Changes In The Structure of Commercial Mortgage Backed Securities Transactions

It was reported in Law 360 (May 6, 2014) that there have been some significant changes in the way CMBS transactions are structured.  In the hot CMBS market prior to 2008, standards and due diligence became, shall we say, a bit slipshod.

The United States CMBS market all but dried up in 2009 as issuance totaled less than $3 billion in 2009, down from more than $200 billion a couple of years earlier. Needless to say, investors had grown more cautious. Since that time issuance has grown steadily and the first quarter saw issuance of more than $20 billion according to the Pension Real Estate Association.

But things have changed materially. The structure of deals has become much more conservative. Some old methods are being redeployed to make the financing more secure. For examples, underwriters are requiring cash management accounts (CMA)  to control the flow of cash, less creativity is being employed in packaging the loans. Loan-to-value ratios are still a lower levels than was the case before the crash. But as the number of deals start to increase again, it remains to be seen as to whether the deal structuring teams will become more aggressive again.

Here follows some of the changes in deal structure that have, for the time being, survived more aggressive structures.

Lenders, in search of more security, have been insisting on CMAs to be associated with the loans. The concept is pretty simple, rather than the cash going directly to the borrowers (mortgage receipts, etc.), cash management accounts are the first stop. This “bullet proofs” the structure avoiding any third parties getting their hands on the cash before the lenders.  Nothing new here but in the “old days” these structures were deemed unnecessary and redundant.

“One thing that we’re seeing now that we did not see pre-2007 is cash management is required in almost every deal. On the biggest deals where you would sort of expect it, down to the smaller deals.,” said Stephen P. Lieske of Allen Matkins Leck Gamble Mallory & Natsis LLP.  “Virtually every CMBS deal is requiring cash management. Cash management seems to have become the norm. .. It’s lenders saying, “We want to maintain a bit more control over the money”.

Each deal will likely have a different cash management structure. In many cases, the lenders will not touch the funds in the CMA unless a certain triggering event occurs such as a covenant breach.

The lenders are looking for more control. The concept was called a “lock box” in past banking times (10 years ago). Th cash management structures will now be in favor of the lender, protecting them from loss as much as possible.

Lawyers have seen less creativity in deals. Less “pushing the envelope”. Lending guidelines are being more strictly followed. Structures are more conservative. With the caution comes closer examination of individual properties (a sound practice you would have thought for commercial real estate lenders). Clearly the underwriters have felt the pain associated with the underwriting standards in 2008 and prior,” Loeb & Loeb LLP’s Thomas F. Hanley said. “They are much more closely scrutinizing each loan transaction. It’s brought more sanity into the process.”

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Another part of scrutinizing the individual transactions is doing more research on geographical markets. Although prior to the crash, such research wasn’t necessarily made a priority by any stretch. It’s now a more important part of lender due diligence.

“I’m seeing significantly more prudent underwriting,” said Matt Case of Madison Partners. “Much more emphasis on the market that the properties are in…I’m seeing much more diligence.” Unfortunately that was not the situation a few years ago. “Any underwriter could grab some figure. They never really dug into the nuance of the market,” Case said. “Whatever the case might be, as long as they could get a few data points, it wen through approval. ” “CMBS lenders are being smart, Lieske said. “CMBS lenders are being careful about what they are doing. What I’m seeing is an awful lot of thought going into each of the deals.”

Documentation has become more complex. In particular, the number of so-called bad boy carve-outs-exceptions to the non-recourse nature of the loans has grown considerably. This has trickled down to smaller loans.

And lastly, loan to value rations remain lower than pre-crash.  It now ranges around 70%. Some go to 80% but the deals are more complex. Mezzanine financing fills the gap. This was unnecessary prior to 2008.  Unfortunately greater competition for these deals seems to be swinging the pendulum back.

