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.

Hank channels Yossarian

Yossarian, the protagonist in Joseph Heller's Catch-22, tries to avoid additional missions as a bomber pilot by asserting he is crazy. However, military rules stipulate that an insane person must not suspect they are insane. Yossarian finds great frustration in trying to defeat this dilemma.

Treasury Secretary Hank Paulson must surely understand Yossarian's frustrations. After initial criticisms of the TARP, Secretary Paulson modified the plan to directly inject equity. Treasury was afraid injections would be stigmatized like Fed discount window lending, or worse - that banks not receiving capital would be assumed insolvent. To avoid this issue, Paulson required the biggest banks to take what had been advertised as "voluntary" government capital. Now the Treasury is taking heat for allowing these same banks to pay dividends, acquire foreign banks, and hoard capital instead of loaning it out. Here, Hank really starts to channel Yossarian. If he had restricted banks ability to pay dividends or make certain acquisitions, bank CEOs - and economic conservatives generally - would have been even more livid at being forced to accept government money. Without these restrictions, he watches $7B of taxpayer money flow to China.

The way out of Hank's catch-22 is to force this capital to be deployed to loans and restrict dividends and certain (e.g., foreign) acquisitions. Half of the $700B TARP funds already out the door, and the rest is waiting for the incoming Treasury Secretary. This Secretary will find it better to loan conditional capital to willing banks than to force ineffective loans on unwilling banks.

Capital Purchase Program

This morning Secretary Hank Paulson made a statement regarding the $250B Capital Purchase Program component of the financial rescue package. Critics of the CPP and TARP question the role of government in the capital markets and believe that the US Government is privatizing profits, while socializing losses.

Although drastic, CPP and TARP are well within the bounds of Treasury’s duties. The following is an excerpt from Department of the Treasury’s mission:

The Treasury Department is the executive agency responsible for promoting economic prosperity and ensuring the financial security of the United States. The Department is responsible for a wide range of activities such as advising the President on economic and financial issues, encouraging sustainable economic growth, and fostering improved governance in financial institutions.

CPP is the direct result of the later two goals. Paulson notes in his statement, “Our purpose is to increase confidence in our banks and increase the confidence of our banks, so that they will deploy, not hoard, their capital.” The restored confidence should open up the credit markets, prudent deployment of capital will enable sound businesses, aspiring students, and honest homeowners to continue the sustainable growth the United States has exhibited since 1776.

Additionally, the Treasury is utilizing market mechanisms to institute additional regulation. Qualifying Financial Institutions (QFI) will only have access to CPP if the institutions agree to caps on executive compensation, clawback provisions, and bans on golden parachutes. The Government is not ruling with an iron fist, rather the Treasury is providing a carrot for banks and thrifts to exercise increased prudence and to incent greater alignment of interest between all stakeholders.

In the near-term, the Treasury may have socialized losses; however, Paulson highlights the CPP is an investment by the Treasury, not an expenditure of the Treasury. The CPP investments will be in the form of preferred stock (5% dividend yield) with warrants for common stock. Assuming confidence is restored and sustainable economic growth persists, the warrants should provide the Government with substantial upside. As Tier 1 Capital, CPP investments will improve the banks’ capitalization and coupled with an improved balance sheet through other TARP initiatives, bank common equity valuations should improve.

Such investments are not risk free; the Treasury cannot guarantee a return OF capital, never mind a return ON capital. In April TPG appeared to have structured their way into a sound investment of preferred equity in Washington Mutual; however, the investment has turned out to be an expenditure. In reviewing the Interim Final Rule for the TARP CPP, as noted earlier, the qualifications are focused primarily around corporate governance and are not focused on the soundness of the preferred equity investment. A return on capital should yield a return to a prosperous United States.

For more information see the CPP FAQ and Application Guidelines.