The Wall Street Journal-20080117-Deal Fees Under Fire Amid Mortgage Crisis- Guaranteed Rewards Of Bankers- Middlemen Are in the Spotlight

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Deal Fees Under Fire Amid Mortgage Crisis; Guaranteed Rewards Of Bankers, Middlemen Are in the Spotlight

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To understand a root cause of the financial crisis shaking global markets, take a look at Kevin Schmidt's paycheck.

Mr. Schmidt arranges mortgages in Shreveport, La. He earns his money upfront, taking a percentage of each loan once papers are signed. "We don't get paid unless we can say YES" to loans, his firm's Web site says.

The problem, which Mr. Schmidt says he sees clearly: Brokers have little incentive to say "no" to someone seeking a loan. If a borrower defaults several months later -- as Americans increasingly are doing -- it's someone else's problem.

At every level of the financial system, key players -- from deal makers on Wall Street and in the City of London to local brokers like Mr. Schmidt -- often get a cut of what a transaction is supposed to be worth when first structured, not what it actually delivers in the long term. Now, as the bond market wobbles, takeover deals unravel and mortgages sour, the situation is spurring a re-examination of how financiers get paid and whether the incentives the pay structure creates need to be modified. This week, Congress asked three prominent executives to testify about their pay packages.

Upfront commissions and fees are well established on Wall Street. Investment banks get paid when billion-dollar mergers are inked. Firms that create complex new securities are paid a percentage off the top. Rating services assess the risk of a new bond in return for fees on the front end.

Critics argue this system can give people a vested interest in closing a deal, regardless of whether it turns out to be a good idea over time.

"It is not clear that existing compensation mechanisms effectively ensure that traders take into account the long-term interests of the bank for which they work -- i.e. its survival," Pierre Cailleteau, the chief international economist for Moody's Investors Service, wrote in a report released last week.

In various forms, a similar pay structure exists at the top of the financial world, where executives can reap lucrative pay packages, even if deals made on their watch later go south.

Merrill Lynch & Co.'s former chief executive, Stan O'Neal, left in October after the firm's $8.4 billion write-down. He didn't get a bonus or severance, but he retained $161.5 million in previously earned benefits and compensation because he met the age and service requirement for collecting those benefits. Charles Prince, Citigroup Inc.'s former CEO, lost his job, too. He left Citigroup in November with stock and other compensation valued at the time at $29.5 million, as well as a bonus. He didn't get severance.

Tuesday, Citigroup reported a fourth-quarter loss of $9.83 billion.

Mr. O'Neal and Mr. Prince -- along with Angelo Mozilo, chief executive officer of Countrywide Financial Corp., the nation's largest home-mortgage lender by loan volume -- have been asked to testify about their pay packages on Feb. 7 before the House Committee on Oversight and Government Reform.

"You should plan to address how it aligns with the interests of . . . shareholders and whether this level of compensation is justified in light of your company's recent performance and its role in the national mortgage crisis," Committee Chairman Henry Waxman wrote in similar letters to the three men.

Mr. O'Neal declined to comment. Countrywide declined to comment. Mr. Prince couldn't be reached for comment.

The financial world's pay structures are also at the center of the market for new investment products, which grew rapidly in recent years.

Wall Street came up with ways to repackage mortgages and other debts into securities that could be traded much like regular bonds. These, in turn, could be sold to new clients -- such as mutual funds -- that would have had little appetite for the original debts.

It enabled financial houses to sell off mortgages and other debts that previously might have remained on their own books. This meant the people who originated the loans often didn't have much of a direct financial stake in whether the loans are eventually paid off.

"As soon as you're out of the deal, you've made your profit," says Rep. Paul Kanjorski (D., Pa.), who heads a House subcommittee overseeing markets. Last year, the House adopted a series of changes to the mortgage market. The Senate is considering its next step.

The new securities are tradable, so they can routinely be sold to others. That has led to the revival of an old one-liner on Wall Street: "A rolling loan gathers no loss."

Financial innovations like these helped spur the lending boom of recent years, by spreading risk more broadly. Along the way, they also boosted profits for Wall Street firms, which typically pocketed fees of around 1% on certain securities they underwrote, to the tune of hundreds of millions of dollars.

All this worked as long as home prices kept rising: Easy access to borrowing, aided by historically low interest rates, helped millions of Americans buy homes. That demand helped spur prices upward. Low- cost borrowing also let corporate executives pull off multibillion- dollar mergers and acquisitions.

Now, as the housing market tanks, some of these same financial innovations are spreading the pain further than expected. That's triggered unusual fallout, such as local governments in Australia and a regional bank in Germany facing potential losses from investments tied to subprime mortgages in the U.S.

Some say the compensation of deal makers should be tied to the long- term performance of their deals. In November, a high-profile panel issued a report -- known as the Geneva Report -- calling on governments to consider requiring financial firms to hold on to some of the bonds they issue that are backed by loans they made.

The panel that authored the report, published by two European think tanks, included Roger Ferguson, former vice chairman of the Federal Reserve and now head of financial services with Swiss Reinsurance Co.

On Nov. 19, Swiss Re said it faced an $876 million after-tax loss due to subprime-mortgage-related holdings.

Some Wall Street firms are taking steps to tie compensation to longer-term performance. Senior traders at Credit Suisse, for example, set aside part of their compensation -- the firm declines to say how much -- for a number of years. That can be taken back to cover losses in future years.

"We have put in place compensation programs that ensure that our peoples' interests are directly aligned with our shareholders over a multiyear horizon," says Brady Dougan, Credit Suisse's chief executive.

