Large Wall Street banks are starting to scale back compensation on trading desks as shareholders grow increasingly restless over weak returns.
Goldman Sachs, Morgan Stanley and some other large U.S. investment banks are not just laying off weak performers and back-office employees. They are also cutting the pay of those they are keeping, scrutinizing expense reports and expecting even the most profitable workers to bring in more business for the same amount of compensation.
"Put simply, in order to get your $1 million bonus before, you had to generate X amount of revenue; now it's X plus 50 percent," said Mark Poerio, a partner at law firm Paul, Hastings, Janofsky & Walker who advises banks on pay.
Wall Street has been overhauling pay practices over the past 2-1/2 years to better align incentives with risk. Banks have lifted base salaries, deferred bonus payments and introduced clawback provisions to protect against trades and deals that seem profitable at first, but may later go awry.
Wall Street pay reached new heights in 2009 and early 2010, in tandem with rising markets, but now the game appears to be changing. With the securities industry entering its fifth consecutive quarter of stagnant trading income — and expecting more difficulty once regulatory reforms take effect — banks are bolstering profits by restraining costs.
Bernstein Research analyst Brad Hintz said the big players must slash pay levels of managing directors by 20 percent to 25 percent, automate more trading and cut jobs.
On Thursday, Hintz slashed his 2011 earnings estimates for Goldman and Morgan Stanley, saying damage from low trading volumes would probably far outweigh cost-cutting.
James Freeman, founder and CEO of advisory firm Freeman & Co, believes that if trading activity remains as weak as it is now, overall compensation could drop 15 percent to 20 percent at large trading houses.
Only the strongest traders will survive, he said. "It's not a pretty picture. It's just, 'Eat what you kill."'
Wielding the Ax
While compensation is Wall Street's biggest cost, it's also the most difficult to reduce. Banks have been tightening staffing throughout the downturn, and they are reluctant to trim the pay of their top stars for fear they will leave for less-frugal competitors.
"Our clients have become more efficient over the years, and efficient clients do more with less headcount," said Deloitte Consulting principal Robert Dicks, who works with large banks.
"For top 50 percent performers, I haven't seen a real change in salaries. If I were in the bottom half, that's where we've seen a real change both in job security and in compensation."
One key difference from five years ago: A diminished focus on all but the biggest, most profitable clients, and fewer jobs available for traders who do not handle such accounts.
Pay and benefits represented 44 percent of Goldman's revenue during the first quarter, up from a year earlier and on par with 2007, before the crisis struck. At Morgan Stanley, compensation rose to 57 percent of revenue from 49 percent a year earlier, partly because of big losses in a trading joint venture with Mitsubishi UFJ Financial.
Meanwhile, return on equity, a key measure of shareholder profitability, has fallen sharply.
Goldman's annualized ROE has ranged from 7.9 percent to 12.2 percent since the second quarter of 2010, down from more than 30 percent in the company's boom years. Morgan Stanley's ROE has been more erratic because of movements in credit spreads, the sale of businesses, a tax gain and Mitsubishi losses. It stood at 6.2 percent last quarter, down from 17.1 percent a year earlier and 8.5 percent for all of 2010.
At $430,700 per employee, on average, Goldman has one of the highest salaries on Wall Street. At Morgan Stanley, the average is $256,596.
Some shareholders have gotten impatient.
While bank shares have historically traded at multiples of book value, Goldman stock was at a premium of just 4.3 percent at Thursday's close, while Morgan Stanley was at a 21.7 percent discount.
Carret Asset Management, which has $1.4 billion in assets under management, recently took a small position in Goldman, but remains cautious.
"I thought Goldman at $130 was worth a look," said portfolio manager Jack Kaplan. "But there are risks involved. They're vulnerable to the trading environment — they're not making what they used to — and the compensation structure is a cost burden."
Goldman and Morgan Stanley have been scrutinizing expenses in recent months. Goldman plans to lay off hundreds of U.S. employees this year and cut noncompensation expenses by $1 billion by mid-2012. Traditionally, the bank has kept a tight lid on travel and technology costs during tough times.
Morgan Stanley has cut weak performers in its wealth-management business and is using penny-pinching tactics to slash costs further. It has begun spelling out the cost of market data services, BlackBerry use, travel and other running expenses to employees, encouraging them to cut back.
"Numerous smaller opportunities ... collectively can be meaningful, given that we're a firm of 60,000 people," Chief Financial Officer Ruth Porat said at a conference last month.
The austerity measures seem to be having an effect on some traders, who have become more cautious in recent months.
"It's tense — everyone is constantly looking over their shoulder," said one former fixed income trader at a large Wall Street firm who recently moved into a risk-management role. "I'm not expensing lunch, and I'm taking the subway home."
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