Part 8 (2/2)

One way to fix this mess would be to create bonus pools that aren't calculated on short-terer ti its ees their performance over the course of several years Let's say a trader's risky bets yield outsize returns one year and equally outsize losses the next Under the current systeet a nice bonus the first year and nothing the second By contrast, under a longer time horizon, the losses would cancel out the profits, and the trader would get nothing at all

A variant of bonus pooling has been proposed by Raghuram Rajan In his scheh returns, but their bonuses would be held in escrow for several years Should a trader incur a loss in subsequent years, it would be subtracted fro bonus account In this ”bonus-malus” syste to the ups and downs of a trader's long-terer the bonuses are held in escrow, the more likely the traders will be to think -term revenue

The bonus-malus system works best if applied on an individual level Unfortunately, bonuses are often calculated on an institutional level, so that when bets pay off, everyone shares in the proceeds Traders and bankers do not directly suffer the consequences of their bad decisions, which are borne by the pool at large Still, collective clawbacks-the repossession of bonuses across the board- desks

The problem of compensation has a more diabolical solution: to compensate traders and bankers not with money or with stock but with the very sa up in their laboratories Traders and bankers would get bonuses, but in a very specific form: a little slice of, say, that CDO that they had a hand in et paid with the sa here is that if traders know that the proverbial chickens will coe, they s they lay

A version of this plan is already operational At the close of 2008, Credit Suisse announced that it was shi+fting some 5 billion worth of toxic assets off its own balance sheet and into a special fund It then paid bonuses to e the usual form of compensation (shares of stock in the company) with shares of this fund This raised some howls of protest; after all,to do with the bad bets Still, however iood start

Yet another kind of compensation scheme could draw from all of these proposals For exa employees with the consequences of their bad bets (as the Credit Suisse sche that bonuses of bankers and traders will be paid in the securities they have a hand in creating Better yet, put those securities-cuh time pass to determine whether they are toxic or not Finally, forbid eainst any potential losses on these future bonuses (They are traders, after all, and if there's one thing they're good at, it's ) Whatever change in compensation is ultimately adopted should be implemented across the board If one major financial firm adopts some version of the bonus-malus system but no one else does, eh-rolling firovernment overnment has the power to reform the compensation system in comprehensive fashi+on It has plenty of justification for doing so: the govern public-has effectively bailed out and backstopped the entire financial syste sure it doesn't have to do it again Moreover, given the tangled web of principal-agent problems, shareholders cannot possibly be expected to reforovern the lines above

Let's be clear: we're not suggesting that governh it would certainly be ithin its rights to do so, particularly with banks still on govern is in a way more radical: that compensation be completely overhauled to reduce risky behavior, and by extension, the likelihood of another systelobal financial syste traders' incentives for taking on short-ter disincentives, in the form of clawbacks) will probably cause co? No In recent years, the financial services industry-and coone exorbitant and utterly unwarranted growth, driven by financial liberalization, financial innovation, elilobalization of finance

In the process, finance's ”contribution”-if that's the word-to the US gross domestic product has soared from 25 percent in 1947 to 44 percent in 1977 to 77 percent in 2005 By that time financial firs of the companies listed in the S&P 500, and these firms' share of the total S&P 500 market capitalization doubled to approxi, the coers exceeded the compensation of the combined income of the CEOs of all companies listed in the S&P 500 In 2008 no less than one in every thirteen dollars in co in finance By contrast, after World War II a mere one in forty dollars in compensation went to finance workers

This outsize and excessive growth of the financial system did little to create any ”added value” for investors While e funds, investers claimed that they could provide investors with superior ”alpha” returns (in other words, bigger returns than those provided by ers), ”sch asset her returns, but investors saw little of it, because the edly superior services

The various players in the financial system parted investors from their money in other ways too Take securitization: at every step of the process, so bank, a hoency-charged high fees for its ”services” and transferred the credit risk down the chain But it was an oligopoly of investe the lack of transparency about these operations to extract profits from credulous investors, most of which ended up in the pockets of these firms' employees rather than those of the shareholders of the firnificant social costs too, as innovation and creativity have fled fro and other old-fashi+oned industries in favor of Wall Street Indeed, since the 1970s, as our colleague Thorowing nuhly educated workers As coly went to Wall Street In fact, a 58 percent of thethe workforce were bound for jobs in finance or consulting In a curious paradox, the United States now has too h ineers

