October 14, 2008 / 4:40 PM / 9 years ago

Perverse bonuses, not exuberance, led to crisis -study

FRANKFURT, Oct 14 (Reuters) - Perverse bonuses for managers at some less-than-prudent banks and financial intermediaries, not irrational exuberance, fuelled the debt securitisation boom that led to the financial crisis, a study said on Tuesday.

"A large number of financial intermediaries retained a prudent policy over the last years. But others, including some large players, did not," said the study by the Center for Financial Studies (CFS) at Frankfurt's Goethe-University.

"This set off the infection which first hit these players, but then undermined the confidence in the financial system on a large scale, with far-reaching contagion effects," CFS said.

The International Monetary Fund (IMF) last week raised to $1.4 trillion its estimate of global losses from the financial meltdown which began in the U.S. subprime mortgage market.

Mortgage loans were bundled by originator banks into packages, split into tranches, then sold directly or through intermediaries to investors keen on the higher yields offered by such securitised products.

"We have identified weaknesses and violations of rules of prudent financial engineering that may be called the root cause of the immense degradation of asset value over the past 18 months," CFS said.

"These violations have also contributed to the strong drying up of market liquidity in several of the most popular financial instruments of the last decade, like CDOs, CPs, and ABS in general," it said, referring to collateralised debt obligations, commercial paper and asset-backed securities.

"This crisis is a 'rational crisis', it is not the result of irrational exuberance of any sort, nor is it the consequence of euphoria and fear, as some observers have argued," CFS said, naming former U.S. Federal Reserve Chairman Alan Greenspan.

Thanks to incentives such as profit-sharing bonuses, banks' managers were keen on asset securitisation "simply because it may increase their income with no commensurate risk premium imposed -- the risk in the form of increased default probabilities is mostly borne by shareholders and third parties in case of bank insolvency," CFS said.

"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".

"Here, perverse means: without proper regard to the implications for the longer-term quality of the underlying assets," CFS said, noting that under such set-ups, "risks imposed on others tend to be ignored". (To access the study, see here) (Reporting by Peter Starck, editing by Will Waterman)

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