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The Subprime Motive: Billions in Revenues and BonusesBy creating, selling, and trading subprime mortgage-related bonds, investment banks generated enormous revenues and drove bonus payouts to record levels.
As US bond markets picked up in the wake of the dot-com collapse, new fixed income (bond) products replaced tech stocks as the profitable darlings of the highest-paid bankers on Wall Street. These relatively new innovations in structured finance relied heavily on securitized subprime mortgages. Bankers who worked with them consistently received some of the biggest bonuses on Wall Street, as the revenues produced in their divisions lifted net revenues to new records. Long before these subprime-related bonds started causing problems, they were generating record paydays for the biggest banks – 2006 was a banner year for Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns: $130 billion in net revenue and $60 billion in compensation, $36 billion of which came in the form of bonuses (all new records).[2] A. SUBPRIME-RELATED BONDS: WALL STREET’S “HOT PRODUCTS" AFTER THE DOT COM BUST Structured financial products such as collateralized debt obligations (CDOs – see “CDOs Up Close") replaced tech stocks as the hottest products on Wall Street in the wake of the dot com collapse.[3] These CDOs and other complex instruments relied heavily on high-yielding subprime mortgage-backed securities. An Investor’s Business Daily article from early 2006 article tells the story of just how integral these financial instruments were to the investment banks’ profits in the years following the tech boom:
The investment banks’ recent multi-billion dollar writedowns in CDOs signal the extent to which these financial instruments relied on subprime mortgages. This is confirmed by other sources, including “The Subprime Lending Crisis," a recent report by the Joint Economic Committee of Congress, which noted that “subprime mortgages have, until recently, been considered terrific assets to include in CDO structures."[5] What are mortgage-backed securities (MBS)? Mortgage-backed securities are bonds backed by regular payments from pools of mortgages. Borrower payments of principal and interest are passed through to investors who purchase these securities. The securities can either be issued by a government related entity (Ginnie Mae, Fannie Mae, or Freddie Mac) or a private entity. If a mortgage is securitized by one of these government related entities, it has to conform to certain standards, and is called a conforming loan; subprime loans are non-conforming. Around two-thirds of outstanding mortgage debt in the US has been securitized. For more on the securitization process, see the box “How a Mortgage Gets Securitized." For definitions of asset-backed securities, structured finance, and securitization, see the list of key terms at the end of the report.
Source: Federal Reserve Bank of Chicago.[6] The path from subprime loan to CDO. This depiction of the securitization process was recently published by the Chicago Fed for educational purposes. The “third party intermediary" that this chart refers to is an investment bank, which buys the loans from the “bank" (referred to as the “subprime lender" in this report) and structures the mortgage-backed securities offering. The second securitization, in which the mortgage-backed securities are re-packaged into CDOs and other structures, is also underwritten by an investment bank. The “SIV" will be discussed in section IV.
Source: Securities Industry and Financial Markets Association.[7] ABS (subprime, CDOs, etc.) growth outpaced growth in every other type of bond 1996-2006. Asset-backed securities (ABS) is the bond category which includes subprime MBS and structured financial products such as CDOs, and its rapid growth was driven by subprime market growth. The above graph compares ABS to issuance of corporate, municipal, and treasury debt. ABS also grew faster than prime mortgage-backed securities (MBS), the largest category of bond issuance (ABS was second largest in ‘06).
Source: Securities Industry and Financial Markets Association.[8] CDO Issuance jumped from $157 billion in 2004 to $550 billion in 2006. Investment banks increasingly looked to subprime mortgage-backed securities to fill the riskiest tranches of CDOs during this time. CDOs were virtually non-existent ten years ago. For a graph of growth in issuance of subprime mortgage-backed securities, see Financing Subprime; for a graph of growth of outstanding Asset-Backed Commercial Paper (another type of structured financial product that relies heavily on subprime mortgages), see "Making" the Market. B. BANKERS SCORED BIG BONUSES FOR WORK WITH SUBPRIME-RELATED BONDS The major investment banks operate on a “pay for performance" system (or, more accurately, “pay for profit"): employees and executives in the business segments that are producing the most net revenue are generally awarded the biggest bonuses (which amount to around 60% of all compensation).[9] Because subprime-related bonds – structured financial products in particular – were such fast-growing sectors in the post-dot com economy, they produced significant revenues for the banks, and this translated into consistently large bonuses for the bankers and traders that worked with subprime-related securities over the past six years:
In recent years, investment banks also waged hiring battles for top talent in mortgage-related fields. In 2004, for instance, JP Morgan hired away an entire structured finance group from Deutsche Bank in order to boost its CDO operations.[16] The same year, Barclay’s began aggressively building mortgage operations by hiring 40 top employees from other Wall Street firms, according to an article in American Banker. These hiring pushes inevitably result in higher levels of compensation for bankers who worked in structured finance. Top talent at the banks naturally migrated from stock desks to bond desks.[17] One of the stars of subprime-related finance was Christopher Ricciardi (quoted above), who liked to be called “the grandfather of CDOs," according to The Wall Street Journal. He reportedly earned $8 million annually as a managing director at Merrill Lynch – apparently because his subprime-related trades were making him “famous" – before leaving in 2006.[18] CDOs Up Close
