Politicians are quick to blame executive greed and big bonuses for causing the financial crisis. And use them to whip up public sentiment for new regulations limiting executive pay, or to at least have bank compensation schemes reviewed by the Fed.
But the real culprit wasn’t excessive compensation, it was excessive leverage, says columnist Andy Kessler, in the Wall Street Journal online. Because of cheap money and weak regulations, risk itself was undervalued. Banks were able to stock up on huge portfolios of real estate loans and mortgages because both they and the regulators didn’t think they were taking on much risk.
As competition and electronic trading reduced their profits in the early 2000s, the big banks redirected their capital into mortgage-backed securities. They earned the 2-3 percent difference between the mortgage rates and their cost of short-term capital. These investments were seen as “safe” low-risk trades. So using leverage to multiply gains on those safe trades didn’t seem particularly risky, says Kessler. And without the access to cheap money and high leverage levels, there would have an investment banking profit crisis, but not a full-blown financial crisis.
Kessler, a former hedge-fund manager, says the knee-jerk reaction to attack “greedy Wall Streeters” is misguided. Instead, there are mechanisms in existence already, including derivatives, that price in the risks of doing business. With a little better transparency, the Fed and the FDIC can use the market to protect the market.