????The Masters of the Universe are taking a pay cut. Surprisingly, few people are happy about it.
????On Thursday, Goldman Sachs GS 2.51% reported earnings for the third quarter. The investment bank’s profits were better than analysts were expecting. That was in part because Goldman’s business was good. Revenue from its bond, commodities, and derivatives trading desk was up by 74%, and fees from managing IPOs and other stock offerings was up more than 40%.
????But the unexpectedly good earnings news was also due in part to the fact that Goldman decided to pay its bankers and traders less.
????Goldman’s closely watched compensation ratio—the percentage of sales it sets aside for pay—in the third quarter was 33%. On $8.4 billion in revenue for the firm, that still equates to a lofty average pay of $83,611 for three months of work for the average Goldmanite. But had Goldman paid its employees the same ratio of sales that it did in the first and second quarter, which was 43%, the bank’s average worker would have received $107,654.
????The pay cut saved Goldman $800 million. Without it, the bank’s third quarter earnings would have been more like $1.4 billion, or about $100 million less than what analysts were expecting, rather than the $700 million more that the firm actually reported.
????So did Goldman manufacture its good earnings?
????Some analysts and investors seem to think so. Goldman’s shares traded down yesterday, despite its nearly 50% reported bottom line jump. (Although some argue that the sell off was due to the fact that some thought the bank’s bond market trading revenue—which was, again, up 74% from the year before, and $300 million more than analysts were expecting—was going to be even higher. But that’s all part of Wall Street’s weird expectations game.)
????On the bank’s earnings conference call, a number of analysts probed Goldman CFO Harvey Schwartz about its compensation ratio drop. Goldman similarly dropped its compensation ratio in the third quarter of 2013, that time to 35%. For the rest of the year, it paid in the 40% range. At the time, the bank was criticized for lowering its pay numbers to make its earnings. At one point in the call, analyst Marty Mosby, who works for a regional brokerage firm Vinning Sparks, asked Schwartz whether Goldman would consider setting one compensation ratio for the year, and not changing it quarter by quarter. Schwartz’s answer: Nope.
????Still, the analysts and the market’s reaction to Goldman’s lower pay is odd. First of all, the compensation numbers that Goldman reports each quarter are sort of made up. Goldman’s employees did not receive an average of $83,611 during July, August, and September. It’s not like the average Goldman worker gets a check every two weeks for $13,935. They probably got a whole lot less.
????Most Wall Street employees get a small annual salary and a big bonus, which comes at the end of the year or in early January. The ratio has historically been 20% salary to 80% bonus. But after the financial crisis, the salary-to-bonus ratio shifted a bit toward salary when bonuses got a bad rep. What’s more, much of that bonus these days comes in the form of restricted stock. So much of that money will never get paid out as an actual cash deposit.
????What shows up in Goldman’s financial statements each quarter, and what is used to determine its earnings, is the amount of money the company sets aside each quarter to pay its employees. It’s an estimate of one quarter of what Goldman thinks those end of the year bonuses will be. But Goldman doesn’t actually incur the compensation expense until the end of the year when the actual bonuses are determined and paid out. So it’s fair to say that Goldman is smoothing its earnings by manipulating its compensation expense. That’s what it always does.
????It’s also worth remembering that compensation is Goldman’s biggest expense. So a drop should be welcome. Wall Street typically loves cost cutting. The question is whether this is a one-time thing. And Goldman, as Schwartz’s answer to the analyst indicates, won’t commit.
????But it may not have a choice. Wall Street, and Goldman in particular, is not as profitable as it once was. Goldman used to consistently have a return on equity of 20% or higher. In the third quarter a year ago, it was 8%. But the bank is still paying like it is making a 20% return. The only way it’s going to get its profitability back up is to pay its workers less. So the pay cuts should not be coming as a surprise. The surprise is how long it has taken the Masters of the Universe at Goldman to realize this. Now that they have, it’s a good thing. And at a time when we are increasingly concerned with the negative effects of income equality, it’s not just good for Goldman, but for all of us.