Of Assets, Elevators and Money Velocity

"It is important where taxpayers have made a central contribution to make sure that taxpayer interests are being put first rather than those of shareholders and certainly rather than those of incumbent management and that's why Ken Feinberg is involved in reviewing compensation levels at the companies where the TARP has made the most major investments."---Larry Summers

When Congress doled out the Troubled Asset Relief Program money in last fall's crisis, it attached strings giving the government numerous ways to control the entities that were getting the money. At first, it sounds fair-any other lender would ask for controls for bailing out a company, wouldn't they? But most other lenders, hoping to get their money back, would want their borrowers to do everything they could to succeed. For example, they certainly would not sell assets way below their fair market value or drive talent away. Would they?

Recently, the Pay Czar struck again. Kenneth Feinberg sharply reduced the overall pay of senior executives at banks and other companies with outstanding TARP loans. There are two kinds of assets in a bank. On the one hand, there are securities, buildings and equipment. On the other hand, there are the assets that go down the elevator every night. These are the bank employees, the ones with their future currently tied to the bank, but who can go across the street.

But what do you do if your star trader, who made you most of the $ 667 million commodities trading profits reported in 2008 when it was so desperately needed, is contractually entitled to $100 million as his cut for his work? What if he worked at Citibank?

The Pay Czar recently induced Citibank to sell Philbro to avoid embarrassment over a top trader's contractual pay. Yet Occidental Petroleum stole it for $250 million, about book value, and an extremely cheap less-than-one year payback. Philbro has historically excelled at trading commodities. What are the chances that skillful commodities trading will be even more highly valued as the government prints money creating inflation risk?

So when Citibank was forced to choose between holding on to perhaps the best counter-cyclical asset it had or making its pay scales cosmetically consistent, its government overseer induced it to sell the cash generator. Whatever was saved in wages was far outweighed by the loss of enterprise value. This is good for appearances when you are waging class warfare, but lousy for getting your money back as a lender. Ironically, it also resulted in many bankers' pay having a bigger component of salary making it less tied to performance and more like Congress' pay, which is completely divorced from whether America is doing better.....or worse from their efforts.

The Pay Czar said today he "doubts" cuts will make bankers leave. But when bank employees go down the elevator, they know that if they have the slightest foot fault, it could be "off with their heads." No wonder 11 of the 25 Bank of America employees left before Feinberg could take a whack at them.

Meanwhile, the pay committees can reduce bonuses, and the Pay Czar gets a second whack. Life becomes tough to plan. And those that remain employees pull in their horns, keep their heads down, and contribute to the slowdown. To avoid risk at the bank, consumer loans are off. Sharply. Commercial real estate loans are down. The private securitization market for loans is a shadow of its former self. While the Fed has doubled the money supply, all the inhibitions on bankers have helped to slow the velocity of money to a crawl. So the conflicting forces creating inflation and deflation rise in intensity, increasing the chances of a volatile outcome.

The problem with the Pay Czar is that he shows that contracts don't mean a thing. What's worse is he is not acting alone, but doing the bidding of Congress, which is imposing punitive pay cuts that will have the net effect of driving talent out of the companies that need it so badly. So now we know. Good results will be tossed overboard if they don't fit into the class warfare kabuki. While this is done in the name of protecting the taxpayer, it's really for purposes of finding a whipping boy to help re-elect Congress.

A real lender would want the bank to be worth as much as possible, and understand that if you drive the smart guys out and show contracts don't mean anything, you will poison your institution, and damage its value. If its value is damaged, your loan won't be repaid. In a world where your boss's word means nothing and your compensation is at more at risk, you will become demoralized, and will reduce your lending commitments. So the velocity of money slows down, and the crisis of confidence is renewed. That is the most likely result when the short term re-election interests of a posturing Congress are put first, far ahead of the taxpayers' and shareholders' long term needs to re-build bank value.