Why Big Banks Fail to Act in Their Own Self Interest

In an earlier post, I characterized some financial institutions as “shadowy and unstable ensembles of desks and divisions whose main goal is slipping by whatever bonus-maximizing scheme won’t set off alarms among risk managers and regulators.” Too harsh? Well, today ProPublica’s Jake Bernstein and Jesse Eisinger offer offer yet another confirmation of value-destroying skulduggery at the core of contemporary finance. They explain how payments of a few million in “bonuses” to employees running one division of Merrill Lynch helped those running another division “offload” billions of dollars in toxic assets to their own firm:

Two years before the financial crisis hit . . . [n]o one, not even the bank’s own traders, wanted to buy the supposedly safe portions of the mortgage-backed securities Merrill was creating. Bank executives came up with a fix . . . .They formed a new group within Merrill, which took on the bank’s money-losing securities. But how to get the group to accept deals that were otherwise unprofitable? They paid them. The division creating the securities passed portions of their bonuses to the new group, according to two former Merrill executives with detailed knowledge of the arrangement.

The executives said this group, which earned millions in bonuses, played a crucial role in keeping the money machine moving long after it should have ground to a halt. “It was uneconomic for the traders” — that is, buyers at Merrill — “to take these things,” says one former Merrill executive with knowledge of how it worked. Within Merrill Lynch, some traders called it a “million for a billion” — meaning a million dollars in bonus money for every billion taken on in Merrill mortgage securities. Others referred to it as “the subsidy.” One former executive called it bribery. The group was being compensated for how much it took, not whether it made money.

The three men at the top of the scheme made about $6 million each that year, and there were probably some handsomely paid lieutenants beneath them. Surely, there must have been someone who objected to such deals? There was: “a Merrill trader [who refused to go along] . . . was sidelined and eventually fired.” The power in the firm was held by those who could make quick money in big deals. Has anything changed about the structure of these firms since the crisis to alter that dynamic?

I think there is one key lesson that emerges out of a story like this, one of an excellent series ProPublica has been doing over the past year: we need a financial transactions tax. Dozens of critics of health care finance have observed that if you pay only for procedures and office visits, you get more procedures and office visits—not necessarily better outcomes. In finance, traders are getting fees for deals with no regard for the ultimate outcome. Some tax on the transactions is needed to pay to clean up the mess this excessive churn will inevitably create.

It’s become fashionable nowadays for thoughtful conservatives to acknowledge the damage that Wall Street wreaks, then immediately claim that very little can be done about it. Richard Posner’s A Failure of Capitalism was ahead of the curve in articulating this position; Tyler Cowen offers its latest incarnation:

For better or worse, we’re handing out free options on recovery, and that encourages banks to take more risk in the first place. In short, there is an unholy dynamic of short-term trading and investing, backed up by bailouts and risk reduction from the government and the Federal Reserve. . . . .And it’s not just the taxpayer cost of the bailout that stings. The financial disruption ends up throwing a lot of people out of work down the economic food chain, often for long periods. Furthermore, the Federal Reserve System has recapitalized major U.S. banks by paying interest on bank reserves and by keeping an unusually high interest rate spread, which allows banks to borrow short from Treasury at near-zero rates and invest in other higher-yielding assets and earn back lots of money rather quickly. In essence, we’re allowing banks to earn their way back by arbitraging interest rate spreads against the U.S. government. This is rarely called a bailout and it doesn’t count as a normal budget item, but it is a bailout nonetheless. . . .

[But we] probably don’t have any solution to the hazards created by our financial sector, not because plutocrats are preventing our political system from adopting appropriate remedies, but because we don’t know what those remedies are.

Cowen has opposed a transactions tax in other contexts, and I can’t see him getting too enthusiastic about this one as a risk-deterring method. But there must be some way of targeting these internal accounting tricks to make reckless risk-taking more expensive.

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