Clawbacks and Consumer Loans

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Wells Fargo.

Clawbacks have been the hot new thing in bank compensation for the last few years, but I confess it never occurred to me that they'd be used much against people still employed by a bank. The clawback's main benefit is that it solves the "I'll-be-gone-you'll-be-gone" problem: If you make a lot of money for a bank, and the bank gives a lot of the money to you, and you quit to spend more time with your money, and then it turns out that you made the money by fraud or by taking excessive risks, the bank can come after you and take the money back. It's a way to discipline bad employees who are no longer employees, and to deter current employees from being bad in slow-burning ways. It's a lesson learned from the financial crisis, when people got paid a lot of money based on an annual marking to market of decisions that turned out, in the long run, to be catastrophes.

But if you're still an employee there are other ways to discipline you. The bank can reduce your bonus for this year, or move your desk somewhere bad, or fire you. Firing you is an obvious choice: Traditionally, when the stuff you were doing turns out to be reckless, or fraud, no one wants you around any more. Of course if it was bad enough, they can fire you and claw back your money. Some misbehavior is bad enough to cut off your entire future at the bank; other misbehavior is even worse, cutting off your future and also coming for some of your past.

But clawing back an executive's pay without firing him sends a strange message. Something like: Your career here was built on a lie, but stick around. Or: Sure your accomplishments for us came with some fraud or recklessness, but we can work with that. It also says something strange about the executive's incentive structure. He has already been paid so much money that he can no longer be motivated by thinking about his future, his bonus this year or his job security. The way to motivate him now is to reach back into the past and take away the money he already made.

Anyway, "Wells Fargo & Co. Chief Executive Officer John Stumpf, fighting to keep his job amid a national political furor, will forgo more than $41 million of stock and salary as the bank’s board investigates how employees opened legions of bogus accounts for customers," and "former community banking chief Carrie Tolstedt will forgo about $19 million in unvested stock." Tolstedt was already planning to retire, but Stumpf still hopes to stick around, though there are those who have other plans for him:

Giving up pay “is a smack on the head, but it doesn’t end the question of whether Mr. Stumpf should be allowed to head a bank,” Erik Gordon, a law professor at the University of Michigan in Ann Arbor.

The money he's giving up is unvested equity; "the awards being forfeited by Mr. Stumpf represent about a quarter of the total compensation he has accrued over his nearly 35 years at the bank," and more than twice his 2015 compensation. 

One other weird question that I have is: How bad was Wells Fargo? I mean obviously you should not go around creating 2 million fake accounts for customers who didn't know about them! It cost the customers some fees, and some heartache, and some -- perhaps a lot -- of damage to their credit ratings. But in the scheme of, like, how much harm it caused to customers or to the American economy, Wells Fargo's years of fake accounts equate to maybe a couple of hours of mortgage origination at Countrywide in 2005. It was exceptionally dishonest, and it was harmful, but it was not exceptionally harmful. That doesn't excuse it or anything, but it makes stories like this kind of weird:

New York's Metropolitan Transportation Authority put business with Wells Fargo Securities and the firm's approval as a senior manager for bond transactions on hold pending its review of the bank's practices.

The MTA's approved banks include Goldman Sachs ("a great vampire squid wrapped around the face of humanity," where I used to work), Bank of America (which, when I last counted, had paid at least $68 billion in fines and settlements for mortgage misdeeds) and Citigroup (which "has become synonymous with financial misjudgment, reckless lending, and gargantuan losses"). Is Wells's scandal worse than what they've been up to? Is it just more recent? Is there something about it -- its direct consumer impact, its bizarre dishonesty, its executives' responses -- that makes it a better symbolic target for political concern? I am asking these questions sincerely; I don't know the answer. Wells Fargo has clearly struck a nerve, but it seems to me that the big banks just take turns striking nerves, and if you pull your business from a bank each time it has a scandal, you will be kept constantly busy.

Related: "The complaint database run by the Consumer Financial Protection Bureau shows that Wells Fargo hasn’t been much of an outlier when it comes to complaints associated with cross-selling and other sales abuses," with Citigroup and Bank of America showing an even higher incidence of complaints than Wells Fargo.

Elsewhere: "How can bankers live with themselves after the destruction wrought by their industry?" McBain, of course, has the canonical answer to this sort of question. 

Goldman lending.

Speaking of the ol' vampire squid, the ex-Goldman-derivatives-structurer in me really wants Goldman Sachs's new online lending platform ("Marcus") to be some sort of clever structuring play. Like: Goldman is in essence a middleman, a market maker, a builder of trades for others. Online consumer loans are a securitizable -- and securitized -- product, with demand from both investors and borrowers. Surely Goldman could find some way to make online loans, slice and dice and package them carefully, and sell them in pieces to investors in a way that is hugely profitable but doesn't require Goldman to take much risk or use much of its own money?

But no it is dead boring:

As a large bank in its own right, Goldman doesn’t have similar concerns. That gives it the flexibility to underwrite more creatively, Mr. Scherr said, letting borrowers pick from a range of sizes, terms and payment schedules for their loans.

