Paying Bankers In Derivatives Worked Out So Well For Credit Suisse That They’re Going To Do It AgainBy Matt Levine
Dealbreaker has long admired Credit Suisse for being on the cutting edge of creative approaches to compensation. In 2008, they gave bankers bonuses consisting of “toxic assets” to (1) incentivize the risk-takers to stick around and (2) remind people that “toxic assets” is a meaningless term if you don’t consider price. That worked out okay. This year, they’re giving junior mistmakers bonuses consisting of nothing, as a gentle reminder that there are other, similarly nonremunerative careers that might be better suited to their interests and talents. That also seems to be working. And now there’s this piece of magic:
Credit Suisse Group AG, Switzerland’s second-biggest bank, plans to pay a portion of senior employees’ 2011 bonuses in bonds packaged from derivatives linked to about 800 entities.
The move “is a risk transfer from the firm to employees,” Chief Executive Officer Brady Dougan, 52, wrote in a memo to the firm’s staff and obtained by Bloomberg News. “We are trying to strike the right balance and align employees with shareholders. These measures help to put us in a good place and to perform well in 2012.” …
The bonds mature in nine years and will pay a coupon of 5 percent for Swiss franc holders and 6.5 percent in U.S. dollars “for holders elsewhere,” Dougan wrote. Credit Suisse will absorb the first $500 million of losses on the portfolio, according to the memo.
How can you not love this? My favorite part is that shareholders eat the first tranche of losses. OOOH NO BANKSTERS ROBBING SHAREHOLDERS, you think – well, not you, but someone thinks – except no. From the Bloomberg report – and I haven’t seen the memo so, y’know, if you have it, send it our way – these things have pretty limited upside. They’re 6.5% bonds; if the underlying derivatives perform awesomely, then all you’ve gotten is a 9-year deferred cash bonus with a 6.5% yield – above market for an investment-grade-ish thing, but not amazing given the messiness of it; if they perform terribly, then you’re a bit shielded but eventually start bearing losses. So it’s not a heads-we-win-tails-you-lose thing; rather it’s that shareholders get the first loss and residual gains – y’know, the equity – while bankers are next in line for each.
Giving the shareholders the equity tranche makes sense if you think that bank employees actually should not have their incentives fully aligned with the interests of shareholders. On this view, which we’ve mentioned before, bankers are not just working for their risk-addled shareholders, but also for their creditors, depositors, and everyone else contingently liable to pony up if their derivatives trades go awry. So bankers should have a more credit-like payout that prioritizes stability as well as profit.
In that light, the incentives here look great. If you’re a Credit Suisse derivatives originator (or maybe even if you’re not*), and you know about this plan, your incentives are:
(1) to book profitable trades so you get a big bonus;
(2) to make those trades safe enough so that the bank sticks around for nine years and you actually get paid out on it.
Both of those are good things! This is a pretty simple way to do it. Other things don’t necessarily do it. Most notably, stock options don’t really create incentive (2) – instead, they just create a continuing series of (1). Every year you want to take risks to make the equity as valuable as possible, because you get all the upside of that; if those risks blow up the bank, then your downside is floored at zero. With these, um, Brady bonds (?), you remain exposed to the downside of blowing up your bank – but your previous-year bonuses don’t have any upside. They’re just their stated value, plus 6.5%. Thus you don’t have the asymmetric incentives that drive critics of banker pay nuts.
One teensy critique: CS’s annual comp whimsy is great fun for outside observers, because each year they find some new way to illustrate a point in compensation theory. But as a way of aligning incentives it is … puzzling. If you think that this bonus structure is a good way to align incentives – and why not? – then it works best if people know about it in advance. Who knows, maybe some short-term-profitable-but-risky trades were put on in December 2011 that, in hindsight, their originators now regret. And as a guide to conducting your business in 2012, “Credit Suisse will find some complicated and amusing way to pay us that no one has thought of before” is not really all that helpful.
* Per the article, “The portfolio covers about 18 percent of the credit exposure in the firm’s derivatives business and is 94 percent investment-grade.” But there’s no need to design this structure to just offload derivatives currently on your books. You could, for instance, lend to customers, then buy CDS on those loans from a synthetic CDO in which you retain the equity and sell the next tranche to your, um, bonusholders. So you could bring commercial bankers, and client coverage generally, into this too.