The City’s Broken Business Model

It is, of course, quite wrong to refer to “The City” as if it were something homogeneous. There are dozens, hundreds, of different business activities in the the City, from sandwich-sellers to shipbrokers, and not all of them use the broken model by any means.

But many do. Investment banks, fund managers, bond dealers and  insurance brokers for a start.

The common key feature of this model is commission-based sales, with profits taken early.

The broken part of it is that profits and risks are time-mismatched.

Time and again we find mis-selling scandals, bubbles and other regulatory failings that prompt soul-searching all round with this common factor at its core.

Although it’s the problem from a few years ago, I’m going to look at sub-prime mortgages to try to illustrate the problem.

You start with an estate agent (real estate agent in the US). He (or she) will get commission if he sells a property. The commission is paid when the property is sold. He finds someone who wants to buy, but doesn’t have the money. So he puts them in touch with a mortgage broker. He, too, gets commission when the mortgage is sold.  Sub-prime mortgages are a bundle of products, including the actual loan secured on the property and a series of other insurance “products” intended to help bail out the lender when the deal goes titsup. All of these are essentially promises, made by the poor person, to pay so much a month for the next twenty-five years or so.   In many cases, these promises could never be kept…. which we’ll come to later. But the person selling the property and the mortgage to buy it don’t need to worry about that, because they will get paid their commission when the sale goes through, whether or not the buyer breaks his promise at any time over the ensuing twenty-five years.

The lending bank then has a mortgage on its books, and the associated money now in the property vendor’s bank account. To lend more, it needs more money to lend.  The institutions with the most money are pension funds, with billions of contributions made every month looking for somewhere safe.  Until 2007/8,  US residential mortgages were considered pretty safe.  The bank can sell its mortgage to the pension fund, getting more money to lend out on another mortgage; the pension company gets the interest on the mortgage.  But no pension fund wants the grief of collecting gazillions of interest payments from mortgagors, or the hassle of chasing them when they default, so the banks sliced, diced and repackaged their mortgages into instruments that were more practical for pension funds to handle. They then sold these instruments to pension funds, paying their brokers a commission for the sale, and booking profits as they did.  The slicing-and-dicing was supposed to minimise the risk associated with these instruments, but it failed to do so; sure enough, poor people couldn’t keep up payments on a mortgage, and the value of the instruments crashed. But many people in the chain had already made a lot of money from them, in the various commissions paid at every stage of the chain.

Commission percentages, paid up-front, discourage brokers of any sort from acting responsibly. The incentive is to do the deal, and pass the risk that someone won’t keep their promise further down the line.

But this model is profitable, until a crash comes. Commission in one form or another is booked as a profit. Banks were making loads of money from commissions, and they still do. It poisoned the way High St banks operate. Visit your local bank manager, and you won’t get friendly advice, you’ll get a salesperson on commission trying to sell you a product. Banking products are generally speaking lopsided promises: a big sum of money one way, in return for the promise of lots of little sums of money into the future.

Now there’s nothing wrong with commission as an incentive, in principle. It’s just that it should be  paid when promises are kept, not when they’re made.

 

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