an unanticipated consequence of
Jack M. Balkin
Jack Balkin: jackbalkin at yahoo.com
Bruce Ackerman bruce.ackerman at yale.edu
Ian Ayres ian.ayres at yale.edu
Mary Dudziak mary.l.dudziak at emory.edu
Joey Fishkin joey.fishkin at gmail.com
Heather Gerken heather.gerken at yale.edu
Abbe Gluck abbe.gluck at yale.edu
Mark Graber mgraber at law.umaryland.edu
Stephen Griffin sgriffin at tulane.edu
Bernard Harcourt harcourt at uchicago.edu
Scott Horton shorto at law.columbia.edu
Andrew Koppelman akoppelman at law.northwestern.edu
Marty Lederman msl46 at law.georgetown.edu
Sanford Levinson slevinson at law.utexas.edu
David Luban david.luban at gmail.com
Gerard Magliocca gmaglioc at iupui.edu
Jason Mazzone mazzonej at illinois.edu
Linda McClain lmcclain at bu.edu
John Mikhail mikhail at law.georgetown.edu
Frank Pasquale pasquale.frank at gmail.com
Nate Persily npersily at gmail.com
Michael Stokes Paulsen michaelstokespaulsen at gmail.com
Deborah Pearlstein dpearlst at princeton.edu
Rick Pildes rick.pildes at nyu.edu
Richard Primus raprimus at umich.edu
K. Sabeel Rahmansabeel.rahman at brooklaw.edu
Alice Ristroph alice.ristroph at shu.edu
Neil Siegel siegel at law.duke.edu
Brian Tamanaha btamanaha at wulaw.wustl.edu
Mark Tushnet mtushnet at law.harvard.edu
Adam Winkler winkler at ucla.edu
ProPublica reporters Jesse Eisinger and Jake Bernstein have been awarded a Pulitzer Prize for National Reporting for their stories on how some Wall Street bankers, seeking to enrich themselves at the expense of their clients and sometimes even their own firms, at first delayed but then worsened the financial crisis.
The Eisinger and Bernstein series was essential because it helped challenge the idea that all "banks" or "hedge funds" are stable, self-preserving entities that would guard against bad behavior to preserve their reputations. Anyone familiar with the work of Karen Ho or Satyajit Das would take a darker and more realistic view: that is often in the interest of individuals in the industry to be part of shadowy and unstable ensembles of desks and divisions whose main goal is slipping by whatever bonus-maximizing scheme won’t set off alarms among risk managers and regulators. In a piece called "The Subsidy," Eisinger and Bernstein explained how payments of a few million in “bonuses” to employees running one division of Merrill Lynch helped those running another division “offload” billions of dollars in toxic assets to their own firm:
Two years before the financial crisis hit . . . [n]o one, not even the bank’s own traders, wanted to buy the supposedly safe portions of the mortgage-backed securities Merrill was creating. Bank executives came up with a fix . . . .They formed a new group within Merrill, which took on the bank’s money-losing securities. But how to get the group to accept deals that were otherwise unprofitable? They paid them. The division creating the securities passed portions of their bonuses to the new group, according to two former Merrill executives with detailed knowledge of the arrangement.
The executives said this group, which earned millions in bonuses, played a crucial role in keeping the money machine moving long after it should have ground to a halt. “It was uneconomic for the traders” — that is, buyers at Merrill — “to take these things,” says one former Merrill executive with knowledge of how it worked. Within Merrill Lynch, some traders called it a “million for a billion” — meaning a million dollars in bonus money for every billion taken on in Merrill mortgage securities. Others referred to it as “the subsidy.” One former executive called it bribery. The group was being compensated for how much it took, not whether it made money.
The three men orchestrating the deals made about $6 million each that year, and there were probably some handsomely paid lieutenants beneath them. Surely, there must have been someone who objected to such deals? There was: “a Merrill trader [who refused to go along] . . . was sidelined and eventually fired”--just like Richard Bowen at Citigroup went from supervising 220 employees to supervising 2 after he expressed concerns about risks. The power in the firm was held by those who could make quick money in big deals.
One of the great mysteries of the financial crisis has been: who wanted to buy securities based on all the bad loans that were made, especially after warning bells were ringing in 2005? Tom Adams & Yves Smith boiled down the answer in a memorable article dismissing many rival theories:
The normal expectation was that warnings and threats about bad lending would have some impact on curtailing the bad loans, but it had the opposite effect: it led to more CDOs and demand for more “product” to short.
Dozens of warning signs, at every step of the process, should have created negative feedback. Instead, the financial incentives for bad lending and bad securitizing were so great that they overwhelmed normal caution. Lenders were being paid more for bad loans than good, securitizers were paid to generate deals as fast as possible even though normal controls were breaking down, CDO managers were paid huge fees despite have little skill or expertise, rating agencies were paid multiples of their normal MBS fees to create CDOs, and bond insurers were paid large amounts of money to insure deals that “had no risk” and virtually no capital requirements. All of this was created by ridiculously small investments by hedge funds shorting MBS mezzanine bonds through CDO structures. . . .
Virtually no one understood why the loans continued to be created, even after alarms were sounded. Almost no one recognized that there was a tremendous financial incentive for bad, rather than good, loans and that the alarms just made such bad loans more valuable. In fact, the alarms created a frenzy of more CDO creation as more hedge funds became aware of the opportunity to short the deals, which created demand for more bad loans.
The public deserves to know why [so many big players] were so eager to make these investments, why they wanted to keep the bad lending machine going, why they wanted to keep their strategies secret (even now), and how they made so much money so quickly. After all, it’s the rest of us wound up holding the bag.
Based on both ProPublica's and Yves Smith's work, James Kwak helped put the pieces together in this blog post:
[The hedge fund] Magnetar made the Wall Street banks look like chumps. [In] one deal . . . Magnetar put up $10 million in equity and then shorted $1 billion of AAA-rated bonds issued by the CDO. It turned out that in this deal, JPMorgan Chase, the investment bank, actually held onto those AAA-rated bonds and eventually took a loss of $880 million. This was in exchange for about $20 million in up-front fees it earned.
But who’s the chump? Sure, JPMorgan Chase the bank lost $880 million. But of that $20 million in fees, about $10 million was paid out in compensation (investment banks pay out about half of their net revenues as compensation), much of it to the bankers who did the deal. JPMorgan’s bankers did just fine, despite having placed a ticking time bomb on their own bank’s balance sheet.
ProPublica's work is also cited in the Levin/Coburn report on the crisis, helping it chronicle numerous investment bank abuses. Thanks in part to their tireless reporting, the Committee was able to conclude the following:
From 2004 to 2008, U.S. financial institutions issued nearly $2.5 trillion in RMBS securities and over $1.4 trillion in CDOs securitizing primarily mortgage related products. Investment banks charged fees ranging from $1 to $8 million to act as the underwriter of an RMBS securitization, and from $5 to $10 million to act as the placement agent for a CDO securitization. . . .
Investment banks were a major driving force behind the structured finance products that provided a steady stream of funding for lenders to originate high risk, poor quality loans and that magnified risk throughout the U.S. financial system. The investment banks that engineered, sold, traded, and profited from mortgage related structured finance products were a major cause of the financial crisis.
Eisinger and Bernstein do a great service in highlighting exactly who stood to gain from these structured finance products. While economists like Peter Radford despair at the possibility of reform of the financial sector, reporting like ProPublica's provides a glimmer of hope that the opaque arrangements at the heart of the crisis can be explained straightforwardly enough to illuminate the core problems of Wall Street. This is journalism of the highest order.