Why Wall Street had a record year and you didn't
The S&P had a measly return of 4.9 percent. Securities firms gave out a record $21.5 billion in year-end bonuses. That's fair.
NEW YORK (FORTUNE) - It was, as you may have already heard, a record year for Wall Street pay. Securities firms in New York gave out $21.5 billion in end-of-year bonuses, according to the state comptroller's office. That's $125,500 per employee (although of course the money wasn't distributed anywhere near evenly).
The last time things were this good for Wall Street's traders and bankers, at the end of the Internet boom in 2000, the rest of the country got to share in the fun. In 2005, by contrast, the S&P 500 had a total return of only 4.9 percent. Wage and salary growth for most Americans lagged inflation. So how is it that almost all of the big investment banks managed to have their best year ever?
One possibility is that Wall Street is a leech upon the body economic, sucking out the lifeblood of domestic industry and excreting it as Lamborghinis and $20 million Manhattan apartments for a lucky few. This is a theory with venerable populist roots, and it has undergone a renaissance lately among Americans angry about outsourcing.
But even if you sympathize with that view, there remains the question of how Wall Street firms are able to get away with such behavior. If the big investment banks are earning unwarranted profits, won't competitors arise? Won't customers demand a better deal? And won't shareholders demand that the firms stop paying out half their revenues as employee compensation?
First, the competition: It can be fierce in certain segments of the securities business. But the investment banks that can do huge, complicated deals for corporate clients are few, and while joining their ranks is possible (UBS and Citigroup have), it's a slow and expensive process open only to already giant financial institutions. The fees paid for investment banking services reflect this very limited competition.
And while banking revenues are highest when markets are booming, the current disconnect between rising profits and plodding stock prices has been driving CEOs to action. Whether they opt for an acquisition, a private-equity buyout, or a Tyco-style dismemberment, Wall Street gets paid. What's more, the big American investment banks are dominant overseas as well, and most non-U.S. markets had a pretty good year in 2005.
But fees for M&A and underwriting are actually no longer what drives the business. The big money now comes from "trading." That includes more than just the proprietary trading you often read about, says Guy Moszkowski, who follows bank and brokerage stocks for Merrill Lynch.
Much of the profit (just how much is not disclosed) is generated by traders executing tasks for clients -- making block trades, structuring derivatives contracts, buying currency for overseas deals, etc. Why is this so lucrative? It's partly a fair reward for taking risks, partly a byproduct of the knowledge the big firms accrue by being at the center of everything that goes on in global financial markets. They're profiting from their customers' comparative lack of knowledge. How long will customers put up with it? As long as they lack knowledge, one presumes.
Finally, there are those bonuses. Yeah, they seem absurd. They're certain to come crashing to earth. At least, that's what FORTUNE predicted in a cover story in 1986--when the average bonus was $13,950. We're not going to make that mistake again.