Financial Engineering and Wall Street Compensation

The Partner Asset Facility

Last week, Bloomberg announced that Credit Suisse (CS) created a new compensation plan for their investment banking executives that exemplifies the financial engineering which will keep investment banking a reliable source of profitability. The Switzerland-based financial services company announced that they would create a Partner Asset Facility that would use leveraged loans and commercial mortgage-backed securities to fund compensation packages. Directors and managing directors would receive an ownership stake in the fund rather than receiving compensation in the form of stock options. The fund will pay the investors semi-annual coupon payments at LIBOR plus 250 basis points.

As financial institutions continue to struggle to pay employees compensation in this difficult environment, this new plan will both fund executive compensation and also remove the risk of the toxic assets from the institution's balance sheet. Many financial institutions are struggling to pay employees compensation as they work to stabilize their balance sheets and raise additional funds to support capital ratios. The Partner Asset Facility will keep the leveraged loans and MBS on Credit Suisse's balance sheet; yet, potential losses resulting from mark-to-market write-downs will be offset by identical gains on the bank's liability to employees.

New Constraints on Employee Bonus Programs

As banks struggle to fund employee compensation, Credit Suisse and other banks are also setting new constraints on employee bonuses. Earlier in December, the New York Times reported that Morgan Stanley (MS) will be attaching a claw-back provision to its annual bonuses that will allow the firm to withhold a portion of an employee's bonuses for three years. If an employee takes excessive risk that results in losses, the firm can withhold this compensation, and is intended to limit excessive risk-taking. These claw-back provisions will discourage employees from taking short-sighted risks, and appeal to the government and taxpayers as Morgan Stanley and others receive billions of dollars of capital injections from the Troubled Asset Relief Program, or TARP. However, these provisions may also reduce traders and other employees from taking risks which would otherwise increase the firm's profitability.

Credit Suisse's new compensation program also includes a similar claw-back provision that allows the bank to reclaim some of an employee's cash bonus from two years after they're paid if an employee resigns. The Credit Suisse Partner Asset Facility also includes a provision that states that the bonuses will take the first hit if the securities further decline in value.

Compensation Must Remain Competitive

Banks must also be careful not to limit compensation too much, as under capitalized firms face the possibility of losing employees to other institutions if they're unable to afford competitive compensation packages. Goldman Sachs (GS) for example, announced that they cut average compensation by 45% to $363,654 per employee amid the firm's first quarterly loss in 4Q2008 since going public. The firm runs a large risk of having the top-earners leaving the firm if Goldman is unable to remain competitive; Goldman Sach's proprietary trading desk and principle investments accounted for 68% of revenue during 2007. Goldman's intellectual capital is one of the firm's greatest assets and they must be able to retain these employees as Goldman's goodwill on Wall Street faces serious challenges.

Disclosures: none

Comments

[Steven Hansen:]

"Banks must also be careful not to limit compensation too much, as under capitalized firms face the possibility of loosing employees to other institutions if they're unable to afford competitive compensation packages."

daniel, if all major banks are receiving government money - then all of their compensation should be limited. the unions use the same argument about compensation. compensation must match the situation.

2008 Dec 23 06:09 AM

[DBS:]

With due respect, as a university student you are well out of your depth when you stray from reporting about facts -- the CS and MS compensation strategies -- into making value judgements and predictions about how compensation relates to employee retention or "Goldman's goodwill on Wall Street" in the current market. You really don't know what you're talking about!

You could do with another English composition class, too; it is very poorly written (examples on request, but they are legion).

2008 Dec 23 07:27 AM

[garyjohn7:]

I, for one am tired of this bogus topic. Intellectual capital? = failure

If these people don't want to work for less, let them leave. There are plenty of talented people who will rise to the occasion.

This is same argument I have with politicians. They also gave themselves a payraise. We don't need more of the same, we need new blood in all aspects of our lives at the moment.

gd

2008 Dec 23 07:29 AM

[Daniel Miller:]

Let me clarify, compensation has been limited and will continued to be limited well into the foreseeable future. However, the key is that banks must remain competitive, and be mindful that limits such as claw-back provisions may unduly limit risk-taking. Plans such as the Partner Asset Facility ensure that a firm is able to afford competitive compensation, while also greatly reducing the firm-wide risk from their mortgage backed security portfolios.


On Dec 23 06:09 AM The hand wrote:

> "Banks must also be careful not to limit compensation too much, as
> under capitalized firms face the possibility of loosing employees
> to other institutions if they're unable to afford competitive compensation
> packages."
>
> daniel, if all major banks are receiving government money - then
> all of their compensation should be limited. the unions use the
> same argument about compensation. compensation must match the situation.
>

2008 Dec 23 08:02 AM

[prudentinve...:]

Congress should consider a retroactive clawback provision as a condition for releasing more TARP funds. Before receiving more taxpayer money, banks, or congress, need to first define a legal mechanism to recoup the hundreds of billions of bonuses that were based on illusory profits that have now turned into taxpayer-funded losses.

2008 Dec 23 12:40 PM

[jimmy46:]

STOCK OPTIONS CAUSED MUCH OF THE CURRENT PROBLEM.

CONGRESS SHOULD TAX OPTIONS THE DAY THEY ARE GRANTED
WHY SHOULD THEY BE TAX FREE FOR 5-10 YEARS???

IF THEY EXPIRE WORTHLESS, THE HOLDER WOULD HAVE A
LONG TERM CAPITAL LOSS HE COULD USE.

2008 Dec 23 02:15 PM