Credit crisis had its genesis in banks' casino culture

Credit crisis had its genesis in banks' casino culture

Bonus-driven reward system perverted investment banking

Matthew Lynn, Bloomberg

Published: 1:34 am

It's the season of goodwill, so some senior bankers, a breed not usually known for giving up rewards, have decided to skip their bonuses for 2007.

John Mack, the chief executive officer of Morgan Stanley, decided he wouldn't accept any extra pay for all the hours he put in at his desk during 2007. So did Marcel Ospel, the chairman of Zurich-based investment bank UBS AG.

As the scale of their losses in the subprime markets continues to be revealed, other bankers may decide that an ostentatious display of parsimony is in order.

Instead of just relinquishing their bonuses for one year, wouldn't it be better for men such as Mack and Ospel to give back some of the money they made in 2006?

It is precisely the "heads I win, tails you lose" attitude that got their banks into so much trouble in the first place. A compensation culture has been created that actively encourages excessive, irrational risk-taking in financial markets. Until that changes, the banks will just repeat the same mistakes.

At Morgan Stanley, Mack declined to accept a bonus for 2007. That hardly seems surprising when you look at the kind of year the bank had. It was forced to write down $9.4 billion in debt securities and reported its first-ever loss in the fourth quarter. It had to get state-controlled China Investment Corp. to provide an extra $5 billion in capital. If they handed out a bonus for that kind of performance, it is hard to imagine what would count as a "no bonus" year.

And yet, two of his co-presidents received stock bonuses worth several million dollars. More significantly, Mack collected a bonus of $40 million in the previous year.

How about Ospel? The Swiss banker said last month he didn't "expect or want" a bonus for 2007. Again, no surprise there. UBS was forced to make writedowns of $10 billion because of its subprime losses, and, like Morgan Stanley, had to look to the Far East to raise fresh capital. It was among the most humiliating years in the history of the bank.

And yet Ospel keeps his earlier bonuses. Last March, UBS said Ospel was paid 26.6 million Swiss francs ($23.7 million) in 2006, the bulk of it in bonuses. He made almost 24 million francs in 2005, making a total of more than 50 million francs over the past two years. So far, the bank hasn't demanded its money back.

Likewise James Cayne, CEO of Bear Stearns Cos., has said he will forgo any bonus for 2007 after it also had subprime losses. Yet last March, Bear Stearns reported that Cayne was paid $40 million in salary and bonuses.

All three men should give at least some of that money back. Here's why.

Imagine you go into a casino. The croupier offers you a stack of free chips and tells you to start playing. If you win, you can keep a slice of the money. If you lose, you may be asked to leave, but no one will ask you to make good the losses. There is only one catch: You have to win this evening, or else you will be replaced with someone on whom Lady Luck smiles more frequently.

What would you do? You would head straight for the roulette table and pile lots of chips on single numbers. The game has been designed to encourage you to make big, risky bets. It is the rational decision. If you win, great. If you lose, never mind.

The same is true of investment banking. Compensation systems have been designed that encourage bankers to bet big and bet fast. True, many of the CEOs receive some of their bonuses in the form of stock and options, giving them a stake in the long-term financial performance of the firm.

But that is overwhelmed by the bonus award. In effect, you need your company to make lots of money quickly. You can only do that by gambling more furiously.

That bonus-driven system has produced an investment-banking culture that increasingly resembles a casino. Some players -- such as Goldman Sachs Group Inc. -- get on the right side of the bet. But inevitably -- just as in a casino -- there will be as many losers as winners.

One way of looking at the credit crunch is as a reaction to the way banks have loaded up with more and more risk. Why are they so reluctant to lend to one another? Because they suspect every bank has made too many risky bets -- just like they themselves have done.

To get the system functioning again, there have to be punishments as well as rewards. Bankers need to be paid for conserving capital as well as increasing it. The rules of the game should be changed. How do you do that? By making bonuses repayable.

Mack and Ospel are to be commended for skipping a bonus. But unless they are willing to hand back some of the fortunes they were paid for 2005 and 2006 they aren't even beginning to fix the real problems