A common refrain one often hears today is that the whole subprime mess was caused by Wall Street greed. Unscrupulous mortgage brokers got homeowners into bad mortgages. Bankers packaged them into structured products no one could understand and sold them off in pieces. Rating agencies are only too eager to make fees to rate the mortgages and CDOs correctly. What we need, it is argued, is to regulate the greed and dishonesty that is so prevalent in the financial industry. We can start by cutting off their bonuses and cap executive pay. Simple enough, and it gets the job done. Right?
The problem with this picture, is that the alleged victim - the subprime borrower, probably got the better deal of the two. He bought a house he could not otherwise afford, paid almost nothing down, and lived in it by paying minimal payments. Now all he has to do is to just leave the house he should not have lived in anyway. Under the new Durbin’s proposal, he may not even have to move out. Compared to what he would have got without the mortgage, he lived better, at least temporarily. The alleged perpetrators - the banks, on the other hand, collectively lost over $500 billion through the crisis. If it is greed of the banks that is the root cause, you would expect the wealth transfer to be from the homeowners to the banks, not the other way around.
What this implies, of course, is that we cannot blame greed from the banks for causing it all. Greed cannot explain why they would willingly lend to borrowers they know could not repay. If anything, some of the subprime borrowers were probably driven by greed to buy abodes that they could not afford, hoping to reap large gains when prices go up. The government cannot ordinance them not to be greedy. Like any other innate human traits, greed cannot be regulated away. Only the lenders can do that by refusing to lend. Yet they failed to protect their own self interest, why?
The answer is that a combination of factors have conspired to lead banks to take ever increasing and imprudent risks, meanwhile keeping the credit party going, ultimately resulting in disaster for all themselves and their investors. Two of the most important of such factors are the agency problem and information cost.
In an article titled “The End” written for Portfolio.com, Michael Lewis wrote: “No investment bank owned by its employees would have levered itself 35 to 1 or bought and held $50 billion in mezzanine C.D.O.’s. I doubt any partnership would have sought to game the rating agencies or leap into bed with loan sharks or even allow mezzanine C.D.O.’s to be sold to its customers. The hoped-for short-term gain would not have justified the long-term hit. “
That, in essence, is the agency problem. The shareholders have appointed the CEOs to run the company for them, and the CEOs ramped up too much risk going after short term profit. This then percolates down, as the CEOs delegate the risk taking responsibilities down to the traders and bankers in the firm, who in turn make reckless decisions with the bank’s capital to reap short term P&L. The subprime mortgage securities and the CDOs created were then sold to investors around the world. Many of the asset managers who bought such securities were squandering their investor’s money without doing enough due diligence on the underlying mortgages. They, too, were agents who failed in their responsibilities to their principals – their investors.
In all of these cases, the agents have options on the principals. CEOs compensation is tied to stock performance, yet, when stocks go down, CEOs do not pay back earnings from past years. Traders’ bonuses are proportional to the annual P&L, yet, when they lose large sums for the banks, they do not have to pay the banks back. Even if the CEO or the traders lose their jobs, they can often go on to a comparable job at a different bank or a hedge fund. The most egregious example, however, is the hedge fund manager who gets incentive fees of 20% on investor profits. When investors lose their shirts, the manager only has to deal with a relatively mild “high watermark,” - definitely not the same as sharing the pains with the investors. Too often, even that rather toothless inducement loses its sting, as the manager from the losing fund will simply jump ship to start all over again at a different fund.
This agency problem, combined with the high cost for information, makes a potent prescription of destruction for shareholder value. Because investors cannot understand the complex instruments the banks/funds are trafficking in, and the complex risks that the banks/funds are taking to generate the profits, short term behaviors take hold. The stock market never punished Merrill Lynch when Stan O’Neal removed all risk controls at Merrill and took on First Franklin. The equity analysts frankly did not understand anything about structured products. Neither do the typical retail equity owner. The cost of obtaining the necessary information and learning all the nitty-gritty’s to understand it is indeed very high. What’s more, it is very much in the agents’ interest not to reveal everything to the principals. The most egregious example here – surprise, surprise – is the hedge funds again. What other industry has the gall to ask investors for a large chunk of money without revealing anything of substance on their investment strategy? What is shocking is how their investor base gladly signs onto such a proposition.
Unfortunately, it does not seem lessons were learned from the financial crisis. Investors are chastising Wall Street. Yet they have not shown a shred of inclination to change how they make their own investments. They continue to look at only short term performance, blaming or rewarding the guy who happens to be in charge when something happened, rather than looking more deeply at how their investments work and how or why they make or lose money. Only this can explain the public fury over John Thain’s bonus while not a whimper was uttered about Stan O’Neal walking away with his huge compensation packages while screwing up Merrill. When the principals do not enforce accountability on the agents, guess how agents will behave in the future?
Hopefully, something positive can come out of the recent Madoff scandal. Investors really need to wake up to the sorry state of today’s investment business, which this fiasco so aptly illustrates. When one replaces good old fashioned due diligence with mere words of mouth, appearance of connections, and feigned exclusivity, their investments are indeed on shaky grounds. While the costs of obtaining and understanding the complexity of today’s high finance will not likely go down, investors at least have to demand the information to evaluate for themselves. Actually, they need to do more. They can start by demanding clawbacks from their hedge fund managers. A capitalist system will only work when the incentives are aligned properly between the agents and the principals.
In the same article titled “The End,” Michael Lewis pertinently predicted an end to Wall Street as we know it. Let us just hope that end comes with requirements for more transparency and accountability. The last thing we need are dumb regulations designed to stop greed or worse, the free markets.
The sad thing is that they not only gladly sign up, they fight a path to the door, and sign up for much worse cocamanine schemes such as hedge fund of funds. Why stop at paying 2% and 20% of profits when you can pay 3% and 30% of profits?
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