The Obama administration’s plans to limit pay on Wall Sttreet in an effort to prevent banks from taking on too much risk is based on a mistake, Andy Kessler argues in the Wall Street Journal today.
“The administration has it wrong,” Kessler argues. “It wasn’t reckless schemes and excessive risk that sunk banks and Wall Street; it was excessive leverage. And thanks to cheap money and twisty regulations, risk was extremely undervalued. Banks owned huge portfolios of real-estate loans and mortgages specifically because they, and regulators, didn’t think they were taking much risk at all.”
As we’ve argued here for quite some time, the idea that banks were recklessly buying risky securities in a desperate search for quick profits just doesn’t fit the facts. Instead, what seems to have actually happened was that Wall Street firms discovered that technology and foreign competition were eating traditional low risk business, like sales and trading on behalf of clients, corporate lending and investment banking advisory. So they turned to another low yield but seemingly safe and steady business, buying mortgage-backed securities and pocketing the 2%-3% difference between mortgage rates and their cost of short-term capital.
Bear Stearns, Lehman Brothers, Morgan Stanley, Citigroup, Merrill Lynch, Goldman Sachs and others believed the mortgage-backed security was the low-risk investment, and so it couldn’t hurt to use leverage—i.e., borrow far more than the capital they had on hand, 20 times or even 30 times as much, to make additional investments in these securities. The firms raised huge sums of money—from other banks, money-market and mutual funds—so they could multiply 2%-3% gains into those large 70% profits and compensation. It wasn’t risk but leverage that did in the financial system. Without that leverage, we’d have had an investment-banking profit crisis, not a credit crisis.
This means that the administration’s public motive for reforming pay on Wall Street is fundamentally misguided.
Or, to put a sunnier spin on the situation, if Obama is serious about ending “the thirst for reckless schemes that produce quick profits and fat executive bonuses to override the security of our entire financial system and leave taxpayers on the hook for cleaning up the mess,” we’ve got good news for him. This isn’t what went wrong on Wall Street, so his mission is already accomplished. Declare victory and go home, Mr. President.