As post-mortems of the financial crisis proliferate, it’s helpful to keep an eye on some foundational causes. Michael Lewis recently commented that “the people who squandered the most money paid themselves the most”—and continue to do so. We’ve all heard about agency problems, but rarely are they as crisply illustrated as in this post by James Kwak:
[The hedge fund] Magnetar made the Wall Street banks look like chumps. [In] one deal . . . Magnetar put up $10 million in equity and then shorted $1 billion of AAA-rated bonds issued by the CDO. It turned out that in this deal, JPMorgan Chase, the investment bank, actually held onto those AAA-rated bonds and eventually took a loss of $880 million. This was in exchange for about $20 million in up-front fees it earned.
But who’s the chump? Sure, JPMorgan Chase the bank lost $880 million. But of that $20 million in fees, about $10 million was paid out in compensation (investment banks pay out about half of their net revenues as compensation), much of it to the bankers who did the deal. JPMorgan’s bankers did just fine, despite having placed a ticking time bomb on their own bank’s balance sheet. Here’s the second lesson: the idea that bankers’ pay is based on their performance is also hogwash. (The idea that their pay is based on their net contribution to society is even more absurd.)
I was recently at a conference on “Too Big to Fail” banks organized by Zephyr Teachout, and several experts explained how the tail of massive compensation was wagging the dog of societal capital allocation. William K. Black‘s theory of “control fraud” is one of many efforts to illuminate the persistent conflicts of interest between banks, bankers, and investors, but one needn’t designate any of these conflicts “fraudulent” in order to see how socially destructive they have become. Rather, pulling back to see the big picture—from the lens of political economy—illuminates the key drivers of the crisis. As Kwak notes, “the crisis was no accident: it was the result of the financial sector’s ability to use its political power to engineer a favorable regulatory environment for itself.” Thinkers across the political spectrum—from Kling to Kuttner—can recognize the critical role of political connectedness in driving bankers’ compensation.