Photographer: Simon Dawson/Bloomberg

The lights of Canary Wharf, kept on, perhaps, by bankers working late to justify their bonuses.

For most white-collar workers, there’s a compensation tool that accomplishes almost everything we want from incentives. It comes at the end of a year of good performance. It encourages employees to stay longer to realize its full benefit over several years. It can be deployed as needed to retain key personnel.

It is the “raise.”

Years ago, in the upper echelons of corporate life, the plain old raise gave way to “incentive pay.” To some extent, pay reformers brought it on themselves. Through the tax code, the U.S. in 1993 largely eliminated pay over a million dollars that wasn’t tied to performance. For CEOs, compensation experts like Harvard’s Michael C. Jensen pushed the pay-for-performance line. One of the key justifications for big CEO pay? The need to compete with bonuses on Wall Street.

Now on Wall Street and in the City, the places where the mega-bonus emerged, it seems to be on its way out, helped along by European legislation. And no document explains why better than the report on Barclays’ business practices released last week. Prepared by Rothschild vice chairman Anthony Salz, the report, which hasn’t gotten much attention in the U.S., includes a wealth of detail about how much bankers get paid.*

So let’s get to the good stuff.

Managing directors at Barclays’ investment-banking unit get paid a base salary. It’s typically £150,000 to £300,000. Whether you think that’s high or low may depend on your income bracket. Now here’s what comes on top. For the average managing director, according to the report, the bonus was 350% of base salary in 2011 and 210% in 2012. That means £150,000 to £300,000 turns into £675,000 to £1.3 million for 2011, or just about $1 million to $2 million. That’s down about about 30 percent for 2012. A related data point: In 2010, 728 employees received over £1 million ($1.5 million); 428 did so in 2012.

Maybe the most stunning number in the Salz review is that in 2007 bonuses made up 94 percent of managing director pay. That’s slipped down to 78 percent in 2011** and 68 percent in 2012. The report notes that the change reflects both increases in base pay and reductions in bonuses. It’s hard to unpack the numbers further; there’s no handy clip-and-save guide. It isn’t surprising that Barclays wasn’t eager to provide one.

Here’s what’s clear: Nobody truly believes anymore that those bonuses were anything but just another word for “really big salary.” The clincher: Only 32 percent of Barclays investment-banking employees thought that pay reflected performance. That share is lower than at other Barclays units, a sign that the people getting the big bonuses had a good sense of how thin the fabric of “incentives” was.

All the restrictions now put on bonuses after the recent backlash–longer vesting periods, payment over several years–make them work more and more like raises. So why are investment banks eager to continue them at all? Maybe because the bonus is a way of paying out a much larger share of bank profits as compensation in really good years than the company could afford in ordinary ones. In effect, this gives the senior employees some of the benefits of being part of a partnership, a structure that investment banks abandoned with the Lazard Ltd. IPO in 2005.

Now British bankers are sobbing that new European rules limiting bonuses to two times salary will spell the end of London as a financial center. That’s not the case. As you can see from the latest Barclays numbers, many managing directors are already close to that point. Remember: a bonus that is two times salary means that salary is just one-third of your compensation.

Does all this mean more top bankers and traders will head off to start their own boutique shops and hedge funds? Yes. The big-bonus era gave them the benefits of both public ownership and private partnership. They could sell the cake and eat it, too, going public and continuing to pay themselves as much as they pleased. Now more of those bankers and traders will have to choose between the safety of big shareholder-owned companies and the prospect of ginormous pay.

Here’s what the decline of bonuses will not mean: any substantial shift in the share of money going to the proverbial 99 percent. This blog has already explored the reasons for the massive growth of banking compensation. Investment banks now have a few more people collecting a lot more in fees. That won’t really change. The difference: Where now top employees get a greater share of the profit, more will shift to shareholders. That takes us back in the direction of a status quo that stood for many years before the bonus era.

That’s a real change, just not the kind that many of those in the anti-bonus fight imagined. The campaign against bonuses started out as one for social and economic equality. It’s ending up succeeding as shareholder protection.

*Along with a few hints that might remind readers that it was Barclays that commissioned his work. An introductory note says that “despite the problems, there are many really good things about Barclays — not least that the overwhelming majority of its people are focused on doing their best for its customers.” Undoubtedly. We’ll stipulate that.
** The review says that bonuses were 350% of managing director pay in 2011. I derived the 78 percent from that.