Hopefully we will not go back to the “not guts, no glory” days prior to 2008. But somehow I doubt it. We seldom learn and greed trumps caution. It comes back to the same issue, lenders need to be more prudent and exercise greater due diligence before pulling the trigger. The problem is that no one gets paid for saying no. No one has really satisfied me that at the “top of the house” doing deals is far more important than saying no. No bonuses and no promotions will come in the absence of booking deals. One issue that still needs to be looked at very carefully is whether the banks and investments banks not withstanding new rules and regulation have to much “lazy capital” above and beyond the regulatory capital requirements. I would venture to say that major financial institutions prior to 2008 were long capital and short investment opportunities. There is little reward for having low risk weighted low return assets on the books. No matter what happens the bills are never paid with prudent lending. The organizations all have bills to pay. Low return low risk assets may in many cases simply not generate enough cash to keep the lights on and feed all those that need to be fed.

Financial institutions in order to attract capital must generate ample returns on equity and returns on assets. Absent tat, CEOs will no be generously compensated for a falling or stable stock price. Let’s get real. We still live in a primarily capitalistic society with capitalistic imperatives. Growth. The problem has from time to time been growth at what cost. It all goes back to each organizations corporate strategy and mission statements. It would be useful to go back and look at what AIG’s and AIG Financial Products’ corporate strategies were. I would suspect that prudence was not high on the list. A discussion worth having at another time. Large financial institutions, especially those taking deposits, have a fiduciary responsibility to their depositors. Why was no one held accountable for the breach of those fiduciary responsibilities?

So stay tuned to this space and let’s see what happens in this robust stock market environment.  Will banks and investment banks be able to resist their old ways or will they find new (old) way to get where they need to go. I think that in the end we will go back to “too big to fail” to eventually save those who should not be saved. To this day, the perpetrators of the enormous losses suffered by investors have walked away “Scot Free” in almost all cases. In the absence of those who brought us there being forced to disgorge the fruits of their “labor” not much will change. Why should it?

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Green Tree Financail Corporation-A Classic Failure

I was recently read a free chapter from a book called “Billion Dollar Lessons” written by Paul B. Carroll and Chunka Mui. These two gentlemen have a consulting firm specializing in corporate strategy aimed at avoiding acquisition disasters. The chapter that they offer from their textbook is called “Faulty Financial Engineering.”

The view that they put forward is that financial engineering is toxic. The position is supported with quotes from Warren Buffett and other notables. Why is financial engineering toxic?

I first became involved in financial engineering is the early 1980s when I worked for Citibank Canada. The bank had just started up Citicorp Investment Banking. Markets were opening up and the banks were challenging the Glass-Steagall Act. The term Glass–Steagall Act usually refers to four provisions of the U.S. Banking Act of 1933 that limited commercial bank securities activities and affiliations within commercial banks and securities firms. Congressional efforts to “repeal the Glass–Steagall Act” referred to those four provisions (and then usually to only the two provisions that restricted affiliations between commercial banks and securities firms). Those efforts culminated in the 1999 Gramm–Leach–Bliley Act (GLBA), which repealed the two provisions restricting affiliations between banks and securities firms. The GBLA was a watershed event in contributing to the financial crises that followed perhaps facilitating the occurrence of those events.

When I was involved in financial engineering the objective of the game was still to add value to the client. The goal was to achieve certain client objectives in the financial realm.

Around that time Salomon Brothers and others structured the first cross currency swap. The swap was structured to allow the counter-parties to achieve certain risk management objectives. Swaps were a corporate finance tool, not a traded instrument. In 1981 IBM had a large amount of Swiss Franc and Deutsche Mark debt. At the same time, the World Bank wanted to borrow in Swiss Francs and Deutsche Marks. IBM was facing a rather substantial amount of currency risk. The Swiss government had limited the World Bank’s access to the Swiss Franc debt market. Because of the interest rate differential between funding in US Dollars and Swiss Francs, the World Bank would have liked to borrow in Swiss Francs. So after much time and effort, Salomon Brothers engineered a swap transaction between IBM and the World Bank to help them both achieve their financing/risk management objectives. The transaction was arranged to meet a specific need.

As markets evolved, swap transactions were commoditized. The need rational seems to have disappeared and the banks transformed swaps into a tradable and trading instrument while further broadening the product. With the amount of financial leverage (minimal capital required to support the product) and the high returns on an ROE basis, the market exploded in the late 1980s. (Another topic worthy of further exploration. The amount of capital required to support swap and other derivative transactions and structures was reduced over the years). The chapter’s title is “Faulty Financial Engineering.” So their objective is to look at a number of firms that crashed and burned as a result of aggressive “financial engineering” mostly on the financing side of their businesses. The authors look at the demise of Green Tree Financial Corporation (GTFC) and attribute it to faulty financial engineering.

