Unintended consequences, volume 1

President Obama announced today that the government will restrict compensation at firms receiving government bailout funds to $500,000 a year. It intelligently allows exceptions for the granting of restricted stock that could not be sold until government funds are repaid. However, it faces it's share of unintended consequences.

First, it could very well force out key talent. To cite but one example, a trader that made $10M in profits for a bank last year could decide that they would rather work at a hedge fund, where the fund could pay substantially more. The trader's bank would lose out on that $10M in profits at a time when they desperately need to find ways to generate profits. Another line of reasoning is this: many of these banks executives are worth millions of dollars. For $500K a year, many could decide they are better off retiring than dealing with grueling 15 hour work days, incredible stress, and now, reduced pay.

Second, it could incentivize banks to pay back government funds quickly. The government would like to be paid back, but at the moment they would rather have the bank lend out those funds to get credit working again. Already Goldman Sachs has indicated it intends to pay back TARP funds rapidly. Wells Fargo has been one of few big banks loaning out money, but with restrictions imposed, it might decide it is better off paying back the government than issuing new loans. By paying back those funds, they reduce their ability to make loans dramatically, prolonging the credit crisis that TARP aimed to fix.

Third, this makes the already dubious policy of forcing government funds on banks even more suspect. The Wall Street Journal reported that Wells Fargo did not want bailout funds, and was essentially required to accept them. While the dilution was bad enough, the additional restrictions Obama is now imposing restrict the compensation of the banking executives that got it right by making smart, prudent loans. While the Obama administration has indicated the condition can be waived under certain circumstances, the fact that Wells Fargo - a successful bank that can help the U.S. emerge from the crisis - is encumbered by government regulation at all demonstrates how seemingly sensible legislation can slow the recovery.

Should this proposal be scrapped in its entirety? Probably not. But the government would be better suited to splitting funds into two types: a solvency bailout complete with restrictions and a lending fund with few restrictions. The solvency funds would be available to firms as a last resort to catastrophic banktrupcy, and could carry heavy restrictions and punitive interest rates/equity ownership stakes. AIG, Citigroup, GM, Chrysler, and other seriously impaired businesses would be the recipients of these funds. These funds would not be designed to spur new lending, but instead would be targeted to preventing the collapse of key institutions. Simply knowing the these funds exist for the purpose of recapitalizing insolvent financial institutions would alleviate some market uncertainty and would help restore lending.

The second type would be to explicitly encourage lending, and would have one simple restriction: net loans outstanding must increase by 90%* of the capital provided to the bank by the next quarter. The interest rate would be low, and the term long. The government loan would have to be double-guaranteed, collateralized by the new assets the bank acquires AND guaranteed by the parent bank's equity. Otherwise healthy institutions - like Wells Fargo - could access these funds voluntarily, and the incentive to obtain long-term, low cost financing that could be used to facilitate profitable lending operations would create strong incentives to take advantage of this program. Yes, this program would be providing a subsidy to healthy banks, but the benefits of restarting lending operations would make the money well spent. Not only would this remove restrictions from banks that should have never faced them, it would jump-start lending and provide specific accountability for some proportion of the TARP funds.

*Or whatever percentage is appropriate given the banks typical loan loss reserve ratio. A second restriction would be that recipients of bailout funds could not recieve the lending funds.