It’s Payback Time!

One of the main criticisms of the massive bank bailouts was that the Feds didn't get sufficiently medieval on bank shareholders, including top executives who owned big chunks of stock. The U.S. eschewed the Swedish approach—simply nationalizing the faltering banks. And it didn't go the British route—nationalizating in some instances and asking existing shareholders to come up with extra capital.

Instead, the U.S. decided to inject cash into banks on favorable terms through the TARP. The government bought preferred stock that carried a 5 percent interest rate and came with warrants. (Warren Buffett extracted much tougher terms from Goldman Sachs than the government did.) What's more, government agencies and the Federal Reserve rushed to the assistance of the banking sector by guaranteeing banks' debt, intervening in capital markets, and slashing interest rates to zero. In essence, the government altered the banking environment so that it would be astonishingly easy for the banks to profit, and thus earn their way out of trouble. As a result, critics said, the banks were being spared many difficult and painful decisions. All carrots and no stick.

And yet, by design or dumb luck, it turns out that the government did have one powerful stick that has pushed banks and their shareholders to reform themselves sooner rather than later: the ability to regulate banks' compensation.

Bankers, especially investment bankers, aren't interested particularly in long-term shareholder returns or even in providing capital to businesses. They're interested making money and getting paid. If you want to do God's work, you don't work at a bank, you quit your job at the bank and teach, or found a non-profit aimed at relieving poverty, like Acumen Fund founder Jacqueline Novogratz did.

From the outset, healthy banks were eager to get out from under the TARP because they wanted to avoid discussions about appropriate levels of executive compensation. The investment banks that were capable of paying back did so in June, the month lawyer Kenneth Feinberg was appointed as TARP's special master for executive compensation. Coincidence?

In October, Feinberg issued compensation guidelines for the companies receiving special assistance, including Citi and Bank of America. That, and the approach of the bonus season, lit a fire under executives at the largest remaining TARP recipients. In the second half of 2009, they were spurred into a manic frenzy. They cut costs, shrank their balance sheets, and raised capital from new investors.

Look what's happened in the past two weeks. First, Bank of America agreed to pay back $45 billion in TARP funds. Bank of America found that the pay restrictions were complicating the search for a new boss to replace Ken Lewis. It raised $20 billion from the public, and agreed to sell $3 billion in assets. The smaller, leaner, better-capitalized bank was able to hire a new CEO on Wednesday.

Citigroup, which is keeping its CEO but wants to retain its legions of highly paid investment bankers, also sprang into action. Earlier this week, it announced it would pay back $20 billion in TARP funds and terminate an agreement under which taxpayers were guaranteeing losses on a big chunk of its loans. Cit raised $20.5 billion of capital, said it would give employees $1.7 billion in stock rather than cash for bonuses. Once the money was paid back to the Treasury, Citi noted, "it will no longer be deemed to be a beneficiary of "exceptional financial assistance" under TARP beginning in 2010."  Translation: Ken Feinberg won't be allowed to tell us how much to pay our folks. Because of its desire to get out from under such scrutiny, Citi has aggressively cut costs (by $15 billion annually), shed assets, and vastly improved its capital position. The smaller, leaner, better capitalized bank isn't completely out of the woods, but it's in a much better place than it was even a few months ago.

Also this week, Wells, Fargo announced it would repay $25 billion in TARP funds by selling $10.4 billion of stock and selling off assets. It, too, will be a smaller, leaner, better capitalized bank.

Among the three, that's $90 billion in repayments to the taxpayers in a week and more than $50 billion raised from the public. Of course, these offerings came at a price. The banks essentially created new shares and sold them to investors at a price below the prevailing market price. They diluted existing shareholders, which is what is supposed to happen when companies suffer losses and need to raise capital. And because of these offerings, future earnings will be spread across a much larger share base. As the TARP transaction report shows, there's still a way to go before the taxpayers have been paid back in full. But as much as anything else, the threat of the government having limiting bankers' compensation spurred the banks to get their houses in order.

Daniel Gross is also the author of  Dumb Money: How Our Greatest Financial Minds Bankrupted the NationandPop!: Why Bubbles Are Great For The Economy.