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Dear John Thain

Dear John Thain

Posted: November 4, 2009 08:27 AM

One Year Later: The Post-TARP Questions We Should Be Asking

What's Your Reaction:

In the time since T.A.R.P. was enacted, there has been a lot of debate over how the government has done. Some of this debate, obviously, is difficult to truly judge -- what would have happened without T.A.R.P.? No one knows. What if we required different things of T.A.R.P. banks at the onset? No one knows.

However, while we can't decisively compare outcomes of choices that were made to alternative choices (certainly a double edged sword in a political debate), we can ask why certain decisions haven't even been tackled. In fact, there seems to be a huge deficiency in tackling very basic issues! Is there a legitimate reason to have not even proposed a solution to institutions being and/or becoming "too big to fail?" I can't think of one. Let's ask some of these questions.

1. How have we fixed the broken incentives at banks?

If we're being honest, the flash point of the public debate has always been compensation. And, by the way, not incorrectly. Consider this: the argument has always been that we need to honor contracts and that saving the banks saved us from a worse fate.

I generally buy into these arguments. However, how is it not fair to say to someone, "If we didn't step in and save your firm all the stock in it you own would have been worthless forever and you would have been out of a job. We saved your firm, but on the condition that you were paid no more than $250,000 while we own it ... Is that not more than the zero (even less, counting the devaluing of your prior stock compensation) you would have received without us?"

This reasoning is perfectly consistent, but instead we're told that that this "talent" (the audacity of that term, referring to people who were at the most broken institutions, is tantamount to lying and laughing at taxpayers at the same time) needs to paid millions or they will go elsewhere. I'll deal with this argument in more depth later (coming attraction: What have we done about institutions being "too big to fail?"). However, gently putting aside this argument (for a later thrashing) still provides us with a myriad of criticisms we can level at the administration for being totally incompetent when it comes to ensuring these sorts of problems don't occur again.

Now, as an astute reader of the news, you're probably wondering, "Hasn't the pay czar helped with this problem?" Well, I'll let the WSJ explain why you're misinformed:

Already, Citigroup Inc. is telling employees the net impact of Mr. Feinberg's rulings will be minimal because the cut salary will be shifted from cash to longer-term stock grants, said people familiar with the matter. (Emphasis mine.)

Whew! Thank goodness we're getting tough on the banks that were reckless! And then, it turns out Mr. Feinberg did the banks the favor of removing the risk from a large portion of their compensation: he boosted base salaries at these firms, fearing top employees might leave (I also fear a leviathan will crawl onto land and end life as we know it). For those unfamiliar with how Wall St. compensation works, the variable portion that can be cut on a whim without recourse is the bonus--by increasing the salaries, he increased the money that is guaranteed.

Regardless of the aforementioned actions, we still don't have a good answer on how firms will tie their own fortunes, in the long term, to that of their employees. Why won't a trader at Bank of America take a big risk hoping for a big payout? What recourse will shareholders and other stakeholders have when decisions made years ago cause problems today? None of these issues have been addressed on a systemic level. Nothing has been innovated to fix these problems and no action on the part of the government has dealt with excessive risk taking by individuals within the institutions that are now their wards. Although, its fine, I'm sure none of the people Mr. Feinberg is trying so hard to retain would ever make bad decisions that could put a massive financial institution in peril. Which leads me to...

2. What have we done about "Too Big To Fail?"

The one thing everyone seems to agree on is that institutions that are "too big to fail" are also "too big to exist." Not only has there not been any movement on solving this problem, but there isn't even a hint of a plan for the institutions that currently fall into this category.

These institutions need to be gutted, broken up, and sold. Instead, they are allowed to limp along and do whatever they can to continue to exist. For example, the argument about needing to pay employees large amounts of money so they won't go to other institutions is a symptom of this problem. Would these firms need to pay so much if they were stable? Why do we want people who can generate revenue sitting at a firm where they won't have capital to use? And, if they are given capital to use, is this how we want to risk taxpayer money, ensuring that star employees at failed institutions can take enough risk to justify their pay?

There's an extra layer to the problem as well, management is out of options. If you back an animal into a corner, it just attacks because it needs to get out of the corner to survive. A comparison, I believe, is apt. Now that the government has declared to the market that these firms are backed by the full faith and credit of the U.S. government, they have just facilitated more risk-taking. As a matter of fact, wasn't this why the government hand-picked replacements at A.I.G. and forced a management change? If you keep the old management, the incentives are for them to try to dig themselves out of the hole, and now they have an implicit government guarantee to help them take even more risk ("Hey, we're backed by the government! You know that it's not going anywhere!")

Further, why should any institutions slow down its own growth? History will dictate that, once a firm is large enough, it has to be saved--by continuing to pay millions and keep management, you're giving no disincentive for future firms. The government needs to put stiff rules in place that will prevent institutions from getting too big, and breakup the ones that exist now. Of course, everyone else agrees that's a good idea as well...

3. What is the administration's exit strategy... for T.A.R.P. banks?!

I know in other realms people tend to harp on the lack of an "exit strategy" a lot. Why not with the banks? If what we've seen actually occur is any indication, there can't possibly be a plan here, and that's not just disappointing, its dangerous.

If private industry has so much to teach us, according to the critics of "public industry," then we should take a play out that book and take aggressive action to get our investment recouped. Changing management, selling parts of these firms, and merging with competitors should, in essence, be forced upon these institutions. Indeed, this has already begun to happen organically at some institutions (think Ken Lewis and Bank of America).

I do not, however, take this non-forced action as a positive development, but a large, looming omen of bad things to come: if an investment firm purchased a distressed company and then waited around, without interfering, hoping that company would right itself... Well, I can't imagine their investors being too happy about their "buy and prey" investment strategy. In fact, I would say they were negligent, in the event anything went wrong--to have control and not exercise it is a tacit endorsement of the current course of action.

Dear John Thain writes the anonymous blog by the same name. His experience in the financial services industry includes extensive time in trading and working with securitized products. He is anonymous so that he can continue to provide an untainted insider's perspective and expertise on a myriad of topics.

 

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