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 Wall Street Gone Wild
By Mike Minter, CFP®
With Financial Reform most likely coming, it makes you think of what Wall Street will do next to game the system and feed their greed.
No, I’m not going to pile on Goldman Sachs. The probability that they were the only investment bank structuring shady deals like the one the SEC is accusing them of right now is unlikely. Actually, I was planning on writing about this subject before this news, but the recent issue is just another example of Wall Street at its best.
But I need to pay my $20 Million mortgage…
The huge bonuses investment banks continue to pay themselves are impressive. Are these guys priceless or what? Think about it. First, they take too much risk and blow themselves up. Next, the government comes in to bail them out with taxpayer money, and now the Federal Reserve has basically been lending them money at zero interest so they can get back on their feet.
So one might think that with all this assistance to keep them from going under, the investment banks would either wait a little while before paying big bonuses again or significantly lower the bonuses for the time being. But instead of trying to fly under the radar, they act as if almost nothing has happened. They use their free money from the Fed to trade on their proprietary desks, making huge profits again and reward themselves to ensure they can continue to afford the extravagant lifestyles they have grown accustomed to throughout the years. When asked about it, the most common argument I hear is these firms would lose their “talent” if they didn’t pay them.
Normally, you might think “well just how talented could they be”?
But let’s not be naïve. Most of the “talent” these companies are referring to are very sharp people. There is no denying that. On the other hand, it seems clear to me that financial instruments have gotten so complex combined with lax regulation and pay incentives that encourage risk taking, that these super smart people are out of their league and they themselves don’t fully understand what they’re doing.
For the financial crisis to happen, they either knew what they were doing and looked the other way because they were making so much money or they didn’t fully comprehend the risks associated with certain investments. My guess is it was mostly the latter but probably a combination of both.
When the “talent” doesn’t get it, things need to change. Unfortunately for Wall Street, some of these changes might cut into their profits and bonuses.
Stock Options are a beautiful thing… But for who?
What do companies do with their earnings? You might think they retain them and use the capital in the best way to move the company forward or pay out some dividends to reward shareholders. Well, this still happens today but it should be on a bigger scale.
Back in the 1990’s, Wall Street began accelerating a new way to benefit company executives with extra compensation (as long as the stock price went up) by creating stock options. Wall Street would justify the use of options by saying that they were an incentive for management to perform, a retention tool and a benefit to shareholders as they would be rewarded in the form of stock appreciation. This is all true and can be great for a shareholder of a company that is always going up in price, but how many of those do you own?
The problem with this incentive is how it was implemented. Executives would typically receive a grant of stock options each year at a certain time with an exercise price around the actual price of the stock. Here is the issue with this set up.
An executive can make a lot of money if his/her stock is volatile which may not be such a good thing for the shareholder. For example, in the beginning of 2008 an executive may get grants with the price of their stock high and then receive even more grants the next year (beginning of 2009) when the stock is low. Then if the share price rebounds, like most public companies did in 2009, the executive has the ability to lock in gains and make a whole lot of money on the cheap stock options while the shareholder can still have losses.
A lot of tech companies had these arrangements in the late 1990’s. As the tech boom was in full swing, corporate executives were making a boat load of money with their stock options but so were shareholders at the time unless they held their stock, which most did, and rode them all the way down in 2000-2002. Again, the results are the same. A lot of corporate executives made out like bandits but shareholders lost big and still haven’t recovered.
The other major concern is how shareholder ownership gets diluted when executives exercise their stock options. Once they exercise, there are more shares of the company in circulation. In other words, every shareholder is an owner of the company they invest in, once more shares are issued, you now own less. This compounds the problems for shareholders because companies don’t want them, especially the institutional shareholders, to see their ownership getting diluted. Instead of paying out more in dividends or retain the earnings, they buy back shares of the company to make it look like nothing has changed. Again, executives are getting rich while the company spends profits on share buybacks to cover it up.
Even worse, these corporations tend to buy back large amounts of stock when the price is high since this is when most stock options are being exercised and discontinue or diminish buybacks when the stock price is low and stock options are under water or worthless.
So how does this benefit Wall Street? Well, most of the big Wall Street firms are the ones who set up these stock option plans and they profit when the executives cash in these options. Then they send in the “suits” to impress the extremely wealthy executives and sell them so they keep their money with the firm. This way they can collect substantial fees off their enormous accounts.
It would make more sense in my opinion, if stock options had a high water mark for executives, where the exercise price for each grant was never lower than the previous high. But as it stands, accounting laws have changed and firms are moving away from this structure anyway. Eventually, enough people figure out Wall Street’s games and somehow it quietly goes away.
The best part of it all is that when Wall Street originally came up with the idea of stock option plans, companies did not have to account for them in their numbers. So if companies did not have to account for them and it was a no brainer for the corporate executives who make the decisions, why wouldn’t they do it?
Keep in mind, we have multiple executives that we work with who have benefitted from this structure and do not fault them at all. As a matter of fact, we want them to continue taking advantage of it while it lasts. Rewarding management for good performance is not the problem and makes a lot of sense. The issue is when the compensation is exorbitant, not justified and takes advantage of shareholders.
Last but not least, let’s not forget about Wall Street coming up with “Operating Earnings” which excludes so called “extraordinary” and “non-recurring” losses even if companies continue to have them. The result is earnings are overstated which in turn makes valuations more reasonable. So what is Wall Street’s incentive to get you to believe valuations are better than they truly are? Well, not many are willing to buy anything they consider overvalued. That being the case, all you have to do to find the answer is look at the correlation between a rising stock market and Wall Street’s profits.
Earnings Per Share
So now that another headwind is upon us (Financial Reform), Fed programs are ending and the stimulus only has a couple more months to go, we are even more cautious than before.
Paraphrasing Dave Rosenberg, who unlike the so called “experts” on television actually saw the risks back in 2008, the last time the S&P 500 broke 1200 was back in mid 2005 with a trailing EPS (operating earnings per share) at around $75. If we take the consensus estimate for Q1 ($18) and add the previous three quarters, the trailing EPS now is less than $65. Not only are earnings currently 20% below where they were in 2005 but the consensus sees operating EPS rising more in the next four quarters ($85) than was the case five years ago when the consensus had a forecast of $80.
This is significant since the current unemployment rate is double what it was in 2005, reform is upon us (health, financial & possibly energy) and housing foreclosures are still at record levels as another wave of Option Arm and Alt A mortgages adjust in an immense way over the next two years. No wonder the Fed vows to leave interest rates low for an extended period.
And the consensus, well maybe they forgot that government intervention and spending can’t last forever as they have 2011 EPS estimates at over $97 or more than 30% higher than where we are now.
Bottom Line…
I hope the cameras were rolling during “Wall Street Gone Wild” because this is actual sleaze we can learn from…
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