Friday, August 20, 2010

Q. Where do bankers' bonuses come from?

A. From huge bank profits of course.
Q. Where do then huge bank profits come from?
A. From lending using little own capital and from trading faulty risk assessments.
Q. Can you please explain?
A. Of course!

Lending: If a bank had to keep 8 percent of capital when lending to triple-A rated borrowers, the same as when lending to a small business, and which implies a leverage of 12.5 to 1, then if the margin on that lending was .5 it would earn a profit of 6.25%, decent but nothing to write home about. But, when courtesy of the regulators they are allowed to hold only 1.6 percent in capital, and which implies a leverage of 62.5 to 1percent, then the margin on lending to triple-A clients have the potential to increase to 31.25 percent a year (.5 x 62.5), meaning that type of stuff that real big bonuses are made of.

Trading: The profits from trading a paper with an absolute perfect credit rating are nil. But the profits from selling a paper that is much riskier than their credit rating indicates, or buying a paper that is much less risky than their credit rating indicates, those can be huge. A risky 11%, 30 years, $300.000 mortgage, sold as what it is could be worth even less than $300.000. But, sold as part of a triple-A security believed to merit a return of only 6%, it is worth $510.000, resulting in an immediate profit of $210.000…meaning that kind of stuff that real big bonuses are made of.

Conclusion: If you think bank profits and bankers´ bonuses are excessive, then you need to focus much more on where the stuff is generated and much less on how it gets distributed.