The world’s financial system is still rigged to reward excessive risk-taking, argues Tracy Corrigan.
Published: 6:03AM GMT 17 Feb 2010
In Greek tragedy, the hero sows the seeds of his own destruction. Aristotle, in his Poetics, argues that the protagonist brings about this downfall due to hamartia – a word often translated as a tragic flaw, but which also covers errors of judgment and mistakes committed as a result of ignorance.
Where in this spectrum does the sorry predicament of modern Greece lie? There was undoubtedly a self-destructive impulse to pile up unsustainable levels of debt, while failing to take steps to modernise the economy; and it was particularly foolish to join the euro. But while bad decisions were made as a result of wilful blindness, the protagonists of this modern drama were also unable, in the grand Aristotelian tradition, to perceive the full consequences of their actions, because they were not in full possession of the facts.
It turns out that the dire situation is even worse than it seemed because, a few years back, Greece was involved in some complex swap transactions with Goldman Sachs and other banks. The upshot of this off-balance sheet wizardry was that Greece ended up with additional debt that didn’t show up on its balance sheet. It’s a similar story for Italy and JP Morgan, and other cases may emerge.
This has an awfully familiar ring to it. Such innovative financial instruments also helped drive the American subprime mortgage market, the collapse of which triggered the recent crisis. It is true that this wouldn’t have happened if people who couldn’t afford to buy houses hadn’t applied for mortgages. But the chain of cause and effect is more complicated. Subprime mortgages were not sold to poor people because poor people suddenly wanted to buy houses – finance doesn’t work like that. These mortgages became widely available because investment bankers wanted “product” that they could re-bundle, with a bit of tinkering, into marketable, triple-A rated securities, in order to earn big fees. This is not, by the way, a conspiracy theory. It is a fact: that is why Lehman Brothers and others bought mortgage lenders to manufacture the loans they needed to feed through the lucrative securitisation machine.
Securitisation, which started out as a clever way of financing mortgages, became a clever way of financing bankers. And when I say bankers, I do mean bankers, and not banks. Because when America’s impoverished homeowners defaulted on their mortgages, they were not the only ones to suffer: so did the banks which took hits on the resulting losses (and there usually are some, even when the risk is supposed to have been offset or sold on).
Ultimately it is the shareholder who feels the pain, unless things get really bad, in which case, as we discovered, it is the taxpayer. If Greece ends up defaulting on its debt – a far from a remote possibility – the same pattern will repeat itself. But guess who definitely won’t be hit? The bankers who sold these gizmos in the first place. They cashed in some time ago.
Here is how the system works. MyBank sells the Republic of Greater Fools – or maybe DumbCorp – an ingenious derivative product, carefully tailored to suit its needs, for a fee of, say, £2 million. MyBank books that sum as profit. I, Tracy the Trader, am the heroine of the hour for having persuaded my clients to cough up all that money. Naturally, I convince my boss that I deserve half the profit as part of my bonus; and I intimate that if I don’t get it, I will flounce off to AnotherBank, taking my lovely clients with me.
I get my way. Unfortunately, when the economy falters a few years later, not only do the Republic and DumbCorp both default, but MyBank suffers a painful hit. With my usual foresight, I have already fled the UK’s punitively high tax rates and am working for a hedge fund in Zug (OK, life isn’t perfect).
Yet bankers are not the only ones responsible for this state of affairs. Those in the City, and various free-market ideologues, who seem to suffer their own wilful blindness on this issue, say that bonuses had nothing to do with the financial crisis, and insist that remuneration is set by the market. But the point is that the market is rigged.
Hank Paulson, Goldman’s former boss, can see this. In On The Brink, his account of his stint as US Treasury secretary, he writes: “I felt the real problem ran deeper… to the skewed systems banks used that rewarded short-term profits in calculating bonuses. These had contributed to the excessive risk-taking that had put the economy on the edge.” There is a surreal moment when Chuck Prince, then boss of Citigroup, turns to Paulson and asks: “Isn’t there something you can do to order us not to take all of these risks?”
The answer is yes. But it hasn’t been done yet. When a few bank executives forego bonuses for a year, or payouts are taxed or given in shares, or donations made to charity, it is little more than a gesture. In the end, traders can still game their bank’s revenue to inflate their bonuses. This is an issue with which regulators – and those who set accounting standards – have repeatedly failed to get to grips. Until it is sorted out, we will be stuck with the same system, and the same tragic flaw.