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Maybe Bank Stocks Are Down YTD Because That's How Bankers Want It?

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We've talked before about the theory that paying investment bankers in stock gives them an incentive to maximize the volatility of their businesses, which is a thing that some people don't want so much. This starts from the notion that in a 10 or 20 or 30:1 levered bank or broker-dealer or futures merchant, the bulk of the money at risk belongs to the creditors, whether unsecured or depositors or repo or ex-wives or whatever. So it's plausible to think of the equity as an at-the-money option to buy the assets from the creditors. And as any Level I CFA test completer could tell you with approximately 70% probability, the value of an option increases with volatility. If you own the equity in a bank with $29 billion in debt and $1 billion in equity market value, then you'll prefer equally likely payoffs of [$25, $35 billion] to payoffs of [$29.99, $30.01 billion], because the higher volatility payoff increases the expected value of the equity (which, after all, can't go below zero). If, however, you are a creditor of that firm, your preferences are the opposite.

This is all pretty straightforward and orthodox, and it probably ought to inform how you think about the incentives to bankers from owning their bank's equity, and if you think that way then maybe you come up with ideas like "pay them in CDS" or whatever. On the other hand this theory shouldn't be taken too seriously. When your entire net worth is in Jefferies stock, "the equity can't go below zero" isn't all that comforting.

But it's worth remembering that incentives from owning equity are not exactly the same as incentives from being paid in equity: people who have a lot of stock feel different from people who stand to one day get a lot of stock. That's the interesting takeaway from this weekend's DealBook piece about the fact that bank stocks sometimes go up. (And sometimes they don't.) For example:

In 2009, JPMorgan Chase gave out 131 million shares of restricted stock, with an average price of less than $20 each. As the stock rose the following year, the company paid out 80 million shares, with an average price of almost $43 a share. On Friday, it closed at $32.33.

Exact numbers here (p. 211) and here (p. 185): 2009's RSU comp expense was about $2.6bn on 131mm shares; 2010's was $3.4bn on 80mm shares. Today the '09 grants are worth $4.4bn, the '10 grants are worth $2.7bn. So 2009 was a worse year with lower comp expense, but the RSUs distributed then are worth more than the higher-nominal-valued RSUs paid in 2010.

A way to think about this is that, really loosely speaking, banks dollar cost average their stock-based compensation. That is, they pay out roughly the same value of restricted stock each year, which means more shares in bad years than in good years.* The internet will tell you that dollar cost averaging "reduces volatility" or something, but I'm pretty sure that the people giving and receiving these comp packages understand that it is a long volatility strategy: the more volatile the stock, the more valuable dollar cost averaging is.**

So if you know (1) you'll get paid in stock and (2) you might be there a while, your incentives to create volatility are even greater than if you just have a lot of stock. And whereas the options-theory model of executive stock ownership leaves you with sort of a vague theoretical bias for risk, but also with a preference for positive-expectation value-enhancing risk, the dollar cost averaging model of executive stock compensation leaves you with a direct and practical bias for actually lowering the firm's value. Which is the sort of thing that just comes out of theoretical models but would never be true in the real world, because getting paid in stock wouldn't actually cause bankers to want to reduce the value of their firm, right? Right, Dealbook?

One senior bank executive says he comes in every day “praying” the stock price of his firm does not go up before bonuses are handed out early next year.

“It is all anyone is thinking about,” the executive said on the condition of anonymity because he was not authorized to speak to reporters.

Yes, because he was not authorized to speak to reporters. Also because it sounds bad when a "senior executive" says "I don't want my company to do well this year, and I think I speak for everyone here when I say that."

Modest Bonus Year on Wall St., but Stock Could Yield Fortunes [DealBook]

* Not literally, but you get the idea. Banks don't pay the same amount of comp every year, but their compensation expense is usually going to be less volatile than stock price, and that the stock-based portion of that expense is going to be even less volatile than the aggregate number since in bad years they pay more of the total in stock.

** Probably obvious but if not consider:

The right hand side is better if you got the stock, worse if you're, like, Dick Bové.