Why the G-20 Must Regulate Bank Pay

How were outlandish bank bonuses one of the principal causes of the credit crisis?

September 23, 2009

How were outlandish bank bonuses one of the principal causes of the credit crisis?

A generation ago, banks took deposits, made loans and collected payments.

Back then, bankers quickly felt the consequences of money lent to folks unlikely to repay.

During the 1980s, deregulation pushed up interest rates on deposits. Banks got caught with old mortgages on their books yielding less than they paid for deposits. The U.S. Savings and Loan Crisis resulted, motivating banks to sell new loans to investors instead of holding those in their portfolios.

Banks wrote mortgages and sold those to Wall Street financial institutions, who bundled loans into bonds and sold those to investors such as insurance companies and foreign governments.

Often, separate mortgage service companies were established to collect payments — and foreclose on delinquent loans.

From loan officers to the Wall Street bond salesmen, opportunities to exaggerate the quality of loans emerged. If local banks or Wall Street financial houses could pawn off high-risk, high-fee loans as reasonably safe, they enjoyed big paydays.

Wall Street bankers wrote bogus insurance policies called SWAPS that were supposed to limit losses for investors when mortgages defaulted. One of the modern world's biggest culprits, AIG, wrote many SWAPS without capital to back them up, and banks even wrote SWAPS on each other's mortgages.

It was as if two homeowners on a North Carolina beach promised to pay one another in the event of a hurricane.

Well, the storm came, and AIG and several big banks became insolvent. In a flash, Washington decided they were too big to fail and bailed them out.

And wouldn't you know it, the key point of writing SWAPS and selling bad bonds to unwitting investors was to permit bankers to earn huge profits and bonuses. When too many mortgages failed, investors and bank shareholders took enormous losses — and U.S. taxpayers had to bail out the banks.

Apart from the TARP, the U.S. Federal Reserve and FDIC permitted banks to borrow at rock bottom interest rates and enjoy big profits to rebuild their capital. Consequently, widows relying on Certificates of Deposit for income now receive much-reduced interest rates. That's right — Ben Bernanke is taxing grandma to bail out Goldman Sachs.

Flush with profits, the banks are up to their old tricks. Once again, they are creating highly engineered financial products, selling swaps, setting aside massive profits for bonuses — and manufacturing conditions for another crisis.

If Wall Street banks are too big to fail, then they are too big to be allowed to continue this irresponsible behavior.

French and German regulators advocate limits on bank compensation, and the Federal Reserve is considering prohibitions on compensation practices that encourage excessive risk taking. The latter is too complex to be realistic — the banks would run circles around such rules, much like lawyers creating tax shelters.

Better to limit bonuses and salaries of bankers to a fixed percentage of net income that aligns financial sector salaries with those of other industries.

Harsh for sure, but so is the pain bankers' recklessness has imposed.

Bankers should not be allowed to pay themselves royally — and put the United States or any other nation, for that matter, at risk again.

Takeaways

Widows relying on Certificates of Deposit for income now receive much-reduced interest rates. That's right — Ben Bernanke is taxing grandma to bail out Goldman Sachs.

The U.S. Federal Reserve is considering prohibitions on compensation practices that encourage excessive risk taking. The banks would run circles around such rules, much like lawyers creating tax shelters.

Banks even wrote SWAPS on each other's mortgages. It was as if two homeowners on a North Carolina beach promised to pay one another in the event of a hurricane.