Bonuses have been in the news this week, but while the discussion has focused on questions of fairness, deception, and possible securities fraud, there is a larger question. Did bonuses cause the credit bubble that led to the current crash?
Performance-related bonuses are tricky. If an employer chooses the wrong metric to calculate a bonus, the results can be disastrous. One bank failure so far this year has been specifically blamed on performance bonuses. When Silver Falls Bank in Oregon failed February 20, it happened because of a series of bad loans — loans that were issued recklessly because the loan officer was being paid a performance bonus based on the volume of loans. Similar stories have played out hundreds of companies. In the long run, workers respond to performance incentives even if their actions could destroy the company.
Banks are not supposed to pay this kind of performance bonus. Silver Falls Bank stopped doing so as soon as the FDIC found out, but it was already too late. There is no such restriction on Merrill Lynch or AIG, however, yet those companies were so closely tied to the banking system that their failures had the potential to bring down multiple banks.
It was just the size of the AIG bonuses, an a time of financial collapse at the company, the alarmed many people, but President Barack Obama was asking about the purpose of the bonuses. They seemed to be rewarding the very transactions that had ruined the company and brought the whole economy to the brink of disaster.
AIG’s involvement in the secondary market for bank loans was huge. The financial scale was larger than you previously could imagine, unless you were thinking of the galactic capital planet in science fiction such as Star Wars or Isaac Asimov’s Foundation series. How did AIG manage to issue hundreds of trillions of dollars in derivatives annually, largely backed up by real estate, when the total value of U.S. real estate at its peak was estimated to be less than $100 trillion? AIG’s bonus structure might be the answer. If AIG managers were paid bonuses based on the volume of financial instruments they issued, then it stands to reason that they would find ways to issue many times more financial instruments than would potentially be useful to anyone. And it is possible that this excess contributed to, or perhaps largely caused, the instability in the financial system.
As a preliminary step toward understanding this and related questions, I continue to believe it is important to have all outstanding derivatives contracts brought into the public eye, placed on the Internet for all to see.
As more details come out about the AIG and Merrill Lynch bonuses, one of the questions is who knew what and when. We are also examining earlier information to try to reconcile the divergent accounts of the sequence of events. Now I am not sure it was ever true that AIG’s bankruptcy had the potential to drag down the banking system as a whole. Its volume of business, on the surface, would seem to say that it did, but if many of its financial instruments were essentially duplicates, its effect would be less, and perhaps a manageable degree of government intervention could prevent any bank failures as AIG goes down. If AIG has become little more than a shell passing government money along to banks, then it would be financially more efficient to shut down AIG in the coming weeks and pass the money directly to the banks. That might be politically more difficult, but it is proper that these trillion-dollar policy decisions be made in public anyway.
And Congress appears to be taking action in that direction. Rep. Barney Frank yesterday had his staff start to draft legislation to give the government authority to seize a company like AIG when its insolvency threatens the banking system. The rules would also apply to bank holding companies such as Citigroup.
FDIC chief Sheila Bair called for “an end to ‘too big to fail’” in testimony before a Senate committee. Her recommendations included more stringent capital requirements and supervision of any bank that becomes large enough to be a threat to the economy, and rules for key institutions and assets in the banking system that are currently exempt from regulation, such as credit default swaps and AIG.
Some of these regulatory reform questions will have to wait until later this year. I hope when Congress takes up the matter, they will not make the banking system more complicated than it is already. The simple answer is to require institutions such as AIG that have a key role in the banking industry to have a banking license and to follow all the regulations that are supposed to cover the banking industry. Effective regulation of the banking system will not be possible until the various securities that are based on bank loans fall within the same regulatory framework as the bank loans themselves.
The risk inherent in bank loans does not go away no matter how you structure or package them. At one time it was thought institutional size provided some protection against these risks, but last year’s multiple large failures suggests the opposite, that a large lender may, beyond a certain threshold, become simply too large to survive an economic shock.
One of those failures, IndyMac, is history now. The FDIC sold it to a Wall Street investment group yesterday, completing a deal worked out on New Year’s Eve. Failed banks almost never keep their names, because of the worry that the association with failure will keep depositors away. The new name for IndyMac, starting today, is OneWest Bank. The OneWest investment group paid $16 billion for IndyMac assets with a book value of $20.7 billion, and is receiving partial loss protection from the FDIC.
While under FDIC ownership in the fourth quarter, IndyMac recorded a loss of $2.6 billion, as the value of California real estate declined. The FDIC estimates its total costs for the IndyMac failure at $10.7 billion. This total could go up or down as more loan losses are recorded and assets recovered.
OneWest says it will make no immediate changes other than the name, but it plans to gradually expand its retail presence and eventually open more branches.
The FDIC might have that bank off its hands, but there were three more bank failures tonight, leaving the FDIC with about $320 million in assets that it can try to sell later.
Most of those assets come from FirstCity Bank of Stockbridge, Georgia, which had $297 million in assets and $278 million in deposits. No bank was willing to take over the deposits and purchase the assets of FirstCity Bank, so the FDIC will be paying depositors about $277 million to cover the insured deposits at the bank. Most of the checks will be mailed on Monday. The failure is estimated to cost the FDIC about $100 million.
The FirstCity Bank failure keeps up the pace of about one bank failure per month in the Atlanta metro area. The story of declining real estate values and defaulting loans is the same, but the history of FirstCity is different, going back to 1905 when it was founded as Gibson Bank. FirstCity had what looked like a viable balance sheet on December 31, but it reported a loss of $8 million last year and the value of its assets continued to decline this year. FirstCity Bank had three offices within a three-mile radius in the southern suburbs of Atlanta.
In Colorado Springs, Colorado National Bank was closed. Its $83 million in deposits are being turned over to Herring Bank, which is also buying 95 percent of the assets at a 3.5 percent discount, with the FDIC providing partial loss protection on about half of the assets.
Colorado National Bank had four offices, located in Colorado Springs and the nearby towns of Peyton and Monument. Herring Bank will operate these offices starting tomorrow.
Herring Bank has 10 offices, most of them in Amarillo, Texas, about a 4-hour drive south of Colorado Springs. The Colorado National Bank acquisition gives it its first presence in Colorado.
Colorado National Bank was affiliated with Teambank of Paola, Kansas, which was also closed tonight. Teambank had 9 offices in eastern Kansas, near Kansas City, along with three in Missouri and two in Nebraska. Teambank had nearly half a billion dollars in deposits. The deposits have been turned over to Great Southern Bank, which is also buying 98 percent of the assets at a 15 percent discount, with the FDIC providing partial loss protection on most of the assets.
Great Southern Bank is a regional bank with more than 30 offices, mostly in southern Missouri. Prior to this acquisition, it had only a slight presence in the Kansas City area.
The FDIC expects losses of $98 for the closure of Teambank and $9 million for the closure of Colorado National Bank.
Credit unions are expected to largely avoid the problems facing the banking system, but that is not the case for the so-called corporate credit unions, regional financial institutions which serve credit unions and operate almost like commercial banks. Some of the corporate credit unions are said to have invested significantly in the derivatives markets and are facing liquidity problems as a result. The National Credit Union Administration (NCUA), which regulates credit unions, seized two of the corporate credit unions, U.S. Central Federal Credit Union and Western Corporate Federal Credit Union, commonly known as WesCorp. Both of these corporate credit unions will continue to operate, and according to the NCUA, the retail credit unions that are their customers should not notice any changes. The two corporate credit unions have a combined $57 billion in assets.