We've noticed that some of the most vocal critics of financial industry pay are those who used to work at investment banks. We're not sure why this is - maybe the former bankers know how grossly overpaid their ex-colleagues are, or maybe now that they've gotten their money they want to pull up the ladder so that their Hamptons vacations aren't spoiled by crowds of current bankers.
That question came to mind as we read yesterday's editorial in Bloomberg by William Cohan, former Lazard and JPMorgan banker and current advocate of killing bankers for their pelts. Cohan wants to end the "moral rot" in banking and get back to basics. Some of his suggestions are standard, like a vague Volcker-Rule-Glass-Steagall “Close the Casino” prescription. But more interesting is this:
We could start by creating a new security that represents the entire net worth of the top 100 executives at the remaining Wall Street companies. These people decide what business lines to be in, how to deploy capital, who to promote and how much to pay. This new security would be at the bottom of the corporate capital structure -- below corporate debt and shareholder's equity -- and would be the first asset to be wiped out if the company performs poorly. This would ensure that today's Masters of the Universe are focused on the risks their businesses are taking.
We’re not totally clear on what this means but we guess Cohan wants every top banker to have 100% of his net worth invested in a sort of subordinated common stock of his company, which in bankruptcy is only paid after common shareholders.
The idea that we need to return to the days where banks had unlimited liability is not new, and calls for bank CEOs to have most of their money in their employer's equity - like Dick Fuld did! - predate the crisis. Cohan is mostly new in calling for it to be subordinated equity. It's a bad idea for lots of boring obvious reasons. Like, for instance, recruiting: anyone who would invest 100% of their net worth in any common stock is probably not someone we want running a bank.
But it’s also a bad idea in an interesting way. As we saw with Brian Moynihan last week, compensation schemes ought to be designed so that executives to have incentives to work for all their constituencies. Mostly you want them to own stock because their first obligation is to stockholders. Sometimes you might want them to own debt claims, because there are cases when executives should dilute shareholders to preserve debt claims even when as pure shareholders they'd rather roll the dice and increase risk. Other incentives also align them with stakeholders - CEOs have to think about employee happiness because otherwise people will be mean to them in the elevator; they have to think about regulator happiness because otherwise they'll get sent to jail or at least a Congressional hearing.
That's why Moynihan's debt claims on BofA were interesting - they gave him good incentives to raise capital if necessary to protect creditors. Cohan's proposal does the opposite. Putting bank CEOs entirely into subordinated equity should have the effect of *increasing* the desire for risk.
Consider a bank with this capital structure:
-Debt - $90 billion
-Equity - $8 billion
-Superequity - $2 billion
Arguably the superequity-holding bankers have a really strong incentive to be really conservative, because that $2 billion represents their entire net worth and any losses can wipe it out. So it seems that Cohan's approach works and encourages conservatism.
But even a conservative bank can suffer losses, say because rates go down and this boring NIM-driven bank has margin compression. Let's say the bank loses $2 billion, leaving it with zero super-equity and still $8 of equity. If the equity trades at book value (not crazy to assume for the kind of boring bank that Cohan wants), then where does the superequity trade? The answer isn't zero. Instead, the superequity is worth some positive value based on the prospects for the equity recovering. In other words, it's an at-the-money call option on the equity.
And call options go up in value when volatility is up. So any losses are going to incentivize bankers - particularly in banks that have recently lost money - to increase risk in order to maximize volatility and increase the value of their superequity stake. It's true of all "put all their wealth in equity" proposals to some extent, but it's amusingly exacerbated in this one.
In any case, as if this wasn’t enough of an obstacle to recruitment, Cohan wants another one:
Cut Wall Street pay at least in half. The compensation is obscene and unjustified, especially now that almost every company is publicly traded. What other publicly traded businesses pay out to their employees between 50 and 60 cents of every dollar of revenue generated? None.
Wait, really? This again is a popular line of inquiry in the media. Which we think is kind of fun – because when someone asks “what kind of a business pays 50 to 60 cents of every dollar of revenue to its employees,” the answer is of course businesses with low fixed costs that make money by selling the intellectual work of their employees. Like banks. And ... media companies.
Bloomberg, where Cohan published this, isn't a public company, but Thomson Reuters is a reasonable comp, and last year it paid $5.17bn in staff costs on $13.07bn in revenue, for a 39.6% comp ratio. Goldman's was 39.3%.
Ending the Moral Rot on Wall Street, Part 2 [Bloomberg]