Friday, December 07, 2007

Are bankers paid to bring down the Economy

In the earlier years of this century, there was a dramatic shift in the finance industry. Actually the pre-cursor was set in the 1990s. Prestigious banks started to face competition from boutique companies and independent financial firms, many of which were established by ex-employees of these big banks. The innovation in products in the big banks were slowing down, and these smaller firms were creating newer attractive products. The big banks had the customers and smaller guys had the most creative products.

So an era of "open innovation" started, where the big banks started adopting the creation of the smaller banks, by distributing the products from these smaller guys. Previously the industry used to be rewarded based on the %age of returns they generated. But now, this could not be done anymore with the big banks having no rights on the products returns. This probably gave rise to the new way of compensating managers - %age of assets managed.

With this new compensation structure, bankers were pushed to sell more and more, and accumulate assets rather than concentrating on returns. The amalgamation of different industry players left customers with few choices of going elsewhere and look for people who had a different structure of operations. Almost all banks issued 3rd party products.

Well bankers kept on innovating products by wrapping up different layers of structured financial methods. One such product is the CDO - collateralized debt obligations. With the compensation structure tied to assets, all it mattered was raising money. The process of due diligence took a back seat. Evaluations were left to third parties. Bad debts were projected as AAA securities and sold to investors. The frenzy caught on, and no banks could resist such an opportunity.

It is estimated that in the $15 trillion US debt industry (this itself is a staggering number) 20% is subprime (not only mortgage it includes everything from credit card, car loans, student loans etc) and in this 90% is bad debt, which will be written down mostly. That mean nearly $2.5 trillion. Till now the total write down is around $100 billion probably. So there is still a lot to come. Embrace bankers embrace. The numbers might be wrong, but it is still huge.

The question is are bankers paid to bring down the Economy?
- the Internet bubble, where the banks issues so many overhyped IPOs
- Now the housing market

History repeats for sure in the banking industry, and mistakes are soon forgotten. Whats the next frenzy wave boys?

disclaimer - this is totally out of my ignorance. I might be grossly wrong

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