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  • 02.17.09

If You’re Not Furious Over the Bank Bailout, Read This

Provisioned within the stimulus bill is a salary cap for executives of any bank that receives federal money through the TARP program. Instead of taking home millions, the top brass will be limited to $500,000 in total annual pay. Sounds like justice, doesn’t it? It’s not. In fact, an outrageous loophole will allow bank executives to take home tens of millions of dollars thanks to taxpayer intervention.

Provisioned within the stimulus bill is a salary cap for executives of any bank that receives federal money through the TARP program. Instead of taking home millions, the top brass will be limited to $500,000 in total annual pay. Sounds like justice, doesn’t it? It’s not.

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In fact, an outrageous loophole will allow bank executives to take home tens of millions of dollars thanks to taxpayer intervention.

You wouldn’t know it by listening to Capitol Hill. Summoning all her populist rage, Senator Claire McCaskill, Democrat of Missouri, referred last week to Wall Street executives as a “bunch of idiots… kicking sand in the face of the American taxpayer.” President Obama himself said on February 4th that “… in order to restore trust, we’ve got to make certain that taxpayer funds are not subsidizing excessive compensation packages on Wall Street.”

Then the President went on to describe the salary cap. It will limit bank executives to “a fraction” of the huge salaries that had been reported recently, he said. Then he added an interesting caveat: “And if these executives receive any additional compensation, it will come in the form of stock that can’t be paid up until taxpayers are paid back for their assistance.”

Whoa, whoa, whoa. What does that mean, exactly?

The possibility for additional compensation can come from “deferred stock,” that as the President explained, can’t be sold until the bank pays back its debt to the Treasury. But deferred stock isn’t the same as restricted stock.

Here’s how Simon Johnson, former chief economist for the IMF, explained the options to Bill Moyers on a PBS appearance on February 13th:

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… you can — sorry to get technical, but — reset the strike price… when your company goes down, and you have massive amounts of stock options that aren’t worth much anymore, because the stock price has gone down, you say, ‘Oh, well, we’re going to reset our option prices.’ [Emphasis mine.]

When an employee gets a stock option plan, there’s a variable on it called a “strike price” that lets him buy company stock at a discount price. The strike price determines at what price those underlying assets can be bought. This happens regardless of what the “spot price,” or market price, happens to be at the time the stock is sold.

In other words, let’s say I’m a bank CEO. If I have stock options with my bank, and the strike price for my option is $1, I can buy the company’s stock for only $1 per share–even if the market price listed today on the NYSE is $2 a share. Ideally, that puts in place an incentive for me to make the company do well, so the stock will go up. That way, when I exercise my option and sell at market price, I make money.

The extent to which the difference between my strike price and the spot price is protifable is called “moneyness.” If a stock can be sold on the market above its strike price, it’s said to be “in the money.” If a stock’s spot price dips below the strike price, it’s “out of the money.”

Obviously, bank stocks are in the bargain bin; a lot of Wall Street CEOs have options plans, as Johnson notes, that would presently be “out of the money.”

Let’s say I’m one of those CEOs, back at Bank A again. The strike price on my option is $1, but the company’s stock is in the toilet today at just $0.20 a share. There’s nothing in the current salary cap that says that my bank can’t reset its strike price to, say, $0.10 a share. I can then buy shares half-price. That means that as soon as my bank pays back the government, I can cash out my stock options and double my money.

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Of course, if the government had not interceded, my bank might have, say, become insolvent and been coopted by the FDIC, and then been broken up and sold off to private equity firms. My stock options would be worth nil. But thanks to Uncle Sam’s loan, I’ve just walked away with a huge 2:1 margin on my investment. I’m in the money.

Of course, there’s nothing wrong with this–except that the whole point of the salary cap was to punish the executives who scuttled our economy in the first place. Walking away with what Johnson predicts could be hundreds of millions of dollars isn’t exactly harsh retribution.

One alternative that might distract executives from exercising their stock options this way could be someting called a “bonus bank,” as described in BusinessWeek on February 16th. A bonus bank is an escrow fund where 1/3 of an executive’s annual bonus money would be automatically deposited. For three years, the banker can draw from the account only if the bank meets predetermined performance targets. If the bank doesn’t perform, the banker loses his bonus.

The idea behind the bonus bank is that execs can see a substantial payout in under three years, which might not be possible with the options scheme laid out above; it could take five or 10 years before a given bank that has received extreme assistance pays back the government in full. Plus, the banker doesn’t run any risk of buying stock that decreases in value.

Investors at E*Trade, Charles Schwab [SCHW], and JPMorganChase [JPM] are all pushing for a bonus bank plan. In practice it can be tricky, however; if a bank fails to meet its goals, there’s significant incentive for a banker to leave instead of ride out the storm.

If bankers do indeed exercise options with reset strike prices, there will be public outcry–and the President might be the one they blame.

About the author

I've written about innovation, design, and technology for Fast Company since 2007. I was the co-founding editor of FastCoLabs.

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