Let’s go back to square one. Remember that financial engineering is defined as “combining or carving up existing instruments to create new financial products.” Nothing inherently devious here. It has gone on since the first financial product was developed-money.

The authors go on to say that GTFC’s first financial innovation was offering a thirty-year mortgage instead of one with a fifteen year term that was standard at the time for a mobile home. An “innovation” is a “new idea, method or device”. I guess it was a new idea to this particular market, not an innovation in and of itself. The collateral or security that GTFC took to secure itself were mobile homes. Most in the business at that time and now presumably knew that these assets were depreciable property. Unlike residential real estate, these were assets that had a shorter economic life than the financing that was being offered by GTFC.

The authors further criticize GTFC implicitly as the borrowers were generally unsophisticated and only looked at the monthly payment rather than their total indebtedness when entering into the financing. This had serious implications for GTFC at a later time. The reality is that the entire leasing industry is based on this premise when it comes to consumers. A smaller monthly payment is what attracts many to car and equipment leasing. Nothing really new here and certainly nothing unique to GTFC.

Their next stop is an analysis of the financial engineering involved in the funding of these assets by GTFC.

But let’s pause for one minute here before we move on to GTFC’s funding model analysis. Let’s look at GTFC’s business. The first problem we have here are poor lending practices. Regardless of the manner in which GTFC funded their assets there was some bad lending going on. The business model was flawed from the start. Medium term assets were funded with long term liabilities. And on top of that, these were assets that would depreciate quickly in value, much like driving the car off the lot. So at some point unless they were incredibly lucky or incredibly smart at GTFC their chickens would come to roost regardless. The question is, was there any financial engineering to blame?

Now let’s just have a very cursory look at the funding of these assets. We could spend a lot of time trying to analyze the financing vehicles used. But they are complex. (First yellow flag, buyer beware). The authors’ lengthy discussion of these structures is a gross oversimplification, perhaps intended for the novice reader. They perhaps by necessity needed to gloss over some of the structural and economic issues. In my view, the real question here is did everyone know what they were getting into? Clearly, GTFC either knew the risks embedded in their business model or they didn’t. Similarly, either the investors understood the risk of what they were buying or did not. If they didn’t understand the risks, why did they buy the paper? If GTFC didn’t understand the risks to their business why did no one notice?

I’m have has this discussion on a number of fronts when discussing accounting or finance. In the end, where does responsibility lie for all the things that went wrong with GTFC? The list is long:

  1. Bad decisions by both the borrower and lenders/investors;
  2. Credit agencies who seemingly learn by trial and error. They seem to be so enamored with the complexity of the structures that they fail to apply “horse sense” on looking at the deals. They bear little responsibility for anything that goes wrong because they are simply expressing an opinion on the structure;
  3. Greedy management and investment bankers. This has already been discussed everywhere “ad naseum”. Those who are motivated by greed and ego will always find a way;
  4. The deal culture in the financial services sector;
  5. Incentive compensation that shapes behavior;
  6. Sloppy application of accounting principles and policy;
  7. Sometimes co-opted auditors who are as often as not part of the deal team .

The list goes on and on. Ultimately, is it the financial engineering that is the problem or the financial engineers?

So what is truly remarkable about this piece of analysis is the failure, in my opinion, to look at the root causes: Greed, poor corporate governance, incentives on main street and Wall Street, over reliance on rating agencies, lack of due diligence (an old joke-due diligence is for wimps). There are many causes, but isn’t shooting the financial engineer the same as shooting the messenger for the message?

Many years ago when I worked at Citicorp Investment Bank I saw a deal team challenged by a senior executive. He had just attended a presentation from a bunch of “propeller heads”. Detailed, complex, everything you would want to justify a deal. The executive pulled out a napkin. He told the deal team that unless they could explain it on the napkin, they couldn’t do the deal. Where has this gone? Complexity, we love it. We have done our homework, we have done our jobs. The math is so robust that it can’t be wrong. After all, the financial experts had vetted the deal. With all these PhD s on board, how could the conclusion be wrong?  Financial crises after financial crises and we don’t seem to get it. Greed trumps due diligence, ego trumps common sense, the deal trumps naysayers. Has anything really changed?

