Compensation Didn't Cause The Crisis

Andy Kessler has a good opinion piece in the Wall Street Journal today. In it, he explains why pay controls for Wall Street are a red herring. I've made the same comment, but it's worth looking at some of the points he makes, because I think they're strong arguments. Here's his key point:

It wasn't reckless schemes and excessive risk that sunk banks and Wall Street; it was excessive leverage. And thanks to cheap money and twisty regulations, risk was extremely undervalued. Banks owned huge portfolios of real-estate loans and mortgages specifically because they, and regulators, didn't think they were taking much risk at all.

I would add two points. First, nothing fundamentally changed over the past decade in Wall Street compensation style. So to say that Wall Street suddenly took greater risks than ever before because of a new prospect of greater pay is an absurd conclusion to draw.

Second, even if pay were capped, Wall Street firms would still try to maximize profits -- because that's what they do. I'm not sure I understand the how capping pay or changing incentive structures would hope to change banker behavior. They will always try to earn the highest return, whether for job security, career advancement or to appease shareholders. The distinction between short-term and long-term profit is dubious at best. Both are important goals. And bankers didn't take short-term risks knowing they would go bad. Kessler explains this:

Populist pay limits are squarely aimed at Wall Street, not local banks, yet for the most part Wall Street doesn't take much risk. Highly profitable investment banking and sales and trading are agency businesses, doing work for customers for a fee.

He goes on to say that bad trades do happen and explains how they did over the past several years:

As competition and electronic trading ate into the agency businesses and profits in the early 2000s, the firms redirected their capital to invest in mortgage-backed securities, pocketing the 2%-3% difference between mortgage rates and their cost of short-term capital. This was the easy trade, the safe trade--not a "thirst for reckless schemes."

In a sense it was a simple arbitrage trade. The problem, of course, was that those mortgage-backed securities weren't as safe as everybody thought. The rest is history.

Would a change in compensation style have prevented that trade? Of course not. It was a way for banks to make money -- and that's their job.