Too Big to Fail and Exec Compensation: Inextricably Linked

Includes: C, GS, JPM
by: Amit Chokshi, CFA

A significant amount of discussion surrounding Too Big to Fail ("TBTF") centers around resolution, essentially how to monitor potentially systemic problems and defuse them in the future. Discussions regarding Wall Street compensation have largely fallen by the wayside as many feel that compensation, while obscene and unjustified in many cases, is a sacred cow. After all, in "free markets" companies should not have pay levels dictated to them by the government. Free markets being displaced by crony capitalism over the past decade aside, policy makers should realize that TBTF and compensation are inextricably linked as TBTF is essentially a taxpayer subsidy for TBTF investors and bank employees to pursue high risk activities.

Current legislation proposed by Barney Frank focuses mostly on how to smoothly address the failure of a TBTF institution in the future such that financial and economic dislocations are minimized. Frank's proposal includes the creation of a "council" consisting of the Fed, FDIC, Treasury, and the SEC that would monitor TBTF institutions. The composition of this council is ironic considering the numerous collective failures during the financial crisis, but another problem with this council is that it is likely to increase the problem of regulatory capture.

As has been well documented, Treasury secretary Tim Geithner spent a great deal of time as Fed Governor of NY regularly meeting with executives of many TBTF institutions. The reports regarding these frequent meetings suggest that rather than have the air of an authority figure meeting with those under his purview, these were far more collegial meetings between those sharing the same ideological views.

The Fed, like the Treasury, is also on the same page as TBTF executives, while the FDIC depends on the Treasury for funding and the SEC has a history of failing investors. Given that the recent crisis appears to have been averted, the key regulatory bodies of this council - the Fed and Treasury - favor the status quo as opposed to substantial legislation, such as the re-enactment of Glass Steagall or the forced divestiture of high risk divisions in TBTF institutions. This ultimately increases the probability of greater systemic risk.

Regulatory capture is the biggest obstacle to any council being successful. An extended aspect of regulatory capture is the appointment of officials that share the same ideological views as those that they must regulate. If policy makers were serious regarding TBTF, they could create one institution headed by people such as Elizabeth Warren, Paul Volcker, and Joseph Stiglitz. Unfortunately, Warren and Volcker do have roles within the administration but are marginalized, while Stiglitz is essentially banished due to his prior conflicts with Larry Summers.

Rather than focusing simply on triage, Frank and other legislators should consider far more biting regulations that can seriously tackle TBTF. Doing this first requires that policy makers actually consider the funding benefits TBTF institutions receive relative to non-TBTF parties as well as the consequences of those taxpayer subsidies.

For example, part of JP Morgan's (NYSE:JPM) funding consists of $117B in commercial paper and other borrowed funds and $272B in long-term debt. If the relative benefit of US taxpayers backing a TBTF institution versus non-TBTF institutions is a reduction in funding costs of 1.5%, JPM management and shareholders are essentially receiving receiving $6B from US taxpayers.

This $6B subsidy can be used to fatten salaries, acquire other businesses, invest in capital market activities, and pay shareholders dividends. However, this $6B handout also provides a major competitive advantage in that the reduced funding costs allows TBTF to undercut non TBTF institutions in various financial activities. For example, the "market" rate for high yield underwriting may be roughly 12%. However, implicit backing by the US taxpayer allows TBTF bankers to underwrite bank debt and bonds for high yield issuers at 1.5% below the "market" rate, crowding out non TBTF lenders.

TBTF also applies to firms like Goldman Sachs (NYSE:GS). GS benefits from its TBTF status in a more aggressive way given its emphasis on principal trading. Like JPM and other TBTF players, GS can borrow with implicit taxpayer guarantees. This reduced funding cost allows GS to further juice its capital markets activities as it can achieve greater leverage than non TBTF participants, all else being equal.

The problem is the asymmetrical risk/reward (privatized profits/socialized losses) presented to the US taxpayer. In the case of high yield lending, TBTF bankers can underwrite riskier credits and crowd out competing non TBTF bankers. The TBTF bankers receive higher compensation as they capture a higher level of deal volume and transaction size. This is not due to any "talent" but due to funding subsidies provided by the US taxpayer. However, the TBTF balance sheet becomes riskier as new assets on the balance sheet have not been commensurately priced for the risk (1.5% below market) and the chance for a blow up due to balance sheet destabilization increases.

In the case of GS, it can utilize the reduced funding from taxpayer susidies to increase its leverage and drive profits. Those profits are ringfenced by GS employees and investors when things go well but when things go poorly, the US taxpayer takes a hit.

GS provides a relevant example of what types of operations should have taxpayer backing. One could argue that general commercial banking that provides credit to the US economy should receive taxpayer backing while investment banking and trading activities should not. Since the repeal of Glass Steagall, many institutions have housed a number of operations that subject the banks, and thus taxpayers, to greater risks but provide little in the way of real economic benefit to the broader economy.

For example, the recent discussion of Phibro and Andrew Hall had many discussing the compensation he and his team negotiated with Citigroup (NYSE:C). Corporate media focused on the temerity of the government's involvement in impacting Hall's contractual pay (while simultaneously excoriating the union's contractual compensation agreements). The impending paycheck and spotlight played a part in C selling this segment to Occidental Petroleum (NYSE:OXY). However, what was largely missed was whether Phibro should have ever been part of C.

Hall was able to leverage C's cheap funding (by virtue of implicit US taxpayer backing) and mint money for him and his team. However, is Hall's strategy something that can be replicated independently? If Hall was the real deal, couldn't he have raised a massive hedge fund, owned 100% of it and made an even greater fortune for himself? Or was a large component of his outsized returns dependent on cheap funding that only C or TBTF institutions could provide? Also, what was the risk of a blowup to C? This was never really discussed. Hall reminds me of former Amaranth natural gas trader Brian Hunter who had a number of successful years before bad bets resulted in the entire fund imploding.

This ties back to the initial topic of TBTF and compensation. TBTF permits organizations that provide credit - the lifeblood of the economy - to operate tied to a number of far less critical but highly risky activities. This ties to compensation because the riskiest operations house the highest paid employees. The corporate banker that underwrites a BBB+ bond offering is not the person that is skewing the average compensation figure to obscene levels. It's those that are in the riskier segments and often times least mission critical parts of banking that reap the largest rewards. If policy makers realize this, perhaps there's a chance that they will come around to understanding that TBTF is too big to exist and that Glass Steagall should be revisited.

When one considers the size of TBTF institutions and the hundreds of billions, essentially over a trillion, that are the funding sources of these organizations that have implicit taxpayer guarantees, the absolute dollar cost subsidized by everyday Americans is staggering. It also presents some context as far as what our priorities should be when hundreds of billions, if not a trillion or more, can be casually spent to enable a welfare financial industry, but the same interests that enable this welfare condition become fiscal hawks when discussing items that can provide a tangible benefit to the broader population. While Frank's legislation is a weak start to legislating these institutions, Christopher Dodd's foray into legislation looks to add some more grit. In addition, if Senators such as Bernie Sanders of Vermont can push through legislation calling for the reinstatement of Glass Steagall and the break-up TBTF institutions, structural imbalances such as a large dependence and fealty to the financial services industry may start to correct.

Author's Disclosure: None

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