Photographer: Jonathan Ernst/Bloomberg

JPMorgan Chase CEO Jamie Dimon at Senate hearings prompted by the bank’s trading loss.

Today’s blockbuster news arrives with a 132-page user’s guide as JPMorgan Chase & Co. cut Chief Executive Officer Jamie Dimon’s pay by 50 percent and issued a detailed report on the “London Whale” trades that left the bank with a $6.2 billion loss. If you’ve already read the news stories, set aside an hour to read  the report itself, here.

The picture of trading that the report draws is much more nuanced than the usual idea of cowboys taking crazy risks with the bank’s money. What comes out in the report is a story of a trader very worried about his position, and pushed deeper in by superiors.

Bruno Iksil, the trader at the center of the JPMorgan saga, has been nicknamed “the London Whale.” The report, unfortunately, doesn’t identify the traders involved by name, citing U.K. privacy laws, so we have to guess at the identities. What’s clear is that early on at least one trader — possibly Iksil (I emailed a lawyer who has represented Iksil to ask, but haven’t heard back) — is not at all eager to be the big fish here. On January 30 the trader:

(Page 34) “… suggested to another (more senior) trader that CIO should stop increasing ‘the notional,’ which were ‘becom[ing] scary,’ and take losses (‘full pain’) now …”

His doubts are significant enough that he requests a meeting with managers, including Ina Drew, the head of JPMorgan’s Chief Investment Office. At the meeting he says his portfolio could lose an additional $100 million. Drew, the report says, at the meeting appears not to be overly concerned.

On March 12, with losses in the portfolio growing, “a trader informed another trader” of growing losses. He says that,

(Page 49) “… mark-to-market losses in the Synthetic Credit Portfolio based on ‘crude mids’ [nb: a valuation method] had grown to approximately $50 million, and that he viewed these losses as a warning sign. He recommended that they reflect this as a loss on the books, even though they could not explain the market movement.”

The Wall Street Journal reported in August that JPMorgan had concluded that Iksil’s boss, Javier Martin-Artajo, had prodded Iksil for higher valuations. It’s not clear from the report if the first trader is Iksil and the second is Martin-Artajo. The more senior trader disagrees and puts off the discussion.

Over the course of the next month the position worsens. Yet again there’s a discussion of potential losses, which in one calculation range up to $750 million. Instead of the worst-case scenarios getting sent up the ladder, the numbers get massaged:

(Page 59) “Over the weekend of April 7 and 8, two of the traders prepared the requested analysis. One of them initially attempted to formulate a loss estimate by constructing numerous loss scenarios that were very harsh … According to the trader who prepared the loss estimates, the other trader responded that he had just had a discussion with Ms. Drew and another senior team member, and that he (the latter trader) wanted to see a different analysis. Specifically, he informed the trader who had generated the estimates that he had too many negative scenarios in his initial work, and that he was going to scare Ms. Drew if he said they could lose more than $200 or $300 million.”

What should be happening at the bank is that higher-ups and risk experts are carefully monitoring the trading and pulling the plug on excessive risk. What actually seems to be happening here is that the person making the trades is intensely aware that he is in trouble, and at risk of sinking deeper.

Over at Reuters Felix Salmon reads the JPMorgan report as demonstrating the near-impossibility of hedging catastrophic risk. He’s probably right about this, but the more general problem may be what the report shows about the difficulty of evaluating risk, catastrophic or not, in a bank like JPMorgan. As the numbers get sent up the ladder, they seemed to be softened and their significance missed.

In an earlier post on this blog I asked whether proprietary trading was really the biggest risk to investment banks. The JPMorgan report introduces an important element in the mix: big banks by nature may not be set up well to manage trading risk.

In theory, a giant enterprise has the advantage of deep pockets that let a bank weather freak mishaps. Deep pockets don’t protect JPMorgan here. They just make it possible to keep losing money. In a hedge fund run by traders this whole story may well have ended with a loss of millions in January, instead of billions later.

The exception that might prove the trading rule here may be Goldman Sachs & Co. Goldman’s fourth quarter profit nearly tripled over last year’s, going to $2.89 billion from $1.01 billion. A big part of the profits came from Goldman’s proprietary investments. Goldman has used its own capital in both much-publicized investments (Goldman’s stake in Facebook) and discreet ones (the Multi-Strategy Investing unit).

