(RTTNews) - Since the credit crisis first seized the financial markets last year, experts have been trying to diagnose the cause. Early suspects have ranged from ignorant borrowers to over-enthusiastic lenders, from inattentive regulators to unresponsive credit rating agencies.
While these are still perceived as prime drivers of the crisis, some critics have moved beyond the specific, institutional issues that contributed to the crisis to identify a more timeless underlying cause: pure individual greed.
Some prominent market watchers have argued that the front-loaded compensation structure used by the majority of firms on Wall Street contributed significantly to the conditions that led to the credit crisis. Under this structure individual employees are financially compensated for short-term achievements instead of for the long-term effect of their actions.
Usually, the member of a corporation - whether it be a trader or a CEO - will take a risk and reap the rewards immediately. However, when things go wrong, there's little penalty, except maybe the loss of a job - often times with millions of dollars in compensation.
Richard Herring, a professor of Finance at the Wharton School of Business at University of Pennsylvania, is among those that put at least part of the blame for the credit crisis on a flawed compensation structure.
'I do believe that a misalignment of incentives was a critical contributing factor,' he told RTTNews. 'Compensation should never be paid upfront for products with long tails.'
In the case of the credit crisis, that could include snatching up mortgage-backed securities, which during the boom of the subprime market resulted in short-term compensation. However, in the longer term these short-sighted risks exposed companies to longer-term damages.
This is clearly seen now after the some of the world's largest financial institutions have announced billions of dollars and losses and storied Wall Street firm Bear Stearns
(BSC), was forced to sell itself to avoid bankruptcy.
Although he believes it played a role in the credit crisis, Herring said that compensation is 'not the whole story,' noting that the bank IKB, one of the first to feel the burn of the credit crunch, was 'unlikely to have had supercharged incentives.'
Still, in many cases, a poorly-structured compensation plan set the stage for the credit crisis.
Financial firm UBS
(UBS) has lost more than $100 billion in U.S. asset-backed securities since the start of the credit crisis, a mere 3 years after UBS was the No. 1 investment bank in the world back in 2004. The company reported an $11.65 billion loss in its first quarter compared to a profit last year, due in large part to losses of around $19 billion on US real estate and related securities.
Barry Ritholtz, author of the Big Picture blog, authored an article examining the compensatory structure of UBS, with 'big salaries and bigger bonuses.' Ritholtz cited structural incentives designed to implement carry trades, a structure that all-but-ignored risk issues when determining compensation, and a lack of incentive to protect the integrity of the UBS franchise over the long-term.
Basically, as Ritholtz explains, employee bonuses - a large source of income on Wall Street - were determined based on revenue after base salaries were deducted and ignored the quality of the earnings.
Speaking at a conference put on by the Federal Reserve Bank of Chicago in mid-May, Jason H. P. Kravitt, a partner at the law firm Mayer Brown, LLP, summed up the concerns of many. He said he believed part of the cause of the recent credit problems was that some compensation systems were oriented toward very short-term performance.
'It is crystal clear to me that every participant in the chain had much to lose so they should have been making careful decisions,' Kravitt said.
He said that these 'front-loaded' compensation plans allowed individuals to make decisions that were not good for their employers - decisions that have ultimately led to what Kravitt termed a 'massive liquidity crunch.'
Speaking with RTTNews, Kravitt noted that most compensation systems in the finance industry are 'very heavily focused' on the gains from a single year, a combination that 'doesn't necessarily align your interest with the self-interest of the institution.'
Kravitt disagrees with those who claim the originate-to-distribute model creates a moral hazard. Rather, he notes that 'every link in the chain has an interest in having high-quality assets move through the system.'
Some suggestions for fixing the problem include basing compensation on realized gain, rather than short term and often temporarily inflated gains.
At Kravitt's firm, 'we try and compensate people over time,' he explained.
'If you have a fantastic year, you're not necessarily going to get compensated,' Kravitt said.
Whether or not the compensation system will see any changes in the wake of the credit crunch remains to be seen. However, Kravitt didn't appear overly optimistic.
'I haven't heard a lot of talk about compensation systems,' he said. 'If you don't hear a lot of talk, it's not likely that people are generally viewing that as part of the problem or are generally dissatisfied with it.'
'Compensation is very tricky, because at root, it's a very competitive market,' Herring noted.
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