Such flexibility “pivots off the ability to fund off our own balance sheet,” he said. Marcus loans aren’t “tailored or conforming to a marketplace to syndicate or sell the exposure.”

Goldman thought about buying a lending platform, but was deterred in part by high valuations, Mr. Scherr said. It also wanted a “clean sheet of paper” to better meet the expectations of regulators and consumers.

(Mr. Scherr is Stephen Scherr, "who runs the bank embedded inside Goldman" and who in a prior role was my boss's boss's boss at Goldman.) Goldman's plan seems to be to take over the traditional banking space abandoned by the traditional banks. Right now, if you walk into a bank branch to ask to borrow $5,000, the bank won't know what to do with you. Loans, to humans, are not really a big business for banks. The big banks "largely rely on credit cards, a big moneymaker they won’t want to cannibalize by offering a competing lending product." But Goldman doesn't really have a credit card business (disclosure: I have a Goldman branded credit card?), so if you walk into a Goldman branch they will be happy to sign you up for a consumer loan. It doesn't really have branches, either, though, so you have to walk in on the internet, but still, this is all pretty "It's a Wonderful Life" stuff. These days I guess that's a niche that only Goldman can fill?

LendUp.

Speaking of consumer lending platforms, LendUp, which is sort of a competitor to payday lending, but a nice payday lender, turned out to be less nice than it had claimed, and was fined $6 million dollars by the Consumer Financial Protection Bureau and the California Department of Business Oversight for, among other things, charging hidden fees and not helping its customers build credit histories as it had advertised. The CFPB press release has this passage, which could serve as a motto for the fintech industry:

“LendUp pitched itself as a consumer-friendly, tech-savvy alternative to traditional payday loans, but it did not pay enough attention to the consumer financial laws,” said CFPB Director Richard Cordray. “The CFPB supports innovation in the fintech space, but start-ups are just like established companies in that they must treat consumers fairly and comply with the law.”

"In those days we didn’t have a fully built out compliance department," says LendUp, which is I guess a shorter and catchier version of that motto.

Data science.

One question for the future of finance is something like: Are there restrictive domain specializations in artificial intelligence and machine learning and data science? Or, if you are good at getting a computer to make decisions based on a big pile of data, will you be good at that regardless of what the decisions and data are? This is relevant for the quant-hobbyist movement, where NASA scientists apply their skills to the stock market, and where the dream is that "a smart guy with a laptop will be able to start his own hedge fund" without  much specialized finance knowledge. But it goes the other way too: If you are good at running a quantitative hedge fund, will you also be good at optimizing movie recommendations on Netflix? Or what about insurance?

Two Sigma Investments LP spent the last 15 years honing its quantitative approach to investing. Now, it’s turning its number-crunching prowess on new prey: insurance.

The firm is joining with American International Group Inc. and Hamilton Insurance Group Ltd. to provide an automated, online analytical system to issue policies in minutes to smaller businesses like clothing shops, beauty parlors and medical offices.

Two Sigma "increasingly is casting itself as the Google Inc. of Wall Street, a technology company that can take its data-crunching skills to task on a variety of finance and economics problems," and "thinks of itself as a company that focuses on 'problems involving risk and economic activity,' rather than a hedge fund," but on the other hand it's teaming up with big insurance companies so you can't write this project off as hubris born of inexperience. Plus, like, those other hedge-fund guys really were good at Netflix, and at least some of the NASA types have had decent luck in the markets. It would be a little rough on Wall Street's self-esteem if investing and risk management turned out to be trivial applications of data science.

Tax policy.

Should Olympics prize money be taxed? Should Nobel Prize money be taxed? Should military salaries be taxed? Should firefighters' salaries be taxed? Should farm income be taxed? Should Donald Trump's income be taxed? Should online columnists' income be taxed? In a tax system (like that of the U.S.) based on income taxation, there is a general framework for answering these questions, which is:

  1. Realized economic income should be taxed; but
  2. My income, and the income of people I really like, ideally should not be.

"It's hard to imagine a tax code more complicated than the one we already have," wrote James Stewart a little while back, and I pointed out that it is actually very easy and happens all the time. Just last week the House of Representatives collectively imagined, and then passed a bill to create, a more complicated tax code, which is to say (1) the one we already have plus (2) a tax exemption for athletes' Olympic prize money. The vote was 415 to 1, and the one objector was Representative Jim Himes of Connecticut, a former rower who "is also a former Rhodes scholar who once worked at Goldman Sachs, so he knows how to add." There is no real economic or tax-equity argument for exempting Olympic income from taxation, but, you know, it's the Olympics. Go team. This is how tax law gets worse.

Blockchain blockchain blockchain.

Izabella Kaminska asks: "can blockchain deal with the phenomenon of lots of different institutional parties thinking they own the very same ETF share?" The issue is that there are a number of exchange-traded funds where "institutional ownership is in excess of 200 per cent for the shares outstanding (so more than two owners per each share in issuance)." This results from short selling: If there are 100 shares outstanding, and A borrows 10 shares from B to sell to C, then now the ownership is 110 percent of the shares outstanding. (Though the net ownership is 100 shares, since A owes B those 10 shares back.) Naked short selling by market makers -- who can always buy the underlying securities and deliver them to the ETF provider to create new shares, instead of borrowing existing ETF shares -- can also contribute.

