How About a Leverage Cap in Lieu of a Pay Cap?

Good Evening: U.S. investors worked themselves up into a pretty hopeful mood this morning, but reality set in this afternoon and led to a down day in Wall Street. Instead of hearing more details about whichever plan the Obama administration might now be leaning toward, market participants were instead treated to a parade of stories of heightened regulation and caps on compensation. Perhaps part of today’s decline can be chalked up to cautiousness ahead of Friday’s employment figures, but investors went home in a sour mood nonetheless. I think investors would rather see a cap on leverage levels of Wall Street balance sheets rather than one involving employee pay levels.

Overseas stock markets and U.S. stock index futures were higher heading into this morning’s trading. This morning’s economic figures took a little shine off this rally, and the Challenger job cut statistics were the first of what turned out to be many reasons to take profits. At 241,000, the number of layoffs announced in January was not only more than expected, it was more than a threefold increase versus the year ago totals. Mortgage applications were also weak, setting the stage for the latest unemployment estimates from ADP. Having tweaked their model just last month, ADP made it difficult to assess whether their estimate for 522,000 job losses in January was a positive or a negative. Either way, the disappearance of 500K+ jobs would be welcomed only by those fearing even worse news on Friday.

On the earnings front, Kraft, Costco, Disney, and Time Warner all reported disappointments of varying degrees. But buyers emerged at the NYSE, anyway, and the major averages were up more than 1% shortly after trading commenced. A better than expected ISM services survey (42.9 vs. a consensus of 39) helped push prices a little higher, but that was it for the upside. A call from the Obama administration to limit compensation for Wall Street employees didn’t sit well with market participants, many of whom work in the targeted institutions. Stories about lending requirements for TARP recipients didn’t help, and neither did calls for the most sweeping regulatory changes since FDR (see stories below).

Stocks began to drift lower into the lunch hour. The selling grew a bit more urgent once the S&P 500 crossed the unchanged mark, however, and even a final hour rally attempt failed. The major averages closed with losses ranging from the NASDAQ’s negligible 0.1% to the Dow’s more noticeable 1.5%. Treasurys also gave some ground as yields rose between 1 bp and 5 bps. The dollar clawed back roughly half of yesterday’s drop, with the dollar index rising 0.75%. Commodities didn’t make much headway today, though. The energy and agricultural sectors were mixed, so only a gain by the precious metals enabled the CRB index to post a modest 0.3% gain.

Investors would like nothing more than to hear the Obama administration come out and propose bold actions to help the banking system get back on its feet. Our President has shown patience thus far, preferring to craft a whole package in favor of offering ad hoc “solutions”. I wish him well, and while it may be unfair to criticize him prior to next week’s big announcement, I think he’s making a mistake in trying to limit Wall Street compensation. I have no problem with our government setting up (and, more importantly, enforcing) a sensible regulatory regime for financial institutions. But targeting leverage levels among the “too big to fail” crowd would be a better way to approach the issue.

Firms employee people, and Homo sapiens is a species with a tendency to make mistakes from time to time. Rather than micromanage each aspect of how Wall Street conducts its business, I would urge Washington to simply put firm leverage limits in place for each institution. Somewhere between 10x and 15x makes sense to me, and I would include off balance sheet transactions in this calculation. A leverage cap limits the impact of the mistakes that future bankers will inevitably make, and a system of this type might prevent the impairment problems of the few from becoming the systemic problems for the many.

An added bonus would be that the less turbo-charged banks would likely generate lower returns, which, in turn, would act as a natural cap on employee compensation. And finally, “macromanagement” (a phrase I’ll coin to describe this concept of a leverage cap) would be a lot easier for the SEC to enforce than a complex web of new regulations. As you’ll see from the final story below about the SEC’s inept handling of Bernard Madoff over the years, the SEC is in no way ready or able to micromanage the Street. If the SEC can’t unravel a simple Ponzi scheme after repeated warnings, how can we expect them to regulate all the complex transactions handled every day inside our vast banks? Let’s just cap the leverage instead. The rest will take care of itself.

— Jack McHugh

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