Good Evening: As 2009 dawned, most investors held out the hope that our capital markets could hold together or even rally into today’s inauguration of President Obama. Conventional wisdom being what it is (i.e. too conventional), it should come as no huge surprise that, a mere three weeks into the new year, the S&P 500 now sports a double digit loss in 2009. The culprits (the banks) remain the same ones as in 2008, highlighting the need for not only change but also for creative solutions to our escalating financial problems. I humbly suggest a matching gift program is one such possible solution.
While U.S. markets were closed yesterday in observance of Martin Luther King Day, markets in Europe were hit when continued woes at RBS and other U.K. banks moved that nation ever closer to a full nationalization of its banking system (see below). The heightened scrutiny of U.K. financial institutions moved across the pond this morning when State Street dropped a bombshell on its stockholders (see below). STT previously held itself out as a different kind of bank, one involved mostly in money management and thus immune to most credit issues. The truth caught up with this Boston-based behemoth in the form of 59% hit to its stock price today, and the drop put pressure on its peers. Citi, Wells Fargo, and Bank of America were all hit for 20% or more, and the KBW Bank index dropped to levels not seen since the last great banking crack up in the early ’90’s.
Unfortunately, the undertow in the banking sector more than offset any wave of good will generated by Mr. Obama’s inauguration speech. Down 2% to 3% at the open, the major averages went sideways until most of the festivities in Washington were over. Once Mr. Obama signed off, the averages went into a slow and persistent tailspin that didn’t stop until the bell rang. The Dow (-4%) suffered least, while the Russell 2000 (-7%) was thumped the most. Oddly enough, Treasurys displayed little of the flight to quality that has consistently lifted them since mid 2007. Yields on the short end of the curve retreated a bit, but the long end saw yields rise as much as 10 bps. 2’s to 30’s steepened 12 bps, perhaps in anticipation of having to stomach all the spending being eyed in Washington. The only truly patriotic reaction to Mr. Obama’s swearing-in could be seen in the currency markets, where the U.S. dollar rose against all but the Japanese yen. The euro, for example, was tagged for a 3% loss, while the British Sterling took a 5.6% pounding. Commodities as an asset class were not spared the lash, though it should be noted that both crude oil and gold managed decent advances. The CRB index fell 2.4%.
Warren Buffett has probably offered more opinions and given more market advice to the public during the past 18 months than he had during the previous 18 years. His latest view is that the U.S. is in the midst of an “Economic Pearl Harbor”. Ever the optimist, Mr. Buffett sees our country eventually coming out of this crisis, saying, “it’s never paid to bet against America” (source: Bloomberg article below). Merrill Lynch, however, thinks this process will take years and that even Mr. Obama’s massive stimulus package will “do little more than provide a cushion to the blow the financial crisis is dealing the U.S. economy” (source: Merrill piece below). Other than offering that any healing will take time, neither of these viewpoints offers up much in the way of solutions for our financial ailments.
I would like to propose at least a partial solution, one that brings together the next round of TARP funding with an idea first proposed by Credit Suisse back in December and endorsed by this author at that time. To use a phrase that might appeal to the incoming administration, let’s create a hybrid of the CS idea and turn the TARP into a “matching gift program”. In its original form, the TARP was conceived to buy troubled assets from financial institutions, and I propose that at least some of the next $350 billion be spent in this manner. Rather than haggle over what prices should be paid for what financial instruments (which, as Hank Paulson discovered in October, is fraught with hazards and doomed the first $350 billion to be little more than a huge collection of bank C.D.s paying 5% to 8%), I believe we can let the prices be initially be determined by the banks themselves. Mr. Market will decide thereafter.
Before anyone hits the reply key with an angry riposte, let me say that the key lies in the Credit Suisse bonus pool plan I described back on December 23 (see: http://www.ritholtz.com/blog/2008/12/creating-mini-tarp-bonus-pools-would-help/). Recall, please, that C.S. proposed to set aside a large portion of its employee bonus pool as a fund to buy toxic assets from the bank. By itself, it is an elegant, though only partial, solution to moving bad assets off of bank balance sheets. But what if we broaden this concept by requiring any bank that has received TARP funding to set up a similar employee bonus pool? We could then turbo-charge the process by offering matching funds from the TARP to pay the same price for the bad assets that the employee bonus pool pays. TARP could match such funds on either a one to one, or even a two to one basis to provide true buying power in removing problem loans and goofy structures off bank balance sheets. If you think these bonus pools are small potatoes, think again; they represent the lion’s share of employee compensation at these firms and usually are the largest expense in the income statement. It is widely accepted that matching gift programs tend to engender more generosity, so let’s harness this force for the high purpose of rescuing our financial system from itself.
What makes this plan work better than the original TARP plan is that the banks will have self interest in choosing a proper price for the assets purchased by their bonus pools and their TARP partners (i.e. us). If the banks try to low-ball the price of assets destined for their bonus pools, then taxpayers will also benefit from the cheap prices and high future returns generated by these assets. If the banks pick too high a price and try to stick it to the taxpayers, then they are also sticking it to themselves by having their bonus pool pay the same high price. Though somnambulant in previous years, perhaps some of the independent directors on each firm’s board could oversee the process of determining a range of possible prices for each pool of tendered assets.
In addition, I would hope than any attempt to “claw back” previous bonus money from bank executives be sent to this same bonus pool cum TARP program. Instead of sponsoring legally dubious witch hunts, our regulators should ask that previous bonus payments made to top executives be used to buy up the troubled assets generated on their watch. Such a provision is not “fair”, but neither is it fair that these characters endangered our financial system and made tens of millions while doing so. Chipping in, say, 50% of their 2006 & 2007 bonuses is the best way to make the senior executives who should have known better pay up for their poor judgment. Besides, they’ll make it all back if the assets are as good as previously advertised to clients and shareholders. And please don’t tell me that each bank’s employees will bolt upon being required to join this scheme. Given the choice, and given short vesting periods, employees would much prefer a stake in these assets to the current cram-down equity programs already set aside for huge portions of their bonuses. They’ll welcome the diversification — just ask any LEH or BSC alumni. It’s over-regulation and/or the dilution created by the TARP thus far that are the real enemies of employee shareholders. Absent a plan like this one, more of both are most certainly on the way.
Yes, this idea can work. Employees, shareholders, and taxpayers will all shoulder similar burdens and should all receive similar outcomes. At once employing the carrot (no further dilution) and the stick (either a lot more regulation, no more TARP funding, or both), my plan is a marriage of Adam Smith’s invisible hand and the visible fist of government. Main Street will love this program, too, since taxpayers want to see Wall Street finally be forced to eat what they ill-advisedly cooked up. Taxpayers might even feel like “insiders” instead of feeling like the open-walleted chumps they’ve been until now. The average person will therefore understand this plan and will likely give it a chance to work under a new president. Heck, if the “TARP matching gift program” works, we can later dump the whole thing, gains and all, into Social Security.
— Jack McHugh