Wednesday, 3 June 2009

Skin in the game

At first glance the sub-prime debacle looks like a classic example of the “principal agent problem” where the principal seeks to align the agent’s interests with his or her own.

The principals here were the buyers of sub-prime debt. The agents were the brokers who sold the debt, the mortgage companies that provided it, the financial engineers who packaged it into asset backed securities and the investment bankers who sold it on to principles as securitisations.

Whereas the principal was looking for a nice, safe earner, the agents’ immediate interests didn’t include the safety of the individual credits. This was because the credit risk involved had been transferred to the principal leaving the agents to chase the fees and commission each new mortgage sale generated. Unfortunately, despite the principle having a clear interest in the underlying credit risk of what they were buying, they had less information about this than the agents. This was why rating agencies were so important; by rating the credit risk attached to the debt packages they performed the necessary due diligence on the principal’s behalf. So whether the interests of the principal and agent were aligned became apparently immaterial. Besides, anyone trying to sell on dross would be subject to reputational damage and a loss of trust that would undermine their ability to sell on their debt in future.

Neither of these checks turned out to be any good. The rating agencies, conflicts of interest aside re: who was paying their fees, got it wrong. Simple. End of. As for reputational risk well if everyone is selling dross, everyone’s reputation is damaged and the market as a whole is affected rather than individual reputations.

The big, big challenge is bankers, politicians, bank regulators and central bankers want securitisation to come back again. Securitisation gave retail banking customers indirect access to institutional investor cash, which they used to buy houses. This made new home owners happy along with builders and stamp duty collecting governments. But, most of all it made all the agents listed above smile like idiots. Unfortunately, right now no one can do a residential mortgage securitisation and sell it onto anyone other than a central bank. With the securitisation market effectively dead and no signs as yet of it recovering nobody is smiling.

This is a major factor when it comes to explaining why the regulations covering securitisation are going to be changed; there are too many vested interests at work for it just to be left to die. Instead bank regulators and central banks are going to try and make it more secure in the hope this will eventually prompt the return of private investors.

One of the main developments here is being led by Charlie McCreevy, the European Commissioner for Internal Market and Services, who is seeing to the introduction of a “5% retention for securitisation”. This means that the people trying to sell on debt will have to retain at least 5% of it. The logic of this is the principal-agent problem writ large because by retaining a small tranche of it the agents will be left with a vested interest in making sure its safe or to quote Charlie the change will mean in future they will retain some “skin in the game”.

It’s a nice idea. In fact for what its worth I’m all in favour, it’s just it’s also a little bit pants and here’s why; if you sell senior debt like a mortgage, worst case scenario at least you can call up the house, sell it and try and get some of your money back. However, if you provided equity instead you only get any crumbs left after the senior debt provider has tried to get their loan back i.e. chances are you’ll get hee haw.

This fundamental difference in risk is why equity investors (think dragons den) typically charge a lot more than lenders. Now, leaping from housing to the commercial property market, yes it saw plenty of commercial property securitisations, however it also saw more and more lenders providing more and more debt AND equity or in Charlie’s terms more and more banks had more and more skin in the game, yet they still fucked it all up.

The real issue for me is what kind of institutional and cultural arrangements see banks continue to throw money at asset bubbles even after they’ve burst regardless of whether they’re principals, agents or jabberwockies. 5% retention? 50% retention? Who cares, rather its about institutional investor expectations and the ability of corporate leaders to manage them, marketing departments that don’t understand the markets they lend to, executives fixated on next quarter’s sales targets and organisational sycophants who know damn fine well the way to get on is to fall into line rather than to apply commercial judgement and common-sense and question whats actually going on.

To give a practical example of this my understanding is in one bank an economics team were quietly advised well into last year not to use the term credit crunch in their reports in case a particular executive read them; because he didn’t believe there was a credit crunch all external analysis had to skirt around the issue. Now how fucked up an organisational culture is that? What kind of risks does it pose and should that level of institutionalised stupidity not also be a target for regulators?

Similarly, the debate over pay and bonuses also strikes me as pants. The big emphasis right now is on deferring compensation with the principal agent problem appearing to underly much of the thinking. Except for executives much of their compensation is already arguably deferred due to the emphasis on share options. Similarly the existing emphasis on rewarding people in shares also means they have a vested interest in the future performance of their employing organisation (think of the comments made by the bank execs summoned by the Treasury select committee about how much they’d personally lost).

I’d argue instead that deferring rewards simply hasn’t enough bite and that 2 additional measures are needed. The first is clawbacks – you do a deal today that ends up costing money in 5 years time? Clawback!Gie us some of your cash and if you haven't got it we'll bankrupt you! The second concerns severance terms.

Right now any banker of any seniority exists largely outside employment law i.e. the amount they’re likely to receive based on a standard compromise agreement of 6 months salary (with the first 30 grand tax free) relative to the maximum award for say constructive dismissal means they have no interest in taking their employer to an industrial tribunal unless they can claim some gender discrimination was going on in which case the potential pay out is uncapped (ahh, so that’s one reason why sacked gay and female financiers flag up gender issues!). Then theres the reputational aspect that means someone even moderately senior who fucks up big time is typically given the opportunity to resign rather than be sacked, which avoids any of the conflict that could lead to a banks institutionalised incompetence hitting the news.

So there’s arguably a culture in corporate banking of throwing money at human resource problems until they go away and/or sweeping them under the carpet. Changing what an employment tribunal can award to a salary multiple and/or the existing limit, whichever is higher, would address this and expose banks to more scrutiny because it would see more bankers taking banks to employment tribunals, which in turn get reported on by the media. Alongside this I’d also suggest reworking executive severance terms into two phases alongside a basic performance clause whereby people e.g. Fred Goodwin, who feck up get feck all. So this would take the standard executive benchmark of share prices and use it to assess (1) the applicability of existing reward policies and then (2) their application with a clear justification issued at each stage that requires signed approval by say a non-executive committee. You’ll still get people fucking up right enough, but hey ho at least they won’t have as much cash left to console themselves with. And for those that question the fairness of treating executives differently, they already are by specialist executive pay teams and consultancies that operate alongside the bods who work out how much to pay everyone else.

A P.S. 17th June - shoulda realised - a big thing with originators keeping a chunk of the debt is it clogs up their balance sheets. If they could sell it all on then their capital base is irrelevant. if they have to keep a slice, then the amount of debt they can originate is constrained by their capital base. So skin in the game is all very well, but here it seems to mean limiting the growth in mortgage finance.

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