Thursday, December 10, 2009

For Every Action ...

[This post originally appeared at The Epicurean Dealmaker on December 10, 2009. It is reproduced here in its entirety.]

Christopher Columbus: "Hello there, hello there. Heh, heh. Ahh ... We white men. Other side of ocean. My name ... Chris-to-pher Co-lum-bus."
Indian chief: "Oh? You over here on a Fulbright?"
Christopher Columbus: "Hah? Uh, no, no. I'm over here on an Isabella, as a matter of fact. Which reminds me: I wanna take a few of you guys back with me in the boat to prove I discovered you."
Indian chief: "What you mean, discover us? We discover you."
Christopher Columbus: "You discovered us?"
Indian chief: "Certainly. We discover you on beach here. Is all how you look at it."
Christopher Columbus: "Ah, I never thought of that."

— "Columbus Discovers America," Stan Freberg Presents the United States of America, Vol. 1: The Early Years

It looks like Alistair Darling is going to have a quiet Christmas.

The UK finance minister unveiled a nasty Christmas surprise for bankers in the City yesterday: a 50%, non-deductible tax on discretionary bonuses in excess of £25,000 (or $41,000), to be levied against their employers' net income. This scurrilous government attack against chalk stripe suits, Soho strip clubs, and London property values landed with a sickening thud in Old Blighty. Many a banker's wife summarily cancelled their holiday plans and started contacting real estate agents in Geneva.

Today, Nicolas Sarkozy of France had the unmitigated gall (Unmitigated Gaul?) to pile on with a parallel policy proposal for his country's budget and an editorial in The Wall Street Journal, co-authored with famously dyspeptic Scot Gordon Brown. The fact that France agrees with the UK and is proposing a similar policy is proof positive that either La Republique has been secretly taken over by a stunted Englishman pretending to be French or the UK's Labour government is so desperate to retain power that it's turning Gaullist. Probably both.

In any event, the policy—as do all new tax policies at the end of the day—has triggered a desperate surge of scurrying about by bankers and banks, as they attempt to discover ways out of the trap. Their prospects do not look good.

London contacts report senior investment bankers stacked three deep on the pavement outside advisory boutiques' offices this morning, banging on the custom paneled mahogany doors to get entrance for interviews. One Vice President remarked he hadn't seen that many bespoke suits in one place since he stumbled into Gieves and Hawkes' basement storeroom on Saville Row by mistake. I predict independent UK advisors will quintuple their headcount by Christmas.

The bankers they don't hire will all get fired by their employers and rehired immediately with guaranteed bonuses—which are exempt from the new tax, for now—or put on retainer as fiendishly well paid independent contractors. The Freelancers' Association of Great Britain should see its membership rolls and dues receipts increase 10,000%, and HM Treasury will no doubt promptly reclassify it as a bank for tax purposes. The stately annual dance of new tax regulation, evasion, and counter-evasion will begin to resemble a cage match at the Ultimate Fighting Championships.

The only parties for whom this will be an unalloyed benefit will be tax lawyers, accountants, and corporate relocation specialists. Their spouses and families won't see much of them over the Christmas holiday, but at least they'll be able to console themselves with frozen rum punch and figgy pudding in £10,000-per-night suites on St. Barts.

* * *

Despite all the frantic squealing by outraged bankers, it is clear the UK government enacted this policy not to "recapture" excess compensation from individual employees through personal taxation, but rather to dissuade banks from paying more than nominal bonuses at all. Instead, it wants them to use the money they save to bolster their weakened balance sheets. Chancellor Darling could not have been clearer:

“I’m giving them a choice. They can use their profits to build up their capital base, but if they insist on paying substantial rewards, I’m determined to claw money back for the taxpayer,” he said.

And, as the following little spreadsheet indicates,1 he plans to do this by making banks choose between their employees and their shareholders:

Given a hypothetical bank with operating profit before discretionary compensation of one million pounds and one employee which management intends to pay half a million quid, the three rightmost columns show the effect on both employee and net income under the new policy under three different scenarios. Under the first, "equal bonus" scenario, the employee still walks away with his £500,000 pre-tax bonus, but instead of earning £360,000 as before, shareholders take a 66% hit to net income, to £122,500. Under the second, "equal net income" scenario, bank management preserves shareholder income at the pre-policy level of £360,000, but the banker walks away with 39% fewer pre-tax shillings. Finally, in the third, "equal pain" scenario, the bank tries to share the pain of the new policy equally between employees and shareholders, and each take a 24.5% hit to their earnings.

Of course, a stubborn bank could go right ahead and pay full discretionary bonuses to its employees, and under the new policy HM Treasury would drain half the excess straight out of the bank's equity account. This hardly seems conducive toward strengthening capital ratios in the financial sector, however. Presumably the government is relying on bank shareholders to scream bloody murder should management try this, not to mention bank creditors, who will scowl with disapproval as their obligors' creditworthiness looks to sneak out the door to a Ferrari dealership in the pockets of its employees.

