exonerating banks by any means possible
Before you publish another article on the causes and the aftermath of today’s financial meltdown, you have to head over to Megan McArdle’s blog on The Atlantic where she quotes that neither the lending practices, or a compensation structure which rewarded ever growing appetites for risk are to blame. Couple that with the popular claims that the government was somehow involved in regulating our system into collapse and we have absolutely no one in the business world to hold accountable. It’s as if banks were pristine angels who’s supremely logical and conservative ways couldn’t protect them from bad information which turned loans given to anyone with the physical ability to sign on the dotted line into toxic assets that plunged in value overnight.
Her first piece of evidence is a study which concluded that mortgages made to customers with a FICO score under the 620 point threshold did peak during the heyday of subprime lending weren’t being securitized at a higher rate than usual. In other words, lenders were giving more mortgages to customers with a significant probability of default, but those loans weren’t actually being packaged into more bonds for investors. How this proves that securitization for mortgage portfolios had nothing to do with the financial crisis is a mystery to me. Generally, when banks got their hands on loan packages, they separated them into tranches according to the level of risk associated at each segment of their loan inventory and created a complex debt structure that was certified by a credit rating agency to be sold off to both private and institutional investors.
However, no financial alchemy will save you when it turns out that the debt obligations on which you’re basing your securities aren’t worth as much as you think. When mortgages weren’t getting paid off and real state was deflating, all those bonds started losing money. Highly questionable subprime lending practices and a lack of due diligence by both banks and credit rating agencies, came back to haunt the financial system. Other loans serving as the backing for exotic securities were also defaulting. The problem wasn’t about what FICO scores represented the biggest area of loss. The tranche arrangement was supposed to contain defaults, minimizing the potential losses from high risk borrowers. But defaults started showing up in loans to people considered at the lowest risk of default. As the pain from the burst of the real estate bubble spread, so did the the financial hemorrhaging. This is why a myopic focus on FICO scores would miss the forest for the tress.
In her defense of executive compensation on Wall Street, McArdle summons a quote about how much money was lost by bankers compensated mostly in stocks and bonuses which were suddenly worth a lot less after the crash, and therefore, it means that we can’t possibly accuse bankers of being greedy when they took on more and more risk during the boom years and into the beginning of the recession.
… bankers were often compensated in stock as well as with bonuses, and the value of this stock was wiped out because of the investments in question. Richard Fuld of Lehman Brothers lost $1 billion this way; Sanford Weill of Citigroup lost half that amount. A study by René Stulz and Rüdiger Fahlenbrach showed that banks with CEOs who held a lot of stock in the bank did worse than banks with CEOs who held less stock, suggesting that the bankers were simply ignorant of the risks their institutions were taking.
To say that this leap of backwards logic provides evidence that outsize pay doesn’t encourage outsize risk is a textbook non sequitur. Just because a lot of bankers took massive hits during the crash says absolutely zilch about their behavior during the boom years. McArdle desperately wants us to believe in her narrative of banks using bad information to make wrong decisions while ignoring the motivation provided by greed in taking on undue risks. Why? She’s scared of regulation that could affect executive pay in the banking industry. Therefore, to admit that a combination of fuzzy knowledge and a lack of due diligence was exacerbated by remuneration big enough to encourage more risk and turn a blind eye to gaps in the data, is simply not acceptable to her.
I can sympathize. I wouldn’t be thrilled with salary and bonus caps for financial execs either, but we have to be willing to admit that there’s something wrong with a system that trades products it barely understands, mints millionaires who get rewarded for selling more and more of them, then asks for government bailouts after its bets go sour. Afterwards, when the government wants to prevent giving more money to what are supposed to be bastions of capitalism, the system fights its efforts, calling on full blown red bating to avoid any changes to its modus operandi. Offering excuses for these self-serving actions based on red herrings and telling us that we have to stop looking for villains and just move on, isn’t going to fix the problem. It will only encourage more of the same practices that have been getting the United States into recessions since the 1980s.