One question regular folks consistently ask about the housing bubble/financial crisis: Why did it go on so long? Why were bankers putting risky borrowers into toxic mortgage products almost engineered to blow up?
One answer is that no one saw it coming. “Hoocoodanode?” says CR. “Who coulda known?” That’s part of it of course. Most everyone involved convinced themselves that “house prices never fall.” If that were the case, borrowers would be able to refinance perpetually and banks would never take losses on their loans.
A more specific answer, however, has to do with the incentive structures for the bankers themselves. As a decent article in today’s NYT explains, bonuses were driven by short-term profits. For compensation purposes, the long-term risks involved in generating those profits were irrelevant:
In all, Merrill handed out $5 billion to $6 billion in bonuses [for 2006]. A 20-something analyst with a base salary of $130,000 collected a bonus of $250,000. And a 30-something trader with a $180,000 salary got $5 million.
But Merrill’s record earnings in 2006 — $7.5 billion — turned out to be a mirage. The company has since lost three times that amount, largely because the mortgage investments that supposedly had powered some of those profits plunged in value.
Unlike the earnings, however, the bonuses have not been reversed.
As regulators and shareholders sift through the rubble of the financial crisis, questions are being asked about what role lavish bonuses played in the debacle. Scrutiny over pay is intensifying as banks like Merrill prepare to dole out bonuses even after they have had to be propped up with billions of dollars of taxpayers’ money. While bonuses are expected to be half of what they were a year ago, some bankers could still collect millions of dollars.
Critics say bonuses never should have been so big in the first place, because they were based on ephemeral earnings. These people contend that Wall Street’s pay structure, in which bonuses are based on short-term profits, encouraged employees to act like gamblers at a casino — and let them collect their winnings while the roulette wheel was still spinning.
“Compensation was flawed top to bottom,” said Lucian A. Bebchuk, a professor at Harvard Law School and an expert on compensation. “The whole organization was responding to distorted incentives.”
Even Wall Streeters concede they were dazzled by the money. To earn bigger bonuses, many traders ignored or played down the risks they took until their bonuses were paid. Their bosses often turned a blind eye because it was in their interest as well.
“That’s a call that senior management or risk management should question, but of course their pay was tied to it too,” said Brian Lin, a former mortgage trader at Merrill Lynch.
Bankers and mortgage brokers got paid for generating accounting profits, regardless of the balance sheet risk involved. In a world of low interest rates (as was the case in the twilight of Alan Greenspan’s term as Fed Chariman), there was huge investor demand for higher-yielding fixed-income products. Wall Streeters, were happy to oblige, taking investor money and putting it into ever more complex “structured finance” products. CDOs, synthetic CDOs, MBS, etc. Mortgage lenders and everyone else involved in real estate were themselves getting paid to keep the gravy train rolling.
These complex products generated rich fees up front, when they were packaged and sold. But what of the long term risks? The article tracks the career of one particular Merrill Lynch banker:
[In 2006] Mr. Kim’s team was eagerly bundling risky home mortgages into bonds. One of the last deals they put together that year was called “Costa Bella,” or beautiful coast… The $500 million bundle of loans, a type of investment known as a collateralized debt obligation, was managed by [Bill] Gross’s Pimco.
Merrill Lynch collected about $5 million in fees for concocting Costa Bella, which included mortgages originated by First Franklin.
But Costa Bella, like so many other C.D.O.’s, was filled with loans that borrowers could not repay. Initially part of it was rated AAA, but Costa Bella is now deeply troubled. The losses on the investment far exceed the money Merrill collected for putting the deal together…
By the time Costa Bella ran into trouble, the Merrill bankers who had devised it had collected their bonuses for 2006.
And therein lies the rub. Bonuses at every level of the organization—not just traders’ bonuses, but also top executives’ and risk managers’—were tied to this year’s profits, with no future penalty for this year’s deals blowing up later on. If your current year pay is based on this year’s profits, you’ll work your ass off to maximize this year’s profits and pay little mind to the long-term risks.
Why did they do it if the whole thing might blow up later? Because before the music stopped playing, the guys at the top would have already generated millions of dollars in bonuses for themselves. The goal was never to build sustainable businesses, it was to gamble and win big quickly.
This was true all over the finance world, not just at the top of it in NYC. Bankers got rich from deals that generated short-run accounting profits even though the profits were totally illusory. The article mentions that Merrill has so far written down $54 billion, more than the company’s combined net profit of the previous 20 years. Or take my favorite example, BankUnited in Florida. They built Florida’s biggest regional bank on one particular loan product, option ARMs, virtually guaranteed to explode. Sure enough, this year’s writedowns are nearly 3x the previous three years’ profits. But executives have already banked years of lavish pay.
And then there’s the guys at the very top, the hedge-funders like Ken Griffin at Citadel and the private equity moguls like Leon Black at Apollo. These guys took huge leveraged bets that generated spectacular short-term profits for a few years. Those bets are now blowing up, but why should they care? Yeah, it must cause them some heart-burn that the firms they worked to build are imploding.
But they can feel comforted by the hundreds of millions in bonuses they earned previously, which of course they’ll get to keep.