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Bankers' Huge Bonuses Should Be Proportionate To The Risks Taken

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By JOHN M. BERRY

Bloomberg News

Published: September 13, 2008

When federal regulators start writing new rules for financial institutions next year, they should demand big changes in how bankers and traders are paid.

For years, bonuses have been passed out based on gains almost irrespective of the risks the institutions incurred. The industry's skewed incentive structure was a key cause of the unfolding financial crisis.

At the end of last year, when almost all the big investment banks were facing enormous losses, they paid backward-looking bonuses comparable to those handed out at the end of 2006 when profits were much higher and the future looked far rosier.

The payments stripped the companies of much-needed capital, leaving them weaker in the process. Why couldn't the chief executives have told employees, "Hey, you know a lot of the bets you helped us make have gone bad and we can't afford to pay big bonuses this year."
Merrill Lynch & Co. paid $9.54 billion in bonuses, down only slightly from what it paid for 2006 even though its net revenue had fallen by two-thirds and it reported a fourth-quarter loss of $9.83 billion.

Morgan Stanley's bonuses increased to almost $10 billion, up from $8.39 billion the previous year. Even Lehman Brothers Holdings Inc., now in a heap of trouble, raised its bonus total by half a billion dollars, to $5.70 billion.
Goldman Sachs Group Inc. paid the largest bonuses of all, averaging almost $400,000 per employee. Of course, Goldman escaped most of the carnage linked to the subprime mortgage mess.

After bonuses are paid in connection with deals and trades that turn out to be so disastrous, the recipients are never asked to pay anything back. Any requirement of that sort would be unworkable.

On the other hand, income that's bolstered by riskier deals that often involve increased leverage shouldn't be treated on the same footing as income from transactions that carry less risk. Bonuses should be calculated with that consideration in mind. Regulators should make that happen.

This isn't a problem just for Wall Street. It afflicts many banks with trading desks, in the United States and elsewhere. UBS AG, the Swiss banking giant, is a prime example.

The short-term focus on earnings for publicly traded companies combined with non-risk-adjusted compensation is a lethal mix.

The trader who makes a killing is generally paid much more than the party-pooping risk manager who has the unenviable task of warning that a deal has too much risk. There are tales of risk managers who were shown the door for pushing too hard.

I'm sure some of those receiving the largest bonuses in recent years were the bright folks responsible for innovations such as collateralized debt obligations, synthetic CDOs and the like. Unfortunately, they were too clever by half, and top executives at their firms didn't know, or perhaps didn't want to know, just how risky these derivatives were.

The whole house of cards was based on a single assumption: that U.S. house prices would increase at a healthy pace.

Many of the subprime mortgages were never viable because of the onerously high interest rates. "Teaser" rates in many adjustable mortgages were 8 percent or more and could move up a lot, and down hardly at all. These loans often were made to borrowers with relatively low incomes who could make just tiny down payments.

The only way they made sense was if house prices kept going up, creating an equity cushion that made it possible to refinance on better terms. This was one way aggressive mortgage brokers pitched the loans to borrowers.

By 2006, that was an unrealistic assumption. Prices had been rising too far for too long. It was less obvious that the bubble would burst as it has, though housing-price stability would have been just about as bad for the subprime world and all the derivatives based on it as the large price decline we've seen.

None of that affected bonus payments - not even at the beginning of this year as the meltdown gained momentum, the market for mortgage-backed assets collapsed and institutions began totaling up their losses.

At a July 22 workshop at Stanford University, a large group of economists, lawyers and current and former Federal Reserve officials discussed the financial crisis, the response by the Fed and the Bush administration to it and how policies needed to be changed to make future disruptions less likely.

Several speakers noted the perverse incentives built into the compensation plans of many financial institutions, first and foremost at investment banks. The present system is "pro-cyclical" in that it encourages ever-more risk-taking, with the immediate beneficiaries usually unaffected by future losses related to those risks, the participants said.

Fixing this won't be easy. But it ought to be part of the broad overhaul of financial regulations that the new president and Congress must tackle early next year.

If the incentives remain perverse, a future crisis will be all the more likely.

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