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How Merrill Lynch Bribed Traders to Buy Bum Mortgage-Backed Securities

It's clear that soaring pay on Wall Street in the years leading up the housing crash encouraged financial pros to take foolhardy risks. But a new piece from ProPublica illustrates just how far some banks went in sowing these perverse incentives into their business models.

When the market for mortgage-backed securities started to ebb in 2006 amid mounting investor concern about the real estate market, Merrill Lynch came up with a novel solution: Bankers at the company offered bonuses to Merrill's own traders to invest in the securities.

Initially, these traders had resisted purchasing the firm's MBSes, which by then were losing money. Merrill even fired one trader who refused to buy the super-senior slices of a collateralized debt obligation, or securitized mortgage pool, the company had created.

To stem such internal conflict and keep the gravy train rolling, Merrill created a new unit expressly to hoover up the "super-senior" tranches of MBSs that the firm couldn't fob off on other investors. The group bought "tens of billions of dollars" of Merrill's AAA-rated mortgage-backed assets -- assets whose value would plummet when housing prices collapsed, sinking Merrill (now owned by Bank of America (BAC)) and requiring a taxpayer rescue. To make the deal palatable for Merrill traders, who were being asked to hold their noses in buying the securities, the company offered big bucks:

Within Merrill Lynch, some traders called it a "million for a billion" -- meaning a million dollars in bonus money for every billion taken on in Merrill mortgage securities. Others referred to it as "the subsidy." One former executive called it bribery. The group was being compensated for how much it took, not whether it made money....

The agreement, according to a former executive with direct knowledge of it, generally worked like this: Each time Merrill's CDO salesmen created a deal, they shared part of the fee they generated with the special group that had been created to "buy" some of the CDO. A billion-dollar CDO generated about $7 million in fees for Merrill's CDO sales group. The new group that bought the CDO would usually be credited with a profit between $2 million and $3 million -- despite the fact that the trade often lost money.

Lawmakers and government regulators are now studying whether to bar such compensation schemes, which lead execs to ignore the long-term interests of shareholders while focusing on the potential for short-term rewards. And well they should. But stamping out such brazenly improper practices is the easy part. Because the dirty little secret in financial services is that even forms of compensation that supposedly encourage executives to behave wisely -- deferring pay, using restricted stock, lowering base salaries, for instance -- don't really work.

Most big banks employed these and other strategies to more tightly link executive comp to company performance and to discourage excessive risk-taking. Indeed, because of Wall Street firms' emphasis on equity-based pay, many bankers lost a bundle during the crash. In other words, financial industry folks often had strong incentives to consider the impact of their actions on a company's long-term performance, and they still rolled the dice.

Why? In a recent report for the Council of Institutional Investors, governance wonk Paul Hodgson and several of his colleagues at The Corporate Library say that three factors drive Wall firms to take excessive risks:

  • Excessive cash bonuses
  • Excessive focus on short-term annual growth measures
  • Pay levels that were so high they effectively insured executives against failure
    The last one gets less attention than it deserves. Although the conventional wisdom in business is that the structure, not amount, of compensation is what really matters, evidence suggests that the sheer enormity of Wall Street pay also led executives astray, Hodgson says.

    That may seem obvious. Yet it's important to note the income disparity not only between the typical big bank CEO and ordinary Americans, but also between that CEO and corporate leaders in other industries. The Corporate Library found that between 2003-07, the five years preceding the financial crisis, Wall Street CEOs had average annual income of $30 million, compared with $12 million for their Fortune 50 peers.

    Combine a fixation on short-term financial results with a level of wealth that insulates execs from major harm and you have, well, the situation as it exists today. Hodgson says that closer federal scrutiny of the financial industry has done little to change Wall Street's comp culture. Only two banks, Morgan Stanley (MS) and Wells Fargo (WFC) have implemented long-term performance incentives. He writes:

    [V]ery little of any real import has changed; on balance, pay practices have worsened.
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