Few issues since the collapse of venerable Lehman Brothers one year ago have caused as much consternation as performance bonuses for bailed-out bankers. Yet, even among sophisticated observers, there is confusion about what really happened. So, with the benefit of a year's perspective, how should we think about banker compensation in the context of bank bailouts?
Here's a hint: The bonus outrage has distracted attention from the more important way that taxpayers underwrote the wealth of profligate bankers, which was to preserve the extensive equity holdings that senior personnel at these institutions had accumulated prior to the debacle of 2008. And this diversion, in turn, has delayed effective action that might inject a bit of moral culture into the money culture of Wall Street.
Setting aside the debate about the culprits of the crisis, we can acknowledge that every major commercial and investment bank in the United States faced a direct threat to its solvency arising from (a) its level of leverage, which ascended to new heights in the credit bubble, (b) its interrelationships with other leveraged institutions--"counterparties"--and (c) its reliance on short-term funding from those counterparties. These facts are undeniable, even if certain conservatives prefer to attribute the genesis of this predicament to a political desire to foster homeownership among lower-income families.
Now, it is true that every insolvent bank arrived in extremis in a slightly different way. Bear Stearns, which had never reported an unprofitable quarter in its history as a public company, suffered a loss of confidence that prevented it from rolling over its short-term funding--but only after having taken its debt ratio to a level of 30 to 1 or higher. Meanwhile, a friend at Lehman confided to me, "We woke up one morning and, instead of an investment bank, we were a real-estate company." That was a week before his firm spiraled into bankruptcy. Merrill Lynch raised its exposure to subprime securitization late in the cycle and, when the music stopped in 2007, got stuck with many more assets--and, hence, much more risk--than it could syndicate.
Bear, Lehman, and Merrill were the three U.S. investment banks that were forced out of existence. But just because other banks might have been better positioned going into the crisis does not mean they would have been safe once the crisis unfolded. Some might have avoided distress in a theoretical world where there were no chain reactions, no credit default swaps, and no panics. But, in the real world, every major bank had used structured finance techniques and wholesale funding markets to ratchet up its leverage. Which meant that, once those markets seized up, every bank was exposed to disaster in the absence of government intervention. And there can be no gainsaying just how aggressive that intervention was. To protect the financial system, the range of actions taken by the Federal Reserve, the Treasury Department, other regulatory bodies, and their international counterparts has been breathtaking. Each surviving bank is the beneficiary not just of one bailout but of multiple bailouts.
Most directly, of course, there were the capital infusions provided under the Troubled Asset Relief Program (TARP). Then there was the fact that the money under TARP was provided on terms far more generous than available in private markets. There were the backstops fashioned to draw a perimeter around toxic-asset exposure. There were the guarantees from the Fed that enabled financial institutions to obtain funding when wholesale markets dried up. There were the efforts to unclog the commercial paper markets.
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