An Update on the “Mini-TARP Employee Bonus Pool” Idea

Good Evening: Since Monday’s commentary, U.S. stocks have swooned and jumped without much to show for it. Sure, they went down by more than 1% on Tuesday and up by a similar amount today, but the major averages are just about back to the closing levels posted on Monday. Yesterday’s retreat was in part blamed on high profile bank analyst, Dick Bove, and his advice to take profits in the financial sector. Today’s move higher was widely credited to some earnings news and the FOMC’s attempt to construct a Goldilocks-like view of the economy. This herky-jerky price action may be summertime noise, but it may also represent a signal that the S&P is struggling with the 1000 level. But no matter where stock prices head for the rest of 2009, we would all be better off if more firms followed Credit Suisse in moving risky assets into the employee bonus pool.

Though stocks in Asia were once again on the defensive overnight (watch this space), U.S. stock index futures were fairly directionless this morning. The trade deficit figures came in about as had been expected, but some positive earnings news put market participants in a better mood. Applied Materials’ results boosted sentiment in the tech sector, while raw materials names were bolstered by a weaker dollar. Similarly positive news from Macy’s and Toll Brothers had the same effect on retailers and homebuilders. With so many sectors thus on the rise, equities shot higher at Wednesday’s open and really never looked back.

After rising between 1% and 2% in early trading, the major averages settled into a sideways range until the Fed announcement. Given how many different constituencies the FOMC was trying to please, I’m sure our central bankers felt a small sense of pride as they watched the markets react to what they conjured up for the press. Stocks initially fell (too cold), then rose to new highs (too hot) before closing just about where they were going into the release of the statement (just right). Goldilocks herself couldn’t have done a better job, Mr. Bernanke and the other governors must have thought as they watched the averages finish with gains between 1.2% (Dow Transports) and 1.8% (Russell 2000). Treasury market participants were less welcoming, but at least maturities on the short end were flat even as yields on the long end of the curve rose 5 to 10 bps. The dollar finished 0.5% lower, and commodities rallied. The energy complex shrugged off rising inventories and gains in that sector propelled the CRB index to a gain just north of 1% today.

The text of the FOMC’s statement can be found below, but the Fed attempted to play Goldilocks with this announcement. Worried about the economy? It’s “leveling off”, says the FOMC. Concerned that the Fed will abort any recovery by raising rates too soon? Short term interest rates will hug the ground for “an extended period”, says one soothing passage. Does the threat of too much quantitative easing and the potential for inflation keep you up at night? Not to worry, says our central bank; the Fed will gradually scale back its QE asset purchases until the stop entirely in October. As for inflation, “the Committee expects inflation will be subdued for some time”.

Despite the obvious attempt to get it “just right” for everyone, it’s this last bit of assurance on the inflation front that many will find hard to trust. The Fed wants investors to think it has their back should prices eventually start rising, but I think the FOMC’s spine will turn into rubber when it comes to inflation fighting. Ben Bernanke’s own playbook (his past speeches) for a recessionary credit contraction calls for a whiff or two of inflation, so why should this episode be any different? To me, it looks as if the Fed is merely posturing in the hope that inflation expectations don’t start to take root and make its job even tougher than it already is. The real possibility the Fed will be all talk and no action when it comes to inflation is one of the reasons I’ve been positively disposed toward precious metals and their related equities since I began writing these commentaries almost seven years ago. That John Paulson and Steve Leuthold seem to agree shouldn’t really matter, but it’s nice to see (see below).

Speaking of past commentaries, I was very heartened last December to see Credit Suisse move toxic credit assets off their balance sheet and into the employee bonus pool. I felt they were setting an example that could be copied by other large financial institutions as a way of better lining up the risks and rewards of financial engineering by the quants, sales forces, and managements on Wall Street. The idea never really went anywhere, but Credit Suisse has just put out an update that shows employees can do well by doing the right thing (the assets in the fund have risen 17% this year — see below). Here’s what I wrote back in December:

“One small source of optimism on this front came from last week’s announcement by Credit Suisse that it would move some troubled assets off its books and place them into a pool funded by employee bonuses (see below). Securitization, the process of pooling income producing assets and issuing layers of interest bearing liabilities against them, took flight until mid 2007. One of the flaws inherent in the securitization process is that middle men between mortgage borrowers (homeowners) and their lenders (the capital markets) didn’t have a stake in the risks they were bundling and peddling. By effectively shifting some of these troubled assets off their balance sheet and into the employee bonus pool, Credit Suisse has perhaps offered a clever (if only partial) solution to what currently so ails many financial institutions. The details (i.e. pricing at transfer) still need some work, but this solution essentially is the old TARP — writ small. Think of it: formerly “toxic” assets move off the CS balance sheet and are replaced by the cash once set aside for employee compensation.

“Voila! CS cleanses its balance sheet and employees get a stake in a long term pool of assets for which “marked to market” means little. Aside from helping to heal the bank, Credit Suisse is in fact also helping to return some appreciation of risk among its senior employees by mandating the retention of said risk among those who previously received bonuses for creating these securities in the first place. It’s brilliant. The publicly funded TARP Wall Street once clamored for can now be a product of their own, private creation! Never has force-feeding senior employees a heaping helping of their own cooking been such a good idea. Of course, this laudable example won’t matter much unless other banks copy Credit Suisse and set about cleansing themselves in similar fashion. Then again, as the credit crisis of 2008 proves only too well, aping one another is a Wall Street tradition. Maybe there is hope yet!” (source: Comment 12/23/08)

It’s sad on many levels that more firms have not followed the example set by Credit Suisse last winter. Financial firms have been yelping (through their mouthpieces, the D.C. lobbyists) that they can’t afford to retain a small piece of the deals they underwrite because it would tie up scare capital. Enter the employee bonus pool. Shareholders (and, by extension, the taxpayers backstopping the large firms) shouldn’t be on the hook for these deals; the employees should bear these risks — not just the rewards.

All these firms have to do is dedicate a goodly portion of the cash set aside for employee bonuses for this purpose. The beneficial side effects will be higher underwriting standards and lower systemic risks. Who knows? As Credit Suisse has shown, the employees might even make an extra nickel or two with this form of forced saving. And, in the name of Adam Smith, wouldn’t it be nice if the sharp-elbowed crowd on Wall Street started feeling compelled by an invisible hand to start competing over who could underwrite the best deals that land in the employee bonus pools? Linking rewards received to risks taken may remain a dream, but Credit Suisse has shown it can make for good policy.

— Jack McHugh

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