Upfront about their pay - and that's the problem

LIAM PLEVEN and SUSANNE CRAIG wrote a front page WSJ article today that only says what a lot of people have been saying for a long time is wrong. Not necessarily morally wrong in that sense, but wrong from a benefit reward sense when the whole system is evaluated. Wrong in the sense that the incentives distort the end goal.

But since the people benefiting from this arrangement include the CEOs and most of management, there has been no one around to try to put a stop to it. And now that the market is putting a stop to the businesses that are skewed this way, the issue is finally getting a bit more spotlight.

It's the way the pay packets are structured, not the size, that is the culprit (well, not for this post anyway). It creates a divergence of interests with the enterprise, not the vaulted convergence.

Guambat reckons last year's tempest in a tea cup about back dating and under gating options was just one aspect of the whole shebang.

But the real journalists probably say it better than a mere sideline, part time, unpaid, anonymous plume de blog observer.

Guaranteed Rewards Of Bankers, Middlemen Are in the Spotlight

To understand a root cause of the financial crisis shaking global markets, take a look at [a broker's] paycheck.

He earns his money upfront, taking a percentage of each loan once papers are signed. "We don't get paid unless we can say YES" to loans, his firm's Web site says.

Brokers have little incentive to say "no" to someone seeking a loan. If a borrower defaults several months later -- as Americans increasingly are doing -- it's someone else's problem.

At every level of the financial system, key players -- from deal makers on Wall Street and in the City of London to local brokers -- often get a cut of what a transaction is supposed to be worth when first structured, not what it actually delivers in the long term. Now, as the bond market wobbles, takeover deals unravel and mortgages sour, the situation is spurring a re-examination of how financiers get paid and whether the incentives the pay structure creates need to be modified. This week, Congress asked three prominent executives to testify about their pay packages.

Upfront commissions and fees are well established on Wall Street. Investment banks get paid when billion-dollar mergers are inked. Firms that create complex new securities are paid a percentage off the top. Rating services assess the risk of a new bond in return for fees on the front end.

Critics argue this system can give people a vested interest in closing a deal, regardless of whether it turns out to be a good idea over time.

In various forms, a similar pay structure exists at the top of the financial world, where executives can reap lucrative pay packages, even if deals made on their watch later go south.

The financial world's pay structures are also at the center of the market for new investment products, which grew rapidly in recent years.

Wall Street came up with ways to repackage mortgages and other debts into securities that could be traded much like regular bonds. These, in turn, could be sold to new clients -- such as mutual funds -- that would have had little appetite for the original debts.

It enabled financial houses to sell off mortgages and other debts that previously might have remained on their own books. This meant the people who originated the loans often didn't have much of a direct financial stake in whether the loans are eventually paid off.

The new securities are tradable, so they can routinely be sold to others. That has led to the revival of an old one-liner on Wall Street: "A rolling loan gathers no loss."

TAGGING ON: Guambat didn't want to make another whole post on it but ran across this bit running not too far off the point of this post, from Steve Waldman's usually informative and interesting Interfluidity blog:

Institutional managers herded into structured products promising high yield at next to no risk, products that seemed to violate the most elementary rule of finance (no arbitrage), and were shocked, shocked when after four years of great bonuses, their clients learned there was risk after all. And bankers of all ilks and alphabets, I-bankers, C-bankers, M-bankers, discovered there was great money to be made, intermediating (originate and sell!), dealmaking (LBOs, baby, it's a new era of infinite leverage and no defaults!), and shoving risks where stockholders and regulators couldn't see them (SIVs are just innovative!).

We should pick on them. It's not because they're bad people. Most bankers are very nice people. We should pick on them because, as Andrew says, banks intermediate. They are a point where all the lunatics meet to transact, a point where applying pressure can change everything. We can rant and rail against human nature, but who cares? People is people, God bless 'em.

But banks are formal institutions, amenable to laws, regulations, and litigable norms and standards that are easily reshaped. We don't have to throw up our hands at frailty and corruption and watch reruns from the 1930s over and over again. We can actually mess with banks (and other financial intermediaries) in ways that indirectly shape the behavior of the rest of us (and that are not terribly intrusive to most of us).

It simply isn't true, in the general case, that human desires are exogenous and "demand will find supply". The explosion of misbehavior on all sides of the credit market over the past several years was not caused by a burst of theta-waves from the Earth's core.

We allowed our institutions to evolve to a place where misbehavior was ordinary, caution uncompetitive, prudence a firing offense. If we change the institutions, we change the behavior. We can do that, and we should do that.

PS. Peter Hartcher, in the Sydney Morning Herald Jan 19th, has this take on that WSJ story: Bad loans have come home to roost