchase an American makes, the bonus-hungry best and brightest devised a way to increase this market.
Ignoring inherent danger, fee-hungry mortgage bankers convinced many to purchase homes they couldn’t afford, or pay higher interest rates than the ones for which they qualified. In 2000, subprime lending, or lending at high interest rates to borrowers with substandard credit profiles, accounted for 9.5 percent of new mortgages. By 2005, this swelled to more than 20 percent, according to the Federal Crisis Inquiry Commission.
This proved a bonanza for Wall Street. Not only did mortgage origination fees swell bank coffers, but securitization of those loans generated more fees. And this translated into bonuses for bankers. What of the inevitable credit risk from default on these loans? The brightest developed what they assured us were risk-deflecting instruments, namely exotic instruments called credit default swaps and collateralized debt obligations. Wall Street sold them to each other, to teacher pension funds, to Iceland, to funds in developing African countries. More fees, more bonuses. In 2006, bonuses paid to New York City securities firm workers alone surmounted $34 billion. The average bonus was $191,000, according to the New York State Comptroller’s office, a calculation that figures the clerks with the credit default swaps traders.
From 1973 to 1985, Simon Johnson points out that the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Similarly, Paul Krugman observes that the financial sector doubled from 4 to 8 percent of GDP between the 1960s and the present.
But, in fact, the homes and high interest rates we couldn’t truly afford eventually meant we owed the banks money we couldn’t pay. When sufficient mortgage payments didn’t arrive in the system, and regulators allowed the vulnerable Lehman Brothers Holding to fail, that bankruptcy demonstrated that those bonus-inspired exotic instruments had actually infected the entire American and world economies. Lehman’s failure caused the Reserve Primary money market fund to pay 97 cents to the customers who had put in $1 for what they thought was a checking account. This led to a run on money market funds and convulsion in commercial paper, freezing the market for short term credit. Now, the real American economy suffered seizure, as if the collective credit cards of all companies were no longer accepted.
Treasury Secretary Henry Paulson and other financial leaders realized they couldn’t let another Lehman fail. So they asked Congress for $700 billion in TARP funds to prop up the likes of AIG, Bank of America, and Citicorp. The web of finance that these over-bonused best and brightest spun also meant we needed to bail out General Electric, because it, too, learned it could make more money from finance than from light bulbs.
Meanwhile, Americans who were struggling to make those mortgage payments cut other spending. Since the real economy turns on consumer spending, the economy producing those actual goods and services shrank. This led to unemployment, and even less consumer spending, and more unemployment. To break what former Federal Reserve Chairman Paul Volcker called a self-feeding spiral, the federal government approved a stimulus package, funding shovel-ready projects. The cost, however, has been spiraling federal deficits.
TARP funds, on the surface, were supposed to help banks buttress their capital so they could return to their primary job of lending to business and build the real economy. But what business needed a loan to grow if it was selling less? And what bank would actually make speculative loans when their regulators might shut them down because of escalating loan delinquencies.
With skyrocketing unemployment, state and local government faced twin problems: less revenue, since income and property taxes are major sources of revenue; and greater demand for services, since the unemployed now qualify for Medicaid and suffer more illness, crime increases requiring greater police protection, etc.
In Wisconsin, lawmakers have struggled with a two-year budget deficit of $3.6 billion. Republican Gov. Scott Walker, whose campaign enjoys funding from the financial sector, has proposed to savage the pay of public sector workers struggling to meet the escalating needs of Wisconsin residents suffering a recession brought on by those same Wall Street bankers. [Wall Street attacks organized labor routinely. Three days after receiving $25 billion in federal bailout funds, Bank of America Corp. hosted a conference call with conservative activists and business officials to organize opposition to the U.S. labor community's top legislative priority. Participants on the October 17, 2008 call -- including at least one representative from another bailout recipient, AIG -- were urged to persuade their clients to send "large contributions" to groups working against the Employee Free Choice Act (EFCA), as well as to vulnerable Senate Republicans, who could help block passage of the bill.] But consider the $20 billion in bonuses paid to financial executives in the city of New York in 2010. In other words, for a 15% cut in bonuses from financial executives in one city, the entire Wisconsin state budget problem would be resolved. Dream on.
Congress approved the Dodd-Frank Wall Street Reform Act which directs regulators to decouple Wall Street pay from risk-generating practices. Regulators must now write, implement and enforce strong new rules. But Congress must also turn to the larger problem that obscene pay in the financial sector corrodes the real economy.
Bartlett Naylor is the financial policy advocate for Public Citizen’s Congress Watch.