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Why I’m wrong

In my narrative of the financial crisis, Gambling with Other People’s Money, I argue that excessive leverage was favored by the executives as a way of inflating returns and generating high profits that justified large levels of compensation. The puzzle is why anyone would lend the money to finance those imprudent bets. My answer is that the US government has systematically rescued large creditors 100 cents on the dollar for the last three decades. This destroyed prudence and made our financial system dramatically more fragile (because of the leverage and interdependence.)

Eric Falkenstein argues that I’m wrong–moral hazard couldn’t be decisive for commercial banks. After conceding that the execs at investment banks did very well even as their companies imploded, he uses a chart of stock prices in the commercial banking  to argue that the same argument doesn’t apply to commercial banks:

While bailouts did not help, I don’t think they were very significant in the creation of the housing bubble. The 2008 crisis hit all banks, not just investment banks. Most non-investment bankers get much more modest salaries and bonuses, often largely in at-the-money options in their firm’s stock, with 5 to 10 year horizons. So, looking at the accompanying chart, which shows the KBW Bank Index since 1994, we see that since 1998, bank stocks were pretty flat, with a slight 25% bump around 2006, but the index now is still below its 1997 level. That means most of the bonuses paid to your average bank executive over the past 10 years are worthless. This crash has been incredibly painful for your average bank decision maker. The Jimmy Caynes and Jamie Dimons may get all the headline, but its naive to anthropomorphize bank decisions via their titular leaders. As Bob Rubin, the erstwhile financial genius demonstrated when he said he knew nothing about Citibank’s exposure to mortgages, these signature guys aren’t too involved in the nuts and bolts of evaluating the NPV of new loans.

Here’s the chart he uses:

The chart is a little hard to read but it’s the KBW Banking Index–a composite of bank stock prices–from May of 1992 through May 2010. Yes, it’s currently around 50, its level in 1997. But at the end of 1994 it was around 25 and by 1998 it had nearly quadrupled, the time period when housing prices started to take off. Yes, it was flat for a while, but between 2003 and 2007, the heyday of subprime, it went from 70 to almost 120. I suspect those were some very good years for banking executives. Yes, they probably could not exercise their options immediately and some of them may have been stupid enough to hold on to them forever, but I would guess that they did just fine. For example, Robert Rubin made about $126 million in his eight years at CitiGroup. He did OK. Maybe a little better than OK. Was he alone among the execs at Citi? I doubt it. Or consider Lehman and Bear Stearns. Their stock prices are way below what they were in 1997, yet somehow, the execs made a lot of money off their stock options, as I mentioned in my paper:

Bebchuk, Cohen, and Spamann have looked at the sum of cash bonuses and stock sales by the CEOs and the next four executives at Bear Stearns and Lehman Brothers between 2000 and 2008. It’s a very depressing spectacle. The top five Bear Stearns executives managed to score $1.5 billion during that period. The top five executives at Lehman Brothers had to settle for $1 billion.42 Nice work if you can get it.

The bottom line is that you can’t just look at the value of bank stocks today compared to 1997 and conclude that execs who held stock options didn’t do very well. If anything, the chart suggests that there were a lot of opportunities for execs with stock options to make a lot of money. I hope someone more skilled and knowledgeable than I am is looking at compensation for top execs in commercial banks over this period.


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