Not coincidentally, the last tirowth in the financial sector was in the years leading up to1929 In the 1930s, coulatory crackdowns that , iftoday's warped co banking boring once e

Compensation is hardly the only problem that cries out for reform; the elaborate system of securitization that helped cause the recent crisis inate-and-distribute model of securitization (see chapter 3), a potentially risky asset-a subprie, for example-was pooled with similar assets and turned into securities that would be sold to investors better able and willing to tolerate the risk

One obvious flaith this system was that it reduced incentives for anyone to actually monitor the creditworthiness of the borrower Instead, the various players in the securitization process pocketed a fee while transferring most, if not all, of the risk to soe broker who handled the initial loan; the hoive inflated values; the bank that originated the e-backed securities; the invested these securities into CDOs and far encies that bestowed coveted AAA ratings along the way; and the monolines that insured those toxic tranches

Any solution to the problem of securitization must somehow force these different players to more carefully consider the risks involved In other words, each player ed to payloans One way to do so is to force inter bank and the investment banks-to hold on to so theoes, will induce the the creditworthiness of the original borrowers (and leaning on the e brokers and others who serve as the first link in the chain)

A number of proposals in circulation push this idea Soroups within the G-20; others are horown, such as the Credit Risk Retention Act, which passed in the House of Representatives in Deceislation proposes that banks involved in creating asset-backed securities (not only es, but any number of loans) be forced to retain 5 percent of the securities they create; a separate proposal in the Senate would increase that figure to 10 percent Both proposals wisely forbid the banks to hedge or transfer any risk that they incur by retaining these securities

Unfortunately, these low ae behavior In the recent crisis, nificant exposure to the various securities that they had a hand in creating Most of the AAA supersenior tranches of CDOs, for example, were retained rather than sold to investors At the time of the crisis, in fact, approximately 34 percent of all the assets of major banks in the United States were real-estate-related; the figure for sinate-and-distribute model transferred some risk, but it certainly didn't transfer all of it; ame Otherwise, they would not have sustained the losses they did

Fir so For this reason, relying on retained risk or ”skin in the ga securitization is questionable While it's a useful complement-and certainly will focus attention down the line on the risk incurred by holding such assets-it's unlikely to be a cure-all Traders ladly comply with requirements to retain risk, particularly if they can find a way of doing so that yields a bigger bonus But a bigger bonus, as we've e firms to retain risk won't doprobleovernment subsidies, all but ceased The reason it remains comatose is that even now, it's not really clear ent into the alphabet soup of securities that fed the booo years was a bit like sausageAde, much less the quality of the meat And so it remains today: financial institutions can still churn out the sausage, but given e know s, is it any surprise that investors have lost their appetites?

Some people believe that securitization should be abolished That's shortsighted: properly reformed, securitization can be a valuable tool that reduces rather than exacerbates systemic risk But in order for it to work, it must operate in a far more transparent and standardized fashi+on than it does now Absent this shi+ft, accurately pricing these securities,the market for securitization, is next to impossible What we need are reforms that deliver the peace of in with standardization At the present time, there is little standardization in the way asset-backed securities are put together The ”deal structures” (the fine print) can vary greatly fro Monthly reports on deals (”reatly in level of detail provided This information should be standardized and pooled in one place It could be done through private channels or, better, under the auspices of the federal govern asset-backed securities to disclose a range of standard inforinal loans to the ainated the security

Precisely how this infor as it is done: we must have some way to compare these different kinds of securities so that they can be accurately priced At the present ties proble them with any accuracy iives us no way to quantify risk; there's far too much uncertainty

Standardization, once achieved, would inevitably create more liquid and transparent ood, but a few caveats also co some transparency to plain-vanilla asset-backed securities is relatively easy; it's more difficult to do so with preposterously complicated securities like CDOs, much less chimerical creations like the CDO2 and the CDO3

Think, for a oes into a typical CDO2 Start with a thousand different individual loans, be they coes, auto loans, credit card receivables, se theether into an asset-backed security (ABS) Take that ABS and combine it with ninety-nine other ABSs so that you have a hundred of them That's your CDO Now take that CDO and combine it with another ninety-nine different CDOs, each of which has its own uniqueassets Do the math: in theory, the purchaser of this CDO2 is supposed to so loans Is that going to happen? Of course not

