Wrong Financial Incentives

The recent market turbulence is not unlike the bursting of the dotcom bubble a few years back in the way that a collection of people (brokers, bankers, marketers, structurers, traders, asset manager) are given pressure to perform based on wrong financial incentives. For example a real estate broker is paid by volume of new deals he brings, not by the quality of the credit. A marketer also gets paid upfront in terms of fee income for a structured product whose risk remains on the trading books for many years.

A trader in a hedge fund can be paid based on excess returns on average volatility is pushed to sell deep OTM options (tinny puts) that provide some income most of the time and blow up once in a while. Even private equity groups can be paid based on their income on realised sells and not on a MTM-based return. Even prime brokerage houses with their crude haircutting are pushed to maximise fee income by maximising balance sheet. Some people knowingly enter risky transactions for free merely to create bragging rights in the plethora of league tables - how nuts is that!

All of these incentives force a group of individually smart people to go down a path or make collective decisions that is catastrophic for the shareholders in the company. The problem with the sub-prime disaster is that wrong financial incentives, loosely based on fees now and no questions asked about the collateral, is in place at each step of the origination and securitisation stage. The resulting collective behaviour is that nobody was paid to check the credit quality of the lender or the quality of the collateral - which looks like bank lending 101. In fact I would hazard a guess that if anyone did, they would be branded as someone who "just didn't get it".

The problem with financial incentives is that they are self-serving, if everyone is doing so well then why rock the boat? The reaction to radical changes in incentive schemes when things are going well is usually brutal with threats to take their business and clients elsewhere. So the only time you can effect change is at the beginning and after the proverbial has hit the fan, which then is of course too late!