In this case the discussion circled back regarding the flawed decision by Conseco to purchase GTFC (a mess) and save it from oblivion. So in advising senior executives about the “common sense” of a transaction, there is one important question that needs to be answered. Has the CEO already decided to go ahead with the deal before the consultant even walks in the door? I believe that the train has left the station once the CEO decides that the deal is a good one. They all (buyer and seller) become committed to the deal at some point come hell or high water. There is no going back.

So I wish Messrs. Carroll and Mui the best of luck in playing the devil’s advocate.

Auto Canada Inc.

One of the stock market darlings in Canada is a company called AutoCanada Inc. (ACQ Toronto). AutoCanada Inc., through its subsidiaries, operates franchised automobile dealerships in Canada. The company offers various automotive products and services, such as new and used vehicles, vehicle parts, vehicle maintenance and collision repair services, vehicle protection products, and other after-market products. It sells various new vehicle brands, including Chrysler, Dodge, Jeep, Ram, FIAT, Chevrolet, GMC, Buick, Cadillac, Infiniti, Nissan, Hyundai, Subaru, Mitsubishi, Audi, and Volkswagen. The company also arranges financing for customers through third-party financial institutions, as well as facilitates the sale of third party insurance products to customers comprising credit and life insurance policies, and extended service contracts. As of December 31, 2013, it operated 28 franchised dealerships and managed 5 franchised dealership investments in British Columbia, Alberta, Saskatchewan, Manitoba, Ontario, New Brunswick, and Nova Scotia. AutoCanada Inc. is headquartered in Edmonton, Canada.

ACQ’s business model is what we used to call a roll-up strategy.

A roll-up is a term used to describe a company that is built primarily though the acquisition of smaller companies with common services or products. Usually, roll-ups are conducted by financial buyers in a specific market that is fragmented and can be consolidated. The market may be dominated by one player, with the balance of the competition made up of smaller private companies without sufficient scale and infrastructure to challenge the dominant player.

The financial buyer will identify the potential acquisition targets that offer products or services within the fragmented market, and usually acquire them through a platform company. The roll-up then entails putting the various businesses together under a common brand, administrative infrastructure, reporting systems, and sales and marketing, so the combined business is presented to the customer base as a single entity. In a roll-up, value is created by building a much larger, scalable entity that will command a higher valuation multiple on exit, and also by establishing a common platform of systems and processes that allows for easy integration of each acquisition.

A roll-up is also known as a consolidation.

Roll-ups can generate value, but they are extremely difficult to execute. The difficulty lies in the mix of different cultures and business practices inherent in each of the companies acquired, as well as the considerable change that these companies experience as they get integrated.

If the change is too immediate, the original owners may get disenchanted quickly and leave which causes a loss of value due to the usual dependence on previous owners in the early stages. Similarly, if the integration change is too slow, then the combined company remains fragmented with a group of companies under one common umbrella, but with no cohesion or infrastructure to operate as a scalable, single entity.

Roll-ups are better suited for company owners who wish to stay on and create value together with other operational and financial partners, rather than those sellers who are simply looking to monetize their company equity through a quick cash exit.

If you take a highly fragmented industry, like used-car sales, funeral homes, office supplies, air-conditioning services, veterinary care, or laboratory diagnostics. Buy up dozens, maybe hundreds, of owner-operated businesses. Create an entity that can reap economies of scale, build regional or national brands, leverage best practices across all aspects of marketing and operations, and hire more potent managers than the small businesses could previously afford.

Consider the dismal results from six leading roll-ups in the late 1990s—Waste Management Inc., AutoNation Inc., the funeral-home companies Service Corporation International, Stewart Enterprises Inc., and U.S. Office Products Company and its rival Corporate Express Inc. After significantly outperforming the S&P 500 for two strong years (1995 to 1996), these six roll-ups came crashing down.

Roll-ups, as we use the term, emerged in the mid-1990s as one form of the many waves of consolidation washing over the globe. Roll-ups differ from conventional merger-and-acquisition activity in three distinct ways.