For that reason, securities like CDOs-which now go by the nicknaulated if not banned In their present incarnation, they are too estranged froive them value and are next to ie part to their individual complexity, they don't transfer risk so much asrisk-ies

In fact, the curious career of CDOs and other toxic securities brings to arbage out” Or to return to the sausage- parts into your sausage, then coe (each filled with equally nasty stuff), you haven't solved the problee

The le of securitization reforredients In the end, the probleredients were sliced and diced beyond recognition than that ood in the first place Put differently, the probleinate-and-distribute lies less with the distribution than with the origination What matters most is the creditworthiness of the loans issued in the first place

That's why reforinated It's not as if the regulatory apparatus for doing so isn't in place In the United States, the Federal Reserve, the FDIC, the Office of Thrift Supervision, the Office of the Comptroller of the Currency, and the National Credit Union Adulate the sorts of loans that end up in various kinds of asset-backed securities The existing regulations and guidelines iven real teeth to ensure that what ends up in the securitization pipeline isn't toxic

The Federal Reserve has already taken steps in that direction, proposing significant changes to Regulation Z (also known as Truth in Lending) These changes would nize the true costs of theIt would also place restrictions on those originating the loans Coer be linked to the interest rate of the loan, e brokers and loan officers would be expressly forbidden to steer consuer or more expensive loans, sies would be sensible, but cleaning up securitization requires that policy : the rade these products Their financial equivalent would be the ratings agencies, and like their counterparts in the USDA, they haven't always lived up to their responsibilities

Refors

In the United States, three encies-Standard & Poor's, Moody's Investors Service, and Fitch Ratings-wield rees to corporate bonds to the sovereign debt of entire nations These grades reflect the likelihood that the borrower or borroill default on their debt, and they are central to how financial s are a way to outsource due diligence: if Moody's says a particular CDO tranche is supersafe and gets an AAA rating, then it spares anyone else fro to pop the hood of the security and look at the underlying assets

The ratings agencies' rise to power began in the 1930s Their forerunners issued ratings that federal regulators used to assess the quality of bonds held by banks This staovernment approval helped cement their influence, and while their poaned in the iain in the 1970s, a tily i risk

In 1975 the Securities and Exchange Conized Statistical Rating Organization (NRSRO) Fitch, Standard & Poor's, and Moody's were anation In effect, anyone selling debt had to get a rating froencies While the SEC eventually recognized seven of these agencies, h the SEC has recently given this designation to a handful of lesser-known cos agencies have changed dramatically In the early years, they made their money from investors, who paid them to evaluate potential investments Over time this revenue model shi+fted, partly because so their friends' rating et around that probleencies adopted a new business model: they would sell their services to issuers of debt rather than to investors At the same ti a rating on anyone anted to sell debt By the 1980s the transition was cos

This arrangement, however, created ato float soencies to find the best rating A ratings agency that looked at a proposed offering and slapped a subprily, the ratings agencies had an interest in giving the custo for an MBS ood chance that's what it got

As if that weren't bad enough, the ratings agencies started to generate revenue froether a structured financial product would go to one of the ratings agencies and pay for advice on how to engineer that product to attract the best possible rating froency the bank would ultimately pay to rate its securities This service was described as ”consulting” or ”” Perhaps In fact, it was a bit like a professor's accepting a fee in exchange for telling students how to get an A on an exaencies be reforenciesservices They should exist for one purpose: to assign a rating to a debt instru more introduces a possible conflict of interest While the SEC has issued rules that forbid the ratings agencies to consult with the companies they rate, this ban is extraordinarily difficult to enforce Instead, the SEC should forbid the ratings agencies to consult or model for anyone

It also ed realht have been difficult to justify ten years ago, when the collective reputation of the big three was still intact, it's an easier sell now Unfortunately, the SEC makes it very difficult for new co: newcomers must have been in business for several years and have etinducted into the sacred circle To address this problem, the SEC needs to lower the barriers to entry, so that more competition-free market competition, if you will-enters into this vitally important industry

More radical still would be to take away the seencies now enjoy Everything froulations to Basel II capital requirenize the NRSROs as the only place fronition invests the that poould be another way of opening up competition

An even encies to return to their original business model, in which investors in debt-not the issuers of it-pay for the ratings Unfortunately, this is easier said than done One reason is the ”free rider proble and ure out the rating and e