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01.17.10

Wall Street's Dirty Little Secret

The biggest problem with 2009’s megabonuses is economic, not moral. Tunku Varadarajan on how Wall Street made money soaking savers and taxpayers, rather than adding value.

Bankers do not deserve bonuses this year, at least not in the Western world. And I don't say this from atop some moral or aesthetic or populist high horse. Instead, my arguments are mostly economic.

Banks are making money because they're borrowing at ridiculously low rates from the public and central banks and then investing in higher-yielding government securities.

In my fantasy world, the entire bonus caboodle—every last cent—would go to the reconstruction of Haiti.

The banks receive deposits from savers (on which they pay negligible interest) and then leverage it several times by borrowing from other banks, or the central bank. LIBOR (the rate at which banks borrow from each other) as well as the Fed's discount window are below 0.5 percent. This is the cost of money to banks. The loot is then invested in government bonds, which are yielding anywhere from 3.75 percent to 4.75 percent in the U.S. and Europe.

This interest margin may not sound like much, but when applied to the trillions of dollars that make up various banks' balance sheets, it produces profits in tens, if not hundreds, of billions of dollars. For a well-leveraged bank, this is a safe "carry" trade as long as the value of government securities does not collapse. In fact, a bank would have to be incredibly inept not to make money in these circumstances. Awarding bankers bonuses is tantamount to paying them for not being certified cretins.

In my fantasy world, the entire bonus caboodle—every last cent—would go to the reconstruction of Haiti. A more realistic scenario would be for most of the money to go to the central banks and departments of treasury around the developed world that have done all of the heavy lifting. After all, the source of the banks' profitability is policymakers' actions, not bankers' skill or their managements' leadership.

The balance should go to savers. A forensic analysis of the banking system's trading books would show that it is the savers and the taxpayers who provided banks with the bulk of their profits last year. According to Bloomberg, personal savings rates in the U.S. have gone from negligible numbers to about 4 percent-6 percent in the past year. That is $500 billion to $700 billion of additional savings, a lot of which is sitting in low-interest bank accounts. M2 data suggests that in the last 12 months, the savings stock in the U.S. banking system has risen by about $700 billion. All of this money is then leveraged and invested in risk-free bonds issued by the Treasury.

We are now on the verge of President Obama's "Corporate Responsibility Fee." But an opportunity was missed in December when the U.K. Chancellor of the Exchequer Alistair Darling fired the first major bonus-tax salvo. He should have corralled his counterparts in the developed world to tax bank bonus pools at about 90 percent, instead of at the 50 percent he announced. A combined assault on bonuses would have greatly enfeebled bankers' resistance.

Such action would also have shown up as specious the argument that "if we do not pay, the talent will go away." If tax measures were implemented globally, where would the talent go? Some of it, perhaps, to hedge funds. That would be an appropriate, even elegant, solution, because the kinds of risks some of the bankers were taking are best suited for hedge funds. As for the rest of the bankers… they should just stay put and expect to get paid when they start adding value, not merely leeching from public policy.

Tunku Varadarajan is a national affairs correspondent and writer at large for The Daily Beast. He is also a research fellow at Stanford’s Hoover Institution and a professor at NYU’s Stern Business School. (Follow him on Twitter here.)