Still, there are significant obstacles to change. While banks may want to curb risky pay incentives, they don't want to discourage risk taking altogether. Nor do they want to lose top producers to firms offering richer packages.

In good times, the pressure to abandon such restrictions could intensify, the Moody's report noted. "A recent policy announced by several banks to cap wages at a 'moderate' level and pay the rest of the compensation in the form of stock is an acknowledgment of this problem. However, such 'good intentions' do not generally survive a boom period, and in any event typically have unintended consequences of their own," the report said.

The Federal Reserve, which oversees the U.S. banking system, recently proposed rules that would tighten requirements for lenders to assess borrowers' ability to repay mortgage loans.

Mr. Schmidt, the Louisiana mortgage broker on the front lines of the mortgage mess, has a more far-reaching idea: "There needs to be a broker score card," he says, a way to tally how many of a broker's loans later get into trouble. The current pay structure has "a lot to do" with America's housing problems, he says.

Mr. Schmidt, who with his wife runs a four-person mortgage-brokerage shop, says it's impossible for him to know what percentage of the loans he brokered have soured, because of rules that protect borrowers' privacy.

The 36-year-old cigar-lover also operates a gravel-and-sand mine, which makes for a stark comparison: In the gravel business, he delivers materials to a customer, but the customer pays later. He has a direct stake in his judgment of a customer's ability to follow through.

Mortgage brokers like Mr. Schmidt are basically independent middlemen who make money only if their clients get loans. In 2006, Mr. Schmidt's firm arranged loans of $11 million on 126 housing units, according to Mortgage Originator, a trade publication. He says he earned an average of 1.5% on those loans, which calculates to about $165,000.

Brokers do have an incentive to have happy customers. They often rely on referrals. And, they note, it is the lenders -- not the brokers -- who decide whether to make the loan.

Until the past couple of decades, most mortgage lenders had a strong motivation to avoid having loans go bad: They carried the loans on their own books. Sometimes they still do. When lenders sell loans to packagers of securities, the lenders often keep the riskiest slices of those securities. However, even that slice was "increasingly traded away" in recent years, according to the Geneva Report.

The market for trading credit risk expanded during the housing boom, through the use of instruments such as collateralized debt obligations. These are securities that can be backed by a mix of assets ranging from mortgages to credit-card receivables.

Even when lenders sell all of their loans, poor lending decisions can come back to haunt them. If loans default soon after they are sold or otherwise fail to meet promises made by a lender, that company can be forced to buy back the loan, often resulting in a huge loss. Such losses have forced some subprime lenders out of business over the past year.

Subprime loans, those given to people with low credit scores, grew from $160 billion in 2001 (or 7.2% of new mortgages) to $600 billion in 2006 (or 20.6% of new mortgages), according to Inside Mortgage Finance, an industry newsletter.

"In the past, banks making loans would have a strong incentive to work with borrowers to prevent them from defaulting," the report said. "Today, a lender can hedge its credit-risk exposure . . . reducing or eliminating this incentive to stave off defaults."

Investors who buy mortgage-backed bonds need some way to measure the risk of these investments. Many turn for guidance to Wall Street rating services, which assess bonds and other investments.

Many of the new securities -- even some backed by mortgage loans to borrowers with low credit scores -- were able to earn top "triple-A" ratings, due to the complex ways in which they attempted to divide the risk.

In recent months, many of those ratings have fallen sharply, making the bonds far less valuable. That's sparking a debate over the role played by rating services in developing the market for securities like these. An issue: the way in which rating companies are paid for their opinion of a bond's risk.

Rating services such as Moody's, Standard & Poor's and Fitch Ratings are typically paid upfront for their assessment of a bond. Later on, if the rating is downgraded, a rating service doesn't have to give back any of those fees. Rating services can also receive fees for monitoring the bonds they've rated.

Of course, a rating service's reputation is on the line each time it issues its opinion on a security, and a damaged reputation can be costly. And representatives of the firms say their aim is to keep ratings and fees independent of one another.

Otherwise, for instance, a rating service could have an incentive not to downgrade a security, even if that seemed necessary, says Anthony Mirenda, a spokesman for Moody's. S&P said, in a statement, that ratings are adjusted when "unforeseen and often unforeseeable events lead us to change those opinions" and added that a change doesn't mean "an earlier opinion was necessarily 'wrong.'"

Upgrades and downgrades of ratings are common, even when the market is much quieter than it's been recently. More than one in four of all corporate bonds rated triple-A between 1981 and 2006 by S&P fell to double-A or lower over the next five years, on average.

For structured products such as mortgage-backed securities, downgrades traditionally are rarer. From 1981 to 2006, just over 2% of top-rated triple-A bonds fell to double-A or below, on average, over the next five years.

Last year, rating services downgraded thousands of mortgage-backed securities and collateralized debt obligations. Some of those downgraded securities had received top-ranking triple-A ratings when they were issued in early 2007, but ended the year downgraded to "junk" status, a fall of at least 10 notches.

One striking thing about the current situation is that some of the investors getting burned worst by the recent market turmoil are among the biggest names on Wall Street and the most sophisticated industry veterans.

Consider, for instance, the market for collateralized debt obligations, or CDOs. Merrill Lynch and Citigroup were the two largest underwriters of CDOs in much of the past three years, according to Thomson Financial. The firms also played the role of investors, and held onto significant slices of the CDOs they underwrote.

Those holdings have proved disastrous for the firms and their shareholders. The stock prices of Merrill and Citigroup lost more than 40% of their value last year.

---

Serena Ng and James R. Hagerty contributed to this article.

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