People response to incentives, shock and bankers sweep mess under carpet, horror

Don’t blame the tool, blame the incentives says a study on the causes of the debt bubble causing such a headache today, according to a study reported in Reuters. (Hat tip, Alea)

“The incentive to expand securitisations was upheld by the fact that the management pay-off was cashed out as a bonus well before the externality was felt in the profit/loss of the bank,” it said, describing such incentives as “perverse”.

In ordinary language, bankers were paid bonuses on the today–for getting the deal done–not for the overall risk-adjusted outcome of the deal. This is as true in M&A deals which generate huge fees for dubious shareholder outcomes; but was especially true during the credit-securitization boom.

These securities had Black-swan tail risk. In other words, they look very nice but have a small (and potentially unquantifiable) risk of blowing up. This risk is an externality which wasn’t priced in to the original deal. The externality having occurred, the structurers have already made off like bandits. Worse, the correlation between these small, unlikely risks was actually rather high. With one setting off another and another, primarily because we couldn’t assess (i.e. price) the remaining risk.

The structurers were not incentivised to think about or price this tail risk, so of course they didn’t respond to it. In other words, they didn’t have to live with the consequences of the deals they made so why bother. Like a naughty child, they swept the rubbish under the carpet hoping they wouldn’t be found out.

In a way that is a rational path. The incentive schemes were wrong and we could hope and pray that nothing went awry. Whoops.

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