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OPINION

Bonusphobia part 1: Casino Banking

Bonusphobia part 1: Casino Banking
September 12, 2014
Bonusphobia part 1: Casino Banking

He wrote this in January 2007, eight months before the run on Northern Rock brought home the banking crisis to the UK public. "I've managed to sell a few abacus bonds to widows and orphans [at the airport]..." he'd say in another self-mocking e-mail. He was reputedly paid over $2m that year, most of which was a bonus.

So, an example of an overpaid banker selling dodgy instruments knowing that everyone else would end up bailing out his bank? If you're thinking that big bonuses drove him and others into taking excessive risks, you're not alone.

But not so fast. What increased risk did the self-dubbed Fab actually cause?

The answer is surprising. The particular exotic instrument that he was selling was Abacus 2007-AC1, a synthetic collaterised debt obligation (don't ask), created by pooling another not-quite-so exotic instrument (credit default swaps) designed to offset risks in dodgy US mortgage lending. His bank, Goldman Sachs, then sliced up the pool into different levels of risk and sold them to speculators (for euphemists: 'investors') who effectively bet on whether the underlying dodgy mortgages (sub-prime loans) would fail.

This was casino banking (creating synthetic instruments to enable clients to speculate on the financial markets). It needs to be distinguished from more normal investment banking, which helps clients manage risk, and from retail banking, both of which benefit the wider economy.

We know all this because the US Securities Exchange Commission claimed that the deal was dishonest and unfair. The instrument was created so that a hedge fund (John Paulson's) could bet that sub-prime loans would fail. Goldman would have to pay out unless they could persuade others to bet the other way. And that was Fab's job. In other words, his bonus wasn't for increasing the risk for Goldman, but for reducing it.

Goldman contested the claims but couldn't deny that they'd later taken out bets themselves that there'd be sub-prime defaults. In 2010, they paid a $550m settlement. In 2013, hoist by his wry sense of humour, Fab was found guilty of six out of seven civil offences. The SEC tried to pin the blame on him for creating the instrument but he was only a middle manager and couldn't have done it on his own. After all, central casting only provides supporting actors - the responsibility sat with those sanctioning it: the risk committee and Goldman's senior executives.

They created excessive risks, but not for them. Because these sort of products had such fine margins, to make meaningful profits they had to be created in massive quantities, which whacked up the assets in the banking system. Selling them on scattered the risks and nobody could say where they ended up. This was an excessive risk for the system, but not for the individual banks responsible for creating them in the first place.

When US sub-prime loan defaults began, the exotic products lost value and institutions holding them had to cover their losses; as other products were marked down, risks that had been offset became exposed, triggering further losses; as the system hollowed out, some banks got into difficulties. Very simplistically, that was the US banking crisis.

Were the senior executives at Goldman and the other, mostly, US banks who were slicing and bundling debt products responsible for this? Partly. They created the products and kept some off-balance sheet. But who was supposed to police the wider system? Only bank regulators have the overview to do that and they allowed a massive market failure. This is where the impact of bonuses gets turned on its head. The Chairman of the Federal Reserve is paid a salary of about $200,000. No bonus, and yet the Fed allowed an excessive risk by failing to control the volumes of toxic assets.

How much did Goldman's excesses cost? Goldman Sachs ended up being bailed out by Berkshire Hathaway and the US Treasury. The company later repaid both, netting US taxpayers not a loss but a gain of about $1.7bn from their $10bn of emergency funding.

Indirectly, the costs were picked up by Goldman's clients in the US and Europe. Abacus allegedly lost them $900m. This was part of the first phase of the banking crisis, which seeded toxic assets into financial systems, resulting in a credit crunch. And yes, high bonuses were paid. The second phase, though, was different. This began in August 2007 when, losing faith in the system, banks stopped lending to each other and a liquidity crisis began. It was this that hit the UK. The bonus structure over here is different - and that's where we'll pick up in part 2 next week.