Interestingly enough, this scenario is also one in which HM Treasury maximizes its own tax receipts, from the personal income and National Insurance tax paid by individual bankers on larger bonuses plus the direct corporate tax on excess bonuses. The silly thing about such a scenario, however, is that the UK government would be far more likely to have to plow its higher tax revenues right back into the newly weakened banking sector in the form of more direct support. Talk about a "doom loop."

Another complicating factor in this whole discussion is that employees often make up a substantial portion of their employer's shareholder base, especially at investment banks. At the extreme, if a bank had only one employee who also happened to be the sole shareholder, a proper tax minimization strategy would be to forgo a discretionary bonus entirely and book that amount into net income. This is because the standard UK corporate rate of 28% is far less punitive than the new 50% top personal rate for high earners, plus National Insurance deductions. But how would Mr. Eddington-Smythe pay his local grocer? Borrow money from his employer, perhaps? Oops, there goes the leverage ratio again.

* * *

On this side of the pond, the evil genius cephalopods at Goldman Sachs have come up with a different approach. The firm announced today that its 30 top executives will take all their discretionary compensation this year in the form of restricted stock, which they cannot sell for five years.

In principal, this strategy actually makes more sense than the UK tax policy does in terms of bolstering banks' and investment banks' balance sheets. For one thing, it implicitly acknowledges that a bank probably should pay something more than a £25,000 bonus to highly productive employees if it expects to keep them, and it puts no explicit upper limit on that pay. For another, it conserves the gajillions in cash a bank would otherwise pay out in bonuses and replaces it with common stock, and unvested common stock at that. That bolsters both the cash and shareholders equity accounts by the amount of deferred bonuses and strengthens the company's credit position. Furthermore, as I have pointed out before, bankers who receive deferred stock compensation are the best kind of shareholders to have, from a credit standpoint, because they are involuntary, long-term providers of permanent capital. No high frequency traders, these.

However, it's worth noting that as announced this policy only applies to the thirty Executive Committee members at the Squid. So, while it may conserve $300 or so million extra cash which would otherwise have been paid out as the cash portion of these executives' bonuses under prior policy, it says nothing about the up to $10 billion in cash which could presumably get sucked out the window in the pay packets of its non-executive employees. As a public relations stunt, and a sop to Congressmen and other populists on the warpath, it is genius, and Lloyd Blankfein and the other 29 sacrificial lambs probably have enough liquidity to weather the privation. But as a credit bolstering event for Goldman Sachs, it probably nets out close to a wash.

In addition, Goldman's new policy carries a real cost, too: increased dilution for non-employee shareholders. For, as our hypothetical little exercise above should have illustrated, there is a natural struggle over the spoils within a bank between its employees and its outside shareholders. The Goldman announcement makes no disclosures on this topic, but I can assure you top management is having heated discussions with major shareholders right now over just how many basis points of net revenue will go to investors and how many to the hired help.

* * *

This argument may be quite interesting to the parties involved—and their wives, mistresses, and household staff—but it has little practical import for those of us on the outside looking in. In fact, strong arguments can and have been made that an excessively large portion of the filthy lucre Goldman and other US banks' investors and employees are arguing over this year doesn't properly belong to them. A huge portion of the outsize sales and trading profits which have been fattening domestic banks' income statements is due to cheap funding provided both directly and indirectly by the government, direct subsidies from the US taxpayer, and the selective elimination of industry competitors through direct and indirect government action during the height of the financial crisis.

People who object to this situation claim the only sensible thing to do is for the taxpayers to claw back a chunk of these profits in the form of a windfall profits tax. Properly designed, such a tax would be levied against operating profits before compensation expense. Then, taxpayers would get back a portion of the outright subsidy they have been handing to the bankers, and bank employees and outside shareholders would be free to squabble over the remainder. The biggest challenge here, of course—apart from worrying about how to prevent politicians from making a temporary windfall profits tax permanent—would be to determine the proper amount of subsidy, and hence tax, to recover. The answer will always be somewhat arbitrary at the end of the day, but there is no reason a sensible number could not be figured out by a couple of accountants with a calculator and a bottle of scotch.

* * *

In any event, the policy tensions both here and abroad are clear: do we want banks to reduce employee payouts, retain capital, and bolster their weakened balance sheets, or do we want reparations of unearned, "excess" profits in the form of corporate, personal, or windfall profits taxes to the public purse? For conundrums like these, we have few instruments available except tax policy. But tax policy is a blunt instrument, and it acts on the economy a lot like a water balloon: every time we squeeze one end, the other end swells up bigger than before.

Moreover, I am sad to say that all available evidence seems to indicate our water balloon is a whoopee cushion, too.

1 Please, please, UK types—especially accountants and tax advisers—cool your jets. I know this example is a gross oversimplification, and it simply does not reflect all the relevant details, the intense value added which you and your firm can bring to the discussion with your extensive expertise, blah, blah, blah. It is meant to illustrate a relatively simple point, for which task I believe it is perfectly adequate. As usual, regular readers of this site know not to take my scribblings seriously in any respect, much less in the cloistered thickets of taxation and accounting.

© 2009 The Epicurean Dealmaker. All rights reserved.

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