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BreakingViews has a couple of posts up about one of my favorite things in the financial universe, Credit Suisse’s habit of paying its bankers in structured credit instruments that take pages to describe. How’s that going? Great:
Three years ago, around 2,000 employees were forced to take some $5 billion of the riskiest assets from the Swiss group’s balance sheet as their bonuses. Now, recipients are being offered the chance to buy more. What once seemed like a punishment has turned into something of a perk.
Investors in the “Partner Asset Facility” already sit on a paper profit of around 80 percent, thanks to a recovery in the value of the original portfolio. That gain is essentially safe, since most of the assets involved have been liquidated or sold down and the funds are sitting in low-risk, low-return investments. The snag is that beneficiaries can’t get to the payouts until 2016.
To ease the pain of waiting, Credit Suisse is giving participants another bite. They have a chance to plough some of their paper profits back in, buying up to $1 billion of risky assets, including mortgage securities, from the bank’s books. Over a third of participants opted in to a similar offer late last year. Some of the purchases are to be funded by leverage, leaving perhaps half to come from willing PAF holders.
Phrases like “risky assets, including mortgage securities,” are always a bit of a minefield, but the sense is clear enough, which is that a whole lot of senior people at Credit Suisse are pretty keen to take money that is basically theirs, which is currently held in the form of basically cash, and invest that on a ~2x levered basis in, er, “risky assets, including mortgage securities,” which let’s just stipulate have a higher risk and higher return than cash.
How would you describe those people?
Matt Yglesias has a theory, supported by JPMorgan’s possibly less than bulletproof risk management approach in its Chief Investment Office, that everyone employed in any revenue or revenue-adjacent capacity at a major bank is a testosterone-crazed gambling-addicted loon. Granting that for a sec, why would that be? One potential culprit is a comp model where banks offer (1) a livable but not-that-special base salary plus (2) a bonus that ranges from zero to ginormous depending on your skill, luck and charm and the skill, luck and charm of your co-workers. The people who take that offer will tend to be the ones who like a gamble every now and again and have a healthy confidence in their skill, luck and charm. If you want to minimize variability in your personal income, be a lawyer.
With that background it’s not surprising to see the CS people choosing a wide-dispersion outcome. This is part risk loving, part confidence: they or their peers chose these “toxic” assets to invest Credit Suisse’s money in, so they have some reason to believe that those assets will outperform market expectations. So they should value those assets more highly than the market does, and I guess that’s implicitly Credit Suisse’s conclusion in hiving off these assets to its managing directors rather than to the highest public bidder.
So what to do with those loons at JPMorgan? Here is BreakingViews’ Daniel Indiviglio:
One way to make JPMorgan executives eat their own cooking would be as follows. Once the size of the group’s 2012 bonus pool is determined, the bank could create a synthetic bond whose notional size mirrors the performance of the so-called Whale trade. The bonus pool essentially would buy the long side of that derivative and the resulting bonds would be delivered to employees in the form of bonuses.
This long-term compensation would be linked to the fate of the bad hedges. The bonds would mature when the trade does. Any losses in the securities doled out to bankers ultimately would benefit JPMorgan and its shareholders. Any gains would flow to the employees involved.
Such an arrangement has worked before. Credit Suisse pioneered the idea of paying banker bonuses with toxic securities. They didn’t love the idea in 2008. But those employees aren’t doing badly. Though it has several more years to maturity, Credit Suisse’s Partner Asset Facility is up by about 80 percent.
Now circumstances have changed, but if you’d offered the London Whale this trade a year ago, what would he have said? Some sort of series of grunts and whistles I suppose, but then he’d be all “yeah, sure, that sounds great.” Because – I don’t know if you know this – but he was loading up on a hundred billion dollars of long exposure to this trade. Leaving aside the possibility that he wanted to blow himself up, you’re left with the sense that he had a fair amount of confidence in his positions.*
Journalists and regulators like to propose schemes like this because they are journalists and regulators, have a stable paycheck that they enjoy getting, and think it would be terrible to have their entire comp for the year tied up in a gamble. Guys who tie up $100bn in a gamble like gambles and think they’re good at them. Give those guys the chance to put their own personal funds in that gamble – and, remember, Bruno Iksil probably couldn’t trade CDX.IG.NA.9 in his personal account, so he couldn’t put his own money in this trade by himself – and they’ll be thrilled.
Which is fine, I guess, in the short run: if the unwind of the Whale trade is still pretty risky, which seems likely, why not give some of it to people who want it rather than to shareholders who mostly don’t?** But in the long run I’m not so sure. People who worry about l’affaire Whaledemort mostly want banking to be simpler and less stuffed with opaque derivatives trades that sometimes fall into small deep holes; those people may like a comp structure that appears to punish the Whale, but they’ll be less thrilled if that comp structure encourages other whales. “If you do a trade that is creepy and attention-grabbing enough, we will give you gobs of equity in it” will deter the risk-averse, but it will let the risk-lovers’ imaginations run wild.
Incidentally, the gurus on this topic, Credit Suisse’s comp structurers, have their own doubts about paying bankers in first-loss slices of their own cooking. Their new 2011 vintage Partner Asset Facility, wittily named PAF2, is as intriguing as the first 2008 PAF, and at least as regulatory-capital-aggressive, but it is not as aggressive-aggressive. Instead, it is a fixed-income, mezz-tranched thing where bankers get limited upside, and also limited downside, in a portfolio of investment-grade, capital-intensive, structurally complex, but not all that risky credit exposure. The goal is to dampen the vol of their compensation, to align their incentives not with those of shareholders – who should like risk and leverage – but with those of the broader group of bank stakeholders including creditors, depositors and regulators. Getting paid in structurally complicated but investment grade 6.5% paper isn’t quite the lurid gamble that getting paid in circa-2008 toxic MBS was. If you want a lurid gamble, you’ll have to look elsewhere – which should, in equilibrium, reduce the risks run at Credit Suisse, and increase them wherever “elsewhere” ends up being.
* The same applies with slightly diminishing force to the layers of people, up to Jamie Dimon, who supervised him: they presumably have a fair amount of confidence in their underlings, since they delegated hundreds of billions of dollars of responsibility to them.
** Though, unless Jamie Dimon was expecting a multibillion-dollar bonus this year, the shareholders will be keeping most of it.