Thanks to disciplined risk-taking, Goldman has made money on investing and trading. The question here is whether other banks can match that kind of discipline to surmount the inherent obstacles to trading in a big corporation. It’s not encouraging that in this case a company normally as well-run as JPMorgan could not.

PS: Felix Salmon notes that even after the JPMorgan report we have no idea of how a loss in the hundreds of millions of dollars turned into one of more than six billion. I second that, and it’s scary. At various points there were good faith efforts to estimate the potential losses, and they turned out to be way, way off the mark.

PPS, January 17: Kevin Roose at New York Magazine has an interesting post dissecting the report. Roose says notes that the report is harsh on people like Ina Drew who no longer work at JPMorgan, and much less so on those still there. Good point, though not sure that’s true of Bruno Iksil, who might come off fairly well if he is indeed the trader who keeps raising concerns.

Photographer: Chip Chipman/Bloomberg

Like some of Wall Street's clients, salmon return to their spawning grounds, where they are caught and smoked.

Two Bloomberg stories today beg to be read together in as perfect a study of the Law of Eternal Return (aka, what goes around, comes around) as you’re likely to get.

In one,  Jody Shenn looks at the performance of mortgage backed bonds. Those who’ve been keeping track know that mortgage bonds have been among the most successful recent investments. February’s Bloomberg Markets magazine profiles Deepak Narula, whose mortgage bond investments propelled his Metacapital Management LP to the top of the hedge fund rankings. Now, Shenn reports, the bonds that have been sent skywards by Fed buying of mortgage debt are sliding, as buyers look ahead to the end of Federal Reserve support.

Meanwhile, Sarah Mulholland reports that with investors looking for higher yield than traditional commercial mortgages now offer, property-backed CDOs — pools of sliced and diced mortgage bonds — are suddenly back. Sales of property-backed CDOs should be up to $10 billion in 2013, nothing like past peaks but ten times this year’s level.

In other words, just as mortgage bonds themselves start to slip, complex investments built from such bonds return. The Market Now will skip further comment here. When fish are packed this tight in a barrel, shooting them is a waste of bullets.

A version of this post appears in the Market Now newsletter. Click here to register at Bloomberg.com and subscribe to The Market Now daily email.

*Update: Clarified the definition of property-backed CDOs.

Photographer Will Wintercross/Bloomberg News

Dangerous as they can be, prop traders weren't the gorillas who beat up Wall Street.

Bloomberg’s Max Abelson today reports on Goldman Sachs’s Multi-Strategy Investing unit — in effect a hedge fund within the bank that bypasses the Volcker rule’s limits on proprietary trading. It’s a great story. It also raises a question: Is prop trading really the problem with Wall Street?

Before you answer, remember what caused the collapse of Bear Stearns Cos. and Lehman Brothers Holdings during the financial crisis, as well as the massive losses at Merrill Lynch and other banks. Obviously all of them took stupid risks with their own capital. It’s just that the risks didn’t come from the sort of trading the Volcker rule addresses.

An excellent succinct discussion of the pattern comes in Jake Bernstein and Jesse Eisinger’s 2010 Pro Publica article about the huge mortgage losses at Merrill, now part of Bank of America Corp. Merrill’s loss came from CDOs that the bank itself had packaged from mortgage-backed bonds. As Bernstein and Eisinger make clear, Merrill’s mortgage traders were the buyers of last resort for derivatives that Merrill bankers had created and no one else wanted.

That’s not the proprietary trading that regulators fear. If anything, it’s the opposite. Instead of letting traders freely choose their own investments, Merrill, like Bear and Lehman, had them stuff their portfolios with the mortgage bonds and CDOs that came out of the bank’s own underwriting and derivatives business.

In their Atlantic cover story this month, Eisinger and Frank Partnoy take apart bank income statements and focus on hat kind of risk with a discussion of “customer accommodation” trading, dryly pointing out that

“at many large banks, customer accommodation can be a euphemism for “massive derivatives bets.”

If banks want to disguise proprietary trading as “hedging,” it’s easy enough for them to do it. Maybe worse, if they want to build up massively risky positions in the service of banking fees, as they did with mortgage bonds, they can do that too. No variant of the Volcker rule stops them.

Before the mortgage meltdown, it was feared that a big hedge fund (like Long Term Capital Management) or a bank prop trader could set off a chain of dominoes that took down the financial system. The Volcker rule responds to the fear, and it’s a legitimate one. It’s just not the crisis that actually happened.