The Black Sheep of the Credit Crisis: the Bonus Payout!

In the hunt for the black sheep of the credit crisis we have arrived at the bonus payouts. The unbridled bonus culture has led to the neglect of the higher importance of banks as institutions and of the financial system in its entirety. But the bonus payouts are not the only black sheep!

Of course it all started in America with the sale of junk home loans to unsuspecting old ladies, vagabonds, and the poor in general. These increased the sellers’ bonus payouts without the institutions providing the mortgages getting suspicious about the risks. There was no need for concern because these institutions were able to pack their risks away in Special Purpose Vehicles (SPVs). These SPVs issued bonds to investors who were under the impression that they were receiving decent securities thanks to the ratings of renowned agencies such as Standard & Poor’s, Moody’s and Fitch (hang on, of course these parties also had the obligation to stay alert). Investment banks earn fees from selling such securities, and here, too, the more they sold, the higher the bonuses. The payouts were so handsome that many, if not all, lost sight of the long-term effects and the risks. That was America.

Here in Europe, banks and other institutions took part in this pyramid scheme. They mainly bought and sold junk securities to investors. Of course that, too, earned fees. Despite this, the situation is different from the American one. The originator fees are higher than the fees in the secondary mortgage markets. Just look at the bonuses for the people at Goldman Sachs ($18.8 billion in 2007, about $10 million per person for each head of department) and compare this to the bonus payouts here: the Fortis sub-top will receive up to a maximum of €140,000 in 2008. Please note that I am comparing two different years.

By the way, not every banker’s bonus payout was linked to the sale of junk home loans. Of course banks did, and still do, other work for which bonus payouts can be defined. This is not necessarily as problematic as the junk home loan constructions. It is nonsense to be hell-bent on a ban of bonus payouts everywhere and always, thinking that they are wrong for every situation. On the other hand, not all bonus payout arrangements make equal sense (for instance, the retention bonus is a very arbitrary one), but that doesn’t mean that they should be forbidden by law. It pays to stop and think first.

It wasn’t just the bonus payouts that led to the crisis we are in at the moment (see my column ‘a lethal cocktail’ for the other building blocks). Size, liquidity surplus and the small number of parties controlling the market play important roles too. However, bonus payouts do encourage perverse behaviour. Large, narrowly defined bonuses lead to a very strong focus on what gets rewarded (in this case turnover or profit) while other aspects are neglected (in this case risk).

The SPV trick then ensured that nobody took ownership of the problem. Everyone focused only on turnover and profit. And, finally, the supervisors for the sector in America failed because they did not point out to the investment banks the magnitude of the risks they were taking.

As a result our black sheep are turning into a nice flock. It wasn’t just the bonuses that caused the evil. A combination of factors led to the problems. It makes sense to adjust the payout construction: less short-term focus, more attention to other relevant aspects (e.g. making the rewards less variable) and more supervision. The combination of factors shows that that’s not enough on its own.

Oscar Couwenberg

Professor of Law and Economics