Christmas in August

Who isn’t getting paid next January?

Bonuses at hedge funds and Wall Street firms are a topic of obsession in the financial press—and in New York generally. (In 2005, New Yorkmagazine neatly dissected how Goldman Sachs would divvy up a projected $11 billion bonus pool.) Whether they come in the form of Goldman CEO Lloyd Blankfein’s $53.4 million haul last December, or in the form of a $1.7 billion payday for a top hedge-fund manager like James Simons of Renaissance Technologies, bonuses are important economic leading indicators for New York-area real estate brokers, art dealers, and gold diggers of all types. The ritual reporting of bonuses provokes envy in some (fellow graduates of MBA programs that are doing well, but not so well), and self-loathing in many (Phi Beta Kappa grads who chose to go into anthropology instead of finance).

In recent years, the only question surrounding bonuses has been: how much?

It’s only August, and a lot can happen in four months. But for many in the Wall Street-Hedge Fund Industrial Complex, this year the question is likely to be: how little?

Wall Street types receive paychecks every two weeks, but they really get paid once a year, typically in January. For many, the bonus can be 90 percent or more of total compensation. (In Wall Street parlance, this method of getting paid is called “getting paid.”) Thanks to the recent stock market correction, the rolling credit crunch, and the sub-prime meltdown, we already know some people who won’t be getting paid this year: the managers of Sowood Capital, the $3 billion hedge fund that went belly-up in July, along with employees of the two large Bear Stearns hedge funds that went bankrupt.

The collapsed hedge funds are just the beginning of the damage. The Financial Times got a jump on the schadenfreude express by reporting today that bankers on Wall Street and in the City of London “face a cut in their end-of-year bonuses of 10-15 percent because of the credit crunch,” and that “structured-credit bankers”—the type of people who put together mortgage-backed securities and collateralized debt obligations—could see cuts of 25 percent. For others, the reductions are likely to be more severe. The rank and file on the desks at large investment banks that originate, sell, and trade mortgage debt (sub-prime and otherwise), could be looking at lumps of coal this Christmas—no bonuses whatsoever.

While business was great at investment banks in the first half of the year, their highly lucrative, fee-generating corporate finance activity—advisory fees on mergers and acquisitions, underwriting commissions, and corporate lending fees—have all slowed down. Large banks like Citigroup may have to take charges for debt that they committed to fund transactions they were unable to sell. Such events tend to drain bonus pools. The stock market is also working against mega-bonuses at the so-called bulge-bracket investment banks in another way. Generally speaking, it’s unseemly for Wall Street firms to pay out massive bonuses to top executives when shareholders are suffering. And their shareholders are suffering. The Amex Securities Broker/Dealer Index, up about 24 percent last year, is down about 9 percent this year. And check out this sad year-to-date chart of Goldman Sachs, Bear Stearns, Morgan Stanley, Lehman Brothers, and Citigroup.

At hedge funds, compensation is perfectly correlated to performance—thanks to the 2 and 20 rule. The proprietors of hedge funds charge a management fee of 2 percent, which they use to pay overhead and salaries (which can run about $150,000 to $200,000 for junior traders and analysts), and they keep 20 percent of the profits they generate, which they use to pay out gazillions in bonuses. Show no gains, and you have no money to pay out. What’s more, most hedge funds try to post results without huge volatility—the optimal result is to gain a percentage point or so every month. So any fund that is down 10 percent, or even 5 percent, with two-thirds of the year gone, may find it difficult to get to break-even in December. Should that happen, its employees likely won’t get paid much, either.

Hedge fund performance is notoriously opaque, so it’s hard to say who won’t be getting paid. But it’s safe to say the guys who run Goldman’s Global Equities Opportunity Fund, which was down about 30 percent for the year in July and had to be bailed out, likely won’t be receiving much in the way of bonuses. According to the research firm Hedge Fund Research, its broadest index of hedge-fund performance shows hedge funds have returned a meager .66 percent year-to-date, after fees—meaning they have produced little in the way of distributable profits thus far. Meanwhile, convertible arbitrage and macro funds are down for the year and won’t have anything to distribute unless they improve this fall. 

Wall Street still has a few months to save the year. But the first signs of a chastened holiday season are apparent. Barron’s reported that in June 2007, real-estate prices in Greenwich, Conn., fell 4 percent from June 2006. For homes priced above $5 million—the sweet spot for successful hedgies—the decline was 8 percent.