First, roll-ups occur in highly fragmented industries as mentioned above, usually service-or distribution-related, but occasionally in manufacturing. As a result, consolidation involves not a handful of mergers and acquisitions, but dozens, or sometimes hundreds.

Second, companies acquired are generally owner-operators rather than large, publicly owned companies. This makes integration much more complicated, because people accustomed to seat-of-the-pants decision-making and complete control are suddenly required to play on a team, with corporate instead of personal goals in the forefront. Additional complications arise because the many small businesses use diverse accounting systems and technology.

The third way in which roll-ups differ from conventional merger-and-acquisition activity is that their strategy is not to gain incremental advantage but to reinvent an industry, creating an entity with a fundamentally superior value proposition.

The bet underlying a roll-up is that it can reduce costs and drive growth to create enormous value. In fact, kindling organic growth is particularly important as the pace of acquisitions begins its inevitable decline. Roll-ups take on considerable costs: premiums paid for acquisitions, debt, high-powered management teams. To make good on that investment, the entity must grow. When all goes well, we find a cycle of value creation that takes on a life of its own.

As acquisitions are made, value is created from a series of concurrent post-merger integration, each focused on forging a bigger and more competitive entity from many fragmented individual companies. The value created is shared with the customers (through more attractive pricing or higher quality of service) and employees (through better benefits or incentives). This results in accelerated organic growth driven by a superior value proposition. The market rewards this kind of growth with a higher P/E ratio, which creates the currency for more acquisitions.

Sounds simple enough, doesn’t it? So what can account for so many failures? Our experience shows it’s the inability of a roll-up to kick-start the wheel of fortune. Contemplate, for a moment, Waste Management’s saga. In 1998, USA Waste Services Inc., an up-and-comer in the solid-waste industry, merged with Waste Management, a faltering leader. Waste Management’s share value roared from below $30 to a peak of about $55 per share in mid-1998, when the merger was finalized and the combined company assumed the Waste Management name.

Its 1998 annual report assured shareholders, “We have met the challenges head on, moving swiftly to unify operations and take full advantage of the potential synergies. We have addressed operational issues on every front—consolidating routes and reducing transportation routes, streamlining field operations and facilities, standardizing systems and procedures, and eliminating duplication of administrative and managerial functions.”

But little more than a year later, in December 1999, Duff & Phelps Credit Rating Company, while reviewing Waste Management’s debt, noted “lingering systems issues” and “the loss of customers through systems and performance difficulties” after the consolidation with USA Waste. Waste Management faced difficulties for many years after that. It has still under-performed the Dow Jones Industrial Average for the last ten years.

When you review ACQ’s financial statements you will find a balance sheet heavily weighted by goodwill and other intangibles that have accumulated through the company’s numerous acquisitions. These balances will be tested for impairment regularly so if the business falters, the write-offs will begin.

The company has a lot of leverage. So time will tell what the inevitable increase in interest rates will do to the company’s operating performance given that it’s finance costs are considerably higher than it’s finance income.

As is normally the case, those who don’t learn from history will be doomed to repeat it. I’ll update the progress of ACQ from time to time. I am skeptical. Here is a recent news release on the company’s results. Buyer beware. “AutoCanada shares soar on record earnings, sales; prospects for greater expansion“.  This is exactly the kind of results one would have anticipated from a roll-up strategy.

Right on Schedule:CEO Option Grants and Opportunism

Three distinguished professors (Robert M. Daines of the Stanford Law School, Stanford University, Grant R. McQeen and Robert J. Schonlau who are both professors in the Marriott School, Department of Finance, Brigham Young University) wrote a research paper (Right on Schedule CEO Option Grants and Opportunism) on whether or not CEOs will behave in an opportunistic fashion in order to maximize the compensation derived from stock options. More particularly, even though stock options are now granted on a scheduled date (to avoid all of the issues that arose on backdating the options that were dealt with by the SEC in 2006), do CEOs that know the dates of upcoming stock grants temporarily depress stock prices before the grant dates to obtain options with lower stock prices. This is part of the continuing debate as to whether senior executives extract too much value out of corporations for themselves to the detriment of shareholders.

