Wall Street Bonuses and the Bailout: A Brief Explanation

If it makes anyone feel better, the executives at Lehman Brothers received no bonuses.  Same with IndyMac Bancorp officers.  And the same with Bank of Honolulu, Meridian Bank, Security Pacific Bank and about 150 other banks.  None of the officers of those banks received any bonuses because the government let those banks fail and paid off the depositors.  When the government steps in to provide capital to a bank to keep the entire bank operation out of bankruptcy so the bank can honor its obligations, all of the bank’s obligations to creditors will be honored, including a major class of creditors — the employees.  

How is it that a bank that loses billions of dollars and is unprofitable can award bonuses?  What are those bonuses based on?  In many cases, the bonuses are based on past performance, or a formula that might measure performance quarterly and average it at the end of the year.  Thus, good performance in the first two quarters of 2008 and negative performance in the final two quarters of 2008 might still result in a hefty bonus depending on how the formula is calculated.  Usually, anything below zero is just zero, and anything above zero is the number above zero.  This encourages risk-taking, and many banks want some entrepreneurial zeal in their employees to take risks.  Many traders actually made money for their banks over the course of the year, even though the bank as a whole last money because the losses in the home mortgage portfolio swamped the profits in the other lines of business.  

Accordingly, if the federal government is going to prop up banks to keep them out of bankruptcy, all of the creditors will have their contracts honored, and that includes employees with claims to big mortgages.  Even though the government is providing capital, the government cannot void contracts of which it does not approve, and neither can the bank.  The only leverage the government has when providing capital is before it provides the capital.  The government could have done “due diligence” to find the possible claims on the bank’s capital, and the government could have negotiated prior to providing capital to have those claimants waive or modify their claims voluntarily.  The leverage the government would have had at that time is that the claimants would have been facing getting nothing if the government let those banks go into bankruptcy.  Alas, there was not time for such negotiations in the heat of the credit crisis, and so the banks were supported, and the claimants kind of got a free ride on the hysteria of the moment.  Maybe the government will move more slowly next time and figure things out; but in a crisis decisions get made quickly and one cleans up the mess afterwards.