One answer to the question is that there's no reason a blockchain couldn't handle short selling. Just transfer 10 shares from B to A, in exchange for a smart contract to return them, and then sell those shares from A to C over the blockchain. Easy as blockchain. C now owns the shares on the blockchain's ledger, while A also "owns" them in the sense that she has a recorded claim to get them back from B. Actually blockchain could be an improvement over the current system because it would allow for clearer and faster tracing of shares: A would know that she couldn't vote her shares without calling them back from B, for instance, and failures to deliver would be less common if the blockchain itself implemented the requirement to borrow shares.

But the broader answer involves not just borrowing shares and then delivering them, but creating new shares (by market makers taking naked positions and then either buying them in or delivering the underlying -- or, more generally, by creating derivative positions not backed by identified physical shares). Again there is no special difficulty with that in principle, except that you can't let just anyone do it. Right now the U.S. securities laws allow some naked short selling by market makers, but regulate who gets to be a market maker. (Among other things, you want to make sure they'll pay back their obligations.) A blockchain would need to do something similar: let some people create new securities on the blockchain, but carefully control who gets that access. The bitcoin model of permissionless trustless access for everyone, in which assets are created by the system itself rather than individual participants, is harder for financial instruments.

People are worried about unicorns.

I take an expansive view of the term "unicorn," and Blue Apron, a venture-capital-backed startup with a valuation in the billions, is clearly a unicorn even though its technology consists mostly of chopping vegetables and putting them in a bag for you. Anyway it might go public:

Blue Apron Inc. is interviewing banks that want to work on the meal-kit delivery company’s initial public offering, people with knowledge of the matter said.

The company is holding what’s known as a bakeoff, in which bankers will pitch their IPO strategies in hopes of working on the deal.

Yes a bakeoff. A bakeoff. The banks will come to Blue Apron's offices and ... look there is no way they are not cooking for Blue Apron, is what I am saying here. That is how equity capital markets pitches works in the cutesy startup world. You wear yoga pants to pitch Lululemon, you wear hoodies to pitch Facebook, you write a threaded tweetstorm to pitch Twitter, you send nudes to pitch Snapchat, and yes, when you are pitching Blue Apron, your team had better show up in blue aprons with your bank's logo on them and whip up some Shokichi Squash Ragù & Mafalda Pasta at the conference table while talking through your IPO credentials. That is just the minimum level of commitment I expect from equity capital markets bankers in 2016. The ECM business is doing terribly; you need to fight for every advantage. Also your pitchbook should have a lot of terrible cooking puns. "We will slowly simmer the offering in a rich stock of Boston-based institutional investors, then season it with a sprinkling of hedge funds," that sort of thing. 

People are worried about bond market liquidity.

People were worried that the Bank of England's purchases of corporate bonds, which started yesterday, would be bad for liquidity, but early results suggest that liquidity is fine:

Prices for sterling-denominated corporate bonds barely budged, according to investors. “All rather boring,” said Edward Farley, head of European corporate bonds at PGIM Fixed Income.

Good work everyone.

Things happen.

Deutsche Bank Rises as CEO Sells Unit, Rules Out Fund Raise. Deutsche Bank Puts Germany in a Bailout Bind. Italy’s Banks Look to an Unlikely Savior: Jamie Dimon. Asia: Where American Investment-Banking Dreams Go to Die. Anheuser-Busch InBev Clinches $103 Billion SABMiller Deal. Close Silicon Valley Ties Pose Hurdles for Twitter Bidders. Media Likes Twitter But Tech May Pay More. Blackstone’s Top Dealmaker Says Now Is The Most Difficult Period He's Ever Experienced. Perella Weinberg Partners Split Off to Open Investment Firm. Facing Losses, Energy Funds Ask Investors for More Time, Money. How Actual Nuts and Bolts Are Bringing Down Oil Prices. Elon Musk's plan to colonize Mars is wonderfully bonkers. Greek Lawmakers Pass Additional Austerity Measures. China’s Ambitious Plan to Make the Yuan the World’s Go-To Currency. Mexican Peso: The Hot Proxy Bet for the U.S. Election. Political Connections and the Informativeness of Insider Trades. Interconnectedness in the Global Financial Market. Oil Services Company Paying $140 Million Penalty for Accounting Fraud. A.I.G. Ex-Chief Testifies at Trial, 11 Years After Charges. Tilton Rejected as U.S. Supreme Court Lets SEC Case ProceedYou can punch Martin Shkreli in the face (for a price). "Shkreling." Boris Johnson makes up for Turkish president jibe by praising the country's 'beautiful washing machines.' NASA changed all the astrological signs and I’m a crab now. Delete your phone app. Dog is foolish. Dogs catch treats.

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net