These instruments are now the source of large devaluations by investment banks, including Merrill Lynch, though they were once considered a highly lucrative financial product. CDOs involve the packaging of securities into different “tranches," or slices, with varying investment grades, so that the same securities issuance can attract investors with varying appetites for risk. CDOs do not necessarily have to rely on subprime mortgage-backed securities, but they frequently did in recent years: high-yielding subprime mortgage-backed securities often filled the low-rated, high risk tranches of the CDOs. Investors in these tranches – typically hedge funds – receive higher returns, but are the first to lose their shirts in the event of rising defaults. The major problem has been that investors in higher-rated tranches are also suffering losses, which has brought down the values of these “super-senior" tranches. This has raised questions about what sorts of assets were used to fill these low-risk tranches, and what models were being used to evaluate them (see more on this in section IV). Since many investment banks are heavily invested in super-senior tranches, they have been devaluing their CDOs by billions of dollars (called “writedowns"). C. INVESTMENT BANK REVENUES AND BONUSES RISE TO NEW RECORDS ON STRENGTH OF SUBPRIME WAVE Recently, the media has been buzzing about how much money the investment banks have been losing due to subprime-related holdings. But long before subprime-related investments were causing problems for the banks, they were generating record revenues and bonuses. Last year, CEOs at the big five investment banks took home the following bonuses:
The CEOs received such large bonuses because revenues at the banks had reached new highs in 2006: $130 billion combined, largely on the strength of record fixed income (bond) revenues. Though subprime-related revenues are a subset of fixed income net revenue totals, signs of just how important they were in driving revenue growth overall can be found in the investment banks’ SEC filings: Management at every one of the five major investment banks reported in discussions of 2006 financial results that record fixed income revenues at their banks were driven at least in part by growth in structured finance, credit, and other mortgage-related areas.[19] The subprime-related bond markets were not unknown niches in the financial markets – they generated major revenues for the investment banks. And there is not a CEO at a major investment bank whose 2006 bonus was not padded by subprime-related revenues in 2006.[20] How a Mortgage Gets Securitized These days, few banks make mortgages in order to keep them on their books and receive payments over the life of the loan. Instead, lenders sell off the loans almost as soon as they are made, as part of the securitization process. The following is a brief, step-by-step description of how this process tends to play out (often unbeknownst to the homeowner).
Though several mortgage originators have set up shell issuers through which the securities are offered, the underwriter – again, an investment bank – is the crucial player in this process, because it is providing access to the investors that are the final source of funding for the mortgage.
Footnotes [1] Serena Ng and Carrick Mollenkamp, “Pioneer of CDOs Helped Move Merrill Deeply Into Business," Wall Street Journal, October 26, 2007. [2] This estimate is based on figures from SEC filings by Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns. The bonus figure of $36 billion was widely reported in the media. [3] For the purposes of this report, the category of subprime mortgage-related bonds includes both subprime mortgage-backed securities – securities backed by the proceeds from pools of subprime mortgages – and structured financial products – complex securities that are backed by several different types of collateral, but rely heavily on re-packaged subprime mortgage-backed securities. [4] Laura Mandaro, “Investment Banks Stay Busy," Investors’ Business Daily, February 21, 2006. [5] Joint Economic Committee of Congress, “The Subprime Lending Crisis: The Economic Impact on Wealth, Property Values and Tax Revenues, and How We Got Here," October 2007. (pdf) [6] Richard J. Rosen, “The Role of Securitization in Mortgage Lending," The Federal Reserve Bank of Chicago, November 2007. This is reprinted for educational purposes. [7] “Issuance in US Bond Market," Securities Industry and Financial Markets Association. [8] “Global CDO Issuance Data," Securities Industry and Financial Markets Association (pdf). [9] “Revenue" refers to “net revenue," which is revenue after interest expense. [10] “Bumper Credit Year Fails to Produce Record Bonuses," Derivatives Week, December 16, 2001. [11] Avital Hahn, “JP Morgan’s Latest Woe," Investment Dealers Digest, December 9, 2002. [12] Avital Hahn, “Employee Guarantees Return to Wall Street," Investment Dealers Digest, December 15, 2003. [13] Adrian Cox, “Oil traders, M&A bankers pull down biggest bonuses," Bloomberg, January 20, 2005. [14] Heidi Moore, “M&A Bankers Again Top Bonus Charts," The Daily Deal, November 15, 2005. [15] The Options Group, “2006 Global Financial Market Overview and Compensation Report," 2006 (summary). [16] Liz Moyer, “Now Hiring, Particularly on Wall Street," The American Banker, September 2, 2004. [17] According to a 2003 Wall Street Journal article, “During much of the late 1990s, bonds were the ugly sister of the securities business. Some firms shifted talented employees to stocks from bonds, while others de-emphasized businesses such as mortgage-backed securities and municipal bonds." (Gregory Zuckerman and Susanne Craig, “A Contrary Bear Stearns Thrives," Wall Street Journal, March 28, 2003.) The reverse was true in the wake of the dot com collapse, and the top bankers began developing and cashing in on innovations that relied heavily on the burgeoning subprime mortgage market. [18] “Pioneer of CDOs Helped Move Merrill Deeply Into Business," The Wall Street Journal, October 26, 2007. [19] The five major banks’ analysis of fixed income revenue and where gains were coming from can be found in “Management’s Discussion and Analysis" in SEC 10-k filings. The following are the url’s and page numbers for each of the five major banks: Bear Stearns, p. 41; Morgan Stanley, p. 44; Merrill Lynch, p. 34; Goldman Sachs, p. 75; Lehman Brothers, p. 41. [20] There is a spillover effect in the Wall Street bonus system: inflated revenues in specific divisions also lift bonuses for bankers in divisions that aren’t producing proportionate revenues, as well as those in the executive suite who don’t work in specific business segments. This is true to the extent that eFinancial News reported in 2002 that bond traders in UK found themselves in a dilemma – they had reaped record revenues through three quarters, but if they took risks over the next quarter their revenues would probably just end up padding the bonuses of bankers in divisions that were less profitable. Why take the risk, when they had already made so much money. “Ian Kerr's Personal View," eFinancial News, August 30, 2002. |