Their paper provides considerable detail on the methodology employed to test their hypotheses, but their thoughts and conclusions are important for my purpose here. The bottom line is that the research confirms that CEOs are still involved in efforts to increase the value of their stock options by using the power vested in them as the senior corporation officers. Notwithstanding the changes in United States securities regulation aimed at eliminating this gaming of the system it appears to go on.

The problem with the research is that in the end of the day, it is still only anecdotal information. It points to an issue, but provides no hard evidence that this is actually going on. Regardless you would have thought that this would give regulators cause to dig further. It is not apparent that this is the case. Much like insider trading, this represents a plague on capital markets. The market continues to be tilted towards the benefit of insiders that can use information to decrease or increase the value of the stock to their benefit, probably without really effecting the long term trajectory of the company’s stock. But who knows.

There would appear to be nothing anyone can practically do bout this other than monitor stock price activity around option dates It would seem that the SEC has the tools available to it. All that is necessary is to monitor a sample of corporations to review the trends and patterns.

A Purpose Beyond Profit

Tony Schwartz is President and CEO of the Energy Project. The Energy Project  partners with organizations to create workplaces that are healthier, happier, more focused and more purposeful. In his blog he wrote about a purpose beyond profit for corporations. I quote “For years, I’ve listened to chief executives of large companies pay dutiful lip service to concepts like corporate social responsibility, investing in the communities they operate in, treating employees as their most precious asset and living their values. Mostly, it comes off as so much canned public posturing — boxes to be checked off, rather than any sort of deep commitment.”

Here was my comment on his blog “A Purpose Beyond Profit“:

Well put. I would like to raise another point.

For many years I marketed derivative products to major corporations in the United States and Canada. I developed a relationship with the president of a major insurance company. They were in to “slash and burn” in terms of downsizing and controlling costs. Many employees were terminated and business lines closed with a major loss of jobs. So I asked him why the continual cost cutting. Why did it seem to never end. The answer was pretty simple. They can control costs but not revenues. To have an immediate impact they can only cut costs and in people intensive industries that means jobs. This was an honest answer but demonstrates the short run decision making process with little thought about the long term. In fact, the insurance company struggled for many years and today it’s share price has only modestly recovered.

What is absent is leadership and vision. What is not absent is these failed attempts to support the share price. Executive compensation is focused on short term results and much of the academic literature confirms that notwithstanding the naysayers.

We suffer from the same malaise in politics. No leaders, just politicians. Power hungry and poll driven rather than doing the right thing. So corporate executives cannot be blamed for behaving the same way. It’s an ongoing and continuing failure of corporate governance that is responsible for this. Co-opted directors and complacent shareholders. As long as corporate executives are given short term incentives they will behave accordingly. Stock options have exacerbated the problem. So I hope that you can get these guys to think long term. But with no long term payoffs, they will not invest in long term results notwithstanding the experience of a handful of others. They will maximize their own returns to the detriment of others as under the circumstances this is the only rational thing to do.

How Dodd-Frank Doubles Down on “Too Big to Fail”

In “How Dodd-Frank Doubles Down on ‘Too Big to Fail'” published in the Wall Street Journal  Charles W. Calomiris And Allan H. Meltzer weigh in on the topic. The article addresses many different aspects of too big to fail. There is, however, one point where I believe many should take issue with the authors: “Several researchers have suggested a variety of ways to supplement simple equity and cash requirements with creative contractual devices that would give bankers strong incentives to make sure that they maintain adequate capital. In the Journal of Applied Corporate Finance (2013), Charles Calomiris and Richard Herring propose debt that converts to equity whenever the market value ratio of a bank’s equity is below 9% for more than 90 days. Since the conversion would significantly dilute the value of the stock held by pre-existing shareholders, a bank CEO will have a big incentive to avoid it.There is plenty of room to debate the details, but the essential reform is to place responsibility for absorbing a bank’s losses on banks and their owners. Dodd-Frank institutionalizes too-big-to-fail protection by explicitly permitting bailouts via a “resolution authority” provision at the discretion of government authorities, financed by taxes on surviving banks—and by taxpayers should these bank taxes be insufficient. That provision should be repealed and replaced by clear rules that can’t be gamed by bank managers. “

