A quarterly magazine of urban affairs, published by the Manhattan Institute, edited by Brian C. Anderson.
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Pay for Performance
A modest proposal for reforming how banking products are sold
5 February 2009
A Yiddish joke tells of a matchmaker who hectors a young man until he finally agrees to meet the woman heavenly ordained to be his wife. The introduction is made, and the matchmaker pulls the client aside: Well? Well?! the client hisses. You might have told me she was old, homely, and lame. You dont have to whisper, comes the response. Shes also deaf.
Part of what led to the current credit freeze is that our banking system adopted the matchmakers ways. When banks lend money on their own booksthat is, from their own capital and their depositorsthey must take meticulous care to ensure that their borrowers will repay. Much like someone seeking a lifelong mate, they realize that a great dealin this case, the viability of their enterprisehangs on their selection. But it is a different matter when investment banks underwrite corporate bonds or produce asset-backed securities out of existing loans. The bank collects a matchmaking fee, but the actual lending risk is assumed by whoever ultimately purchases the debt.
This non-balance-sheet lending has a long pedigree, as everyone now knows, but it ballooned in recent years as all kinds of debt productsmortgages, auto loans, and credit-card receivables, to name just the most conventional oneswere, in a process called securitization, bundled into tradable securities. According to Federal Reserve data that Nicole Gelinas cites, some two-thirds of the $25 trillion in outstanding private debt in America is in bonds and securities.
The growth of securitization brought numerous advantages. When a Wall Street firm bundled a set of mortgage obligations into securities, it enabled the original lending banks to offload some of their credit risk and free up capital to lend again. The securities purchasers could calibrate their own desired level of risk with a diverse array of holdings. There were also broader societal benefits, or at least seemed to be: credit at all levels become more accessible and affordable, and capital markets became more liquid.
But there were considerable drawbacks, as we have learned. Like matchmakers, investment bankers and brokers were being paid according to how much they could bundle and sell. Their incentive became to push money out the doorthat is, to create as much marketable inventory as possiblerather than to issue and underwrite the soundest possible loans and instruments. The risk, after all, was someone elses (unless, as in many cases, banks themselves purchased such securities, or couldnt sell them after creating them). The overeager hustling also trickled down to banks doing direct lending. Knowing that they did not need to carry loans until maturity, they loosened their own credit standards in order to do business by volume.
Now that so many lame products have been exposed and trustthe vital component of credithas vanished from the banking system, how are the credit markets to be revived? Congress and the new administration have floated several ideas, mostly involving curbs on bankers compensation and greater regulation of mortgage brokers, investment banks, and credit-rating agencies. But even if the federal government can implement these measures effectively, it may find them to be at odds with the accompanying Washingtonian imperative that banks stop hoarding capital and start lending.
An idea that need not involve governments heavy hand is for investment banks to adopt a self-regulating compensation model that better aligns their interests with those of their depositors and borrowers, trading counterparties, and clients. Instead of getting paid up front according to how much money they push out the door, they might borrow a practice from industries in which fees get paid for the performance of the product or services sold. Commercial real estate leasing brokers, for example, are routinely paid their commissions over time as tenants make good on their rent. Insurance and annuity products create recurring revenue streams for both the underwriter and the selling broker as clients pay their regular premiums.
Why shouldnt the same model apply to banking? When a debt instrument is created, some of the fee that, until now, has been paid up front should instead go into an escrow account, to be released over time as the instrument and underlying debt prove sound. The parameters might include paying bankers a significant chunk of the fee, say 20 percent, upon closing (or issuance of the security), with the remaining 80 percent escrowed. For short-term loans, the escrowed money could be paid out in equal installments until maturity, while for longer-term loans, it could be paid out in smaller increments, with a large final balloon by, say, the sixth year. (There is a limit, after all, to how long the underwriter can be held responsible.) In the event of default, a pro rata share of the fee would go to the holder of the debt; a refinancing or early satisfaction of the debt, on the other hand, would trigger the release of the remainder.
Numerous advantages would accrue to any institution that took up such a program. Over time, trading partners and clients would gain confidence that lenders and securitizers had a new incentive to deal in products likely to work. Steady cash-flow streams from escrowed fees coming due would reduce year-to-year earnings volatility and the turmoil of a business slowdown. Above all, the reform would go a long way toward repairing the disconnect between risk and reward that has brought our financial system to its knees.
David Billet is assistant editor of Commentary. Michael Davis is the principal of the Plymouth Group, a real-estate investment and advisory firm in New York.