Bonuses that lead to bankruptcy

In the wake of the current financial crisis, it has not escaped notice that large brokerage firms and investment banks were paying out record bonuses while the beneficiaries of these bonuses were getting them into serious trouble. Here are two examples: Merrill Lynch paid about $9.5 billion in bonuses in 2007, the same amount as in 2006; meanwhile, net income dropped by two-thirds, with a $9.8-billion fourth-quarter loss. Lehman Brothers raised its bonuses by 10% in 2007, bringing them to $5.7 billion; today the firm is bankrupt. And what if these bonuses were a source of the financial crisis?

The incentive mechanisms applied in the financial services industry in particular reward income generated regardless of risks. The foreseeable result: unjustified risk-taking.

That’s how things stand. Several economists warned companies against these practices, reminding them of the fundamental principles of incentive mechanisms. One of the most important principles is to take account of the risks taken so as to avoid what economists and insurance companies call “moral hazard.” Bernard Sinclair-Desgagné, a CIRANO fellow and professor at HEC Montréal, has been suggesting for years that bonuses be made conditional on risk audits so as to penalize – rather than applaud – fabulous financial results that rely on ill-advised risk-taking.

But there seems to be light at the end of the tunnel. In the rescue of Fannie Mae and Freddie Mac, the managers, shareholders and bondholders of these overly dominant mortgage credit companies, protected by complacent regulators, will have to swallow their medicine. The government, thus the public, will be reimbursed first. And these companies can no longer benefit from political relationships to hide their mismanagement: the door is being closed! Even if the horse is gone, the foal is still in the stable.

That being said, it is hard to understand the current panic on financial markets. Delinquency rates on mortgage loans remain, as a whole, within acceptable and manageable limits. The variable-rate subprime mortgage market is clearly experiencing trouble, with a 21% default rate in 2008 (compared to an average rate of 14% in the period from 2000 to 2007), but the great majority of households continue to honour their mortgage commitments. Overall, the default rate on mortgage rates went from 5% in the 2000-2007 period to slightly over 6% in 2008. There is nothing here to provoke or justify the current panic and its vicious circle. Once liquidity is back to normal, today’s bargain hunters will enjoy substantial gains.

Marcel Boyer is Vice President and Chief Economist of the Montreal Economic Institute and Bell Canada professor of industrial economics at University of Montreal .

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