This is yet again a rather simplistic solution to a much more complex problem. This concept of convertible debt is rather silly. I cannot imagine anyone buying this debt when the time they will get converted into equity is when the financial institution is a disaster. In order to be compensated for this risk, investors will need to extract a hefty premium from the debt issuer. And even this premium will likely not be enough to encourage large institutional investors to participate. Shoring up the capital base is a worthy cause. But trying to induce investors to participate is an entirely different matter.  The problem will be the cost of this capital “ab initio”. When things are good, banks will be loathe to issue this kind of instrument. Expensive. So what happens? Will the regulator force them to put this capital in place? Don’t these mechanisms already exist? Again, in my view, the problem is a simple one. As Steven M. Davidoff wrote in the New York Times in August 2008 in an article entitled: “A Partnership Solution for Investment Banks?” : “Still, to the extent we are moving into a new regulatory structure, the need to create the right incentives here is paramount. The partnership model for banks may be long gone, but in any regulation to come of the investment banks, regulators would do well to look at the stabilizing element of the partnership model: responsibility.” These solutions do not look at the real problem. Making these guys responsible for what happens. There is no way around it.

Executive Compensation: An Overview of Research on Corporate Practices and Proposed Reforms

In a study prepared by Professors Faulkender, Kadyrzhanova, Prabhala and Senbet,  the authors make the following comment:

“And this incentive and externality problem is compounded by the moral hazard problem associated with federal deposit guarantees. Deposit-raising by banks is facilitated by deposit insurance provided by the FDIC. At non-bank companies, creditors are able to place restrictions on risk-taking through covenants and to “price” the risk-taking of the debtors in the debt contracts they negotiate with them. In the case of banks, the FDIC acts as an insurer and should be able to place similar restrictions on risk-taking. To the extent compensation contracts contribute to risk-taking, it is reasonable for the FDIC to place covenant-like restrictions on the compensation contracts of institutions that benefit from deposit insurance. A study by John, Saunders, and Senbet (2000) shows that if deposit insurance were priced to reflect the incentive features of bank management compensation, banks would be likely to pre-commit  to a compensation structure that provides decision-makers with incentives to maintain their activities at a socially desirable level of risk and, in so doing, help maintain the stability of the banking system. As an alternative, bankers’ compensation could be adjusted to include payments that reflect not just the returns to equity, but the payoffs to depositors, bondholders, and other claimants. In such a case, compensation would depend on the value of the whole firm rather than the equity slice alone.”

This observation is completely wrong headed. Financial or similar covenants place the burden on the corporation, not directly on the individuals receiving the compensation. Even with covenants, there are  material breaches and immaterial breaches. What causes the FDIC to act? What is reasonable compensation? Clearly the authors have no first hand experience on the wording of such a covenant. How would the covenant be drafted? Who pays the incremental legal fees? What are the remedies for a breach of the covenant? Will the bank go into default? Who does this protect? The shareholders, the depositors, the creditors? Academic theories versus practical realities are coming into play here. To use FDIC insurance as the means of reining compensation will lead to distortions in the market place. When does the FDIC pricing kick in? At all levels of compensation or above a threshold? What’s the pricing model? Whose pricing model? Placing more power in the hands of the regulator is not the solution. This creates a greater role for Washington to control economic activity which many do not believe is a good thing.

Deposit insurance was created to project the depositors to whom the financial intermediary has a fiduciary responsibility. Rather than discourage risk taking, it will encourage risk taking. The problem here is a seeming lack of goal congruence between management, shareholders, depositors and regulators. Riskier deals generate greater returns and require a greater allocation of capital. To the extent that the deal generates risk the deal will get booked subject to documentation as long as the risk adjusted rate of return is in excess of the hurdle rate. Riskier deals tend to generate more cash or operating income. More operating income generates more bonuses. It’s this nexus that needs to be examined. It would seem to me that an easier path to follow would be director and officer liability. The tools are already in place but need to be expanded. Banks and other financial intermediaries should not, however, be allowed to cover the risk to their directors and officers through corporately funded directors and officers liability insurance.  That burden should be borne by the director or officer personally, with the corporation being the beneficiary under the policy.  Insurance companies will be much better at pricing the risk than the FDIC. And the cost will likely be a wake up call to those concerned. Let the courts enforce the penalty. That’s what courts are for.