“Never forget that primary equities is where all the money is made,” the head of research at a well-known investment bank once declared to us here on The Value Perspective. “Secondary equities make no money at all. Everybody at this company knows which side of the business is bringing in all the money.”
For anyone not fully versed in the intricacies of investment banking, primary equities takes in initial public offerings, the issuance of new shares and other types of corporate finance. In contrast, the focus of secondary equities is on shares that are already in issue – for example, company research and trading services – and, as that head of research was implying, it does not pay the bills.
A firm can set up all the Chinese walls in the world and yet, if the people who provide research on companies believe their pay-cheques essentially come courtesy of other colleagues with an interest in keeping such companies – also known as ‘potential clients’ – in good humour, then regardless of whether anyone makes the point explicitly, they are beholden to another master.
So is this another analyst-bashing article in the spirit of ‘Hold’ on, where we most recently questioned the worth of ‘buy’ and ‘sell’ recommendations? Well, it is not like us to pass up the chance – but there is also a link to another recent piece, Desperate measures, where we touched on how incentives can often bring about a different result from the one their architects had intended.
Do loan officers’ incentives lead to lax lending standards? is the name of a 2012 academic paper that is raised above many others of its type by the identity of those it studies. While the subjects of much academic research will necessarily be students lured by the promise of a £20 book token or whatever, the people covered in this report were actual employees of an actual and very large US corporate bank.
The bank decided to use its 130 loan officers, whose job was to assess loan applications from small businesses, as human guinea-pigs – arbitrarily splitting them up into two groups on different pay structures. One group continued receiving the same fixed pay they always had but the other group started to operate under a new remuneration scheme that included an incentive element.
This group saw their fixed pay cut by 20% but there was instead the potential for bonus payments that were calculated on such factors as the value and number of loans approved and the time it took to do so. These employees were, in short, significantly incentivised to approve more loans more quickly and, as you might expect, the bank began to see this group’s “loan origination” levels significantly increase.
Initially the results seemed promising. Simply by adjusting the pay structure of existing employees, the division had apparently become more efficient and competitive, more and larger loans were approved, the time taken to make decisions was shorter, the incidence of unhappy loan officers quitting their job was reduced and, crucially, loan quality – as it was then measured by the bank – improved.
‘Seemed’. ‘Initially’. ‘Apparently’. ‘As it was then measured’. Are you beginning to gain a sense the experiment did not end so happily? If so, you sense right because the bank subsequently discovered another important metric also went up. Unfortunately that metric concerned loan default rates, which rose by more than a quarter.
The increase in defaults was concentrated in loans that would not have been made in the absence of commission-based compensation and in loans that were particularly high-value, the study concluded, adding: “Our results support the idea the explosion in mortgage volume during the housing bubble and the deterioration of underwriting standards can be partly attributed to the incentives of loan officers.”
So this real-world study found the loan officers had certainly responded to their new incentives. It was just that these incentives were not quite targeted enough to encourage them to do the most effective job for their employer and, in aiming to do more, faster, they ended up overlooking or ignoring some important information on credit quality.
Investors should always look to understand the nature of any incentive scheme operating in a business they buy. To return to our initial point, they would also do well to ask themselves whether investment banks and their employees are more incentivised to offer the best company research or to forge the best company relationships. The two things are not, we would argue, particularly compatible.