FDIC Chair Sheila Bair has it right: It's time to change bankers' incentives

fdic-chair-sheila-bair-has-it-right-its-time-to-change-bankers-incentivesI have to hand it to Federal Deposit Insurance Corp. Chairwoman Sheila Bair: The former University of Massachusetts economics professor gets it right on key policy issues. She's right about ending the doctrine of too-big-to-fail, and now she's proposing an idea that I've been pushing with no effect for years. That is, to align the interests of the banks that bundle assets and sell them as securities -- so-called asset-backed securities -- with those of ABS investors.

Before getting into the details of her proposal, I should disclose that I'm not entirely objective in analyzing it. I worked with the FDIC back in the early 1980s to help build a system to manage the liquidation of the assets the FDIC gets when it helps find partners to absorb failed banks. And I have posted repeatedly about the idea of putting bankers' pay in escrow as a way to align the interests of those who create investments with those who buy them.

Asset-backed securities matter because they accounted for $1.7 trillion in write-downs since the financial crisis began, according to Bloomberg News. So what is Bair proposing to prevent such a thing from recurring? Bloombergreports that Bair will propose "greater disclosure on assets backing securities, limits to how much of the underlying debt lenders can buy from others to put deals together and a demand that issuers retain a certain amount of the credit risk from the underlying loans."

More important, Bair wants to change bankers' incentives. Bloomberg interviewed Michael Krimminger, special adviser for policy to Bair, who said bankers' incentives need to change to align them with investors' interests. "The underwriters get all their cash upfront, the ratings agencies get all their cash upfront and nobody really has a strong incentive to make sure the loan performs in the long term," Krimminger told Bloomberg.

Ensuring Bankers Have Some Skin in the Game

How would this work? Krimminger e-mailed Bloomberg that lenders should have their compensation tied to how well they meet the contractual promises they make over the quality of loans that back bonds. Such promises could require originators to repurchase ineligible debt.

This is a great idea. The only problem I see with it is that it will go over like a lead balloon with bankers. That's because they cannot predict what will happen to the loans they bundle into ABS. And therefore, those securities are fraught with risk that the bankers cannot predict. As a result, under Bair's pay scheme, the bankers would have to assume the risk that they might not get paid for their efforts.

If Bair's pay scheme goes into effect -- and I doubt it will due to the financial industry's power over Washington -- the ABS market might cease to exist.

And as I have posted, that would be a great idea, because if the bankers who create a product aren't willing to take on the same risks and returns as the investors who buy it, then perhaps it shouldn't exist in the first place.

There are 1.7 trillion reasons why such thinking would have prevented the financial crisis that has already cost us up to $23.7 trillion in taxpayer obligations and $12 trillion national debt.

Peter Cohan is a management consultant, Babson professor and author of nine books, includingCapital Rising (due in June 2010). Follow him on Twitter.

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