Thursday, 09.25.08
Risky Business
Chip Somodevilla/Getty Images
Treasury Secretary Hank Paulson spent the first half of this week warning us that the executive compensation regulations proposed by congressional Democrats will appear "punitive" and scare financial institutions away from participating in the federal bailout. The fact that Paulson has now given in should please, among others, Congressman Barney Frank, who spent the week arguing that such regulations were an issue of fundamental fairness. In Frank's words: "I don't want the federal taxpayer to be at risk for their bad debt and then the guy who incurred the debt gets tens of millions of dollars on the way out the door.''
I don't want that either, but both sides of this debate are missing a big point in favor of compensation regulations -- a point that has nothing to do with the degree to which the regulations are punitive or fair. Smart regulations could prevent the sort of compensation packages -- and incentive structures -- that helped get us into this mess in the first place.
To understand why, it's necessary to understand how executive compensation packages are structured. At present, salary comprises a very small slice of a finance executive's total earnings. Unlike most other companies, executive compensation at a financial institution is tied mostly to the institution's annual performance and doled out in the form of a year-end bonus. This bonus is invariably staggering (in Goldman Sachs CEO Lloyd Blankfein's case it was $68 million in 2007), and it is usually split about evenly between rewards that are intended to create short-term and long-term financial incentives. Short-term incentives generally take the form of cash, while long-term incentives, which take several years to vest, include restricted stock units and stock options.
For instance, Morgan Stanley's 2008 proxy statement lays out its bonus structure as follows: "Pay levels should be determined based on company, business unit and individual results compared to quantitative and qualitative performance priorities set at the beginning of the year," and annual "profit before taxes and return on equity are key performance measures considered in making pay decisions."
The stated aim of this kind of performance-based compensation is to align executive interests with shareholder interests. But the emphasis on annual performance -- based on non risk-adjusted factors like profit and return on equity -- means that executives are motivated to take major risks to maximize revenue and boost stock prices in the short term.
Although the long-term incentives built into the bonus are designed to reduce such risk taking, these incentives are still awarded for short-term success. If executives act in a prudent, risk-averse manner, they will receive a smaller pot of long-term incentives to protect on bonus day. It is thus rational for them to maximize their compensation by taking large risks. And the cash bonuses are often so large that an executive can float into gilded retirement even if his financial institution tanks. (Just ask former Merrill Lynch CEO Stanley O'Neal, who netted an $18.5 million cash bonus in 2006.)
Creating an incentive to take risks can blind finance executives to the pitfalls of hazardous investment instruments like bundled subprime mortgages. This is a familiar insight. At a recent hearing of the House Committee on Oversight and Government Reform, Nell Minnow, co-founder of corporate governance research firm The Corporate Library, testified that compensation plans determined mostly on annual earnings and equity returns can "push for sales without adequate concern for quality."
Any bailout legislation passed by Congress should include a mechanism to limit bonuses that reward taking potentially catastrophic risks. Senator Chris Dodd's bailout proposal, which places "limits on compensation to exclude incentives for executives to take risks that the Secretary deems to be inappropriate or excessive," is disturbingly vague, but at least it is a start. And it might even be fair, too.
(1)
These limits are long overdue and probably necessary in other areas of business. As it did in Roosevelt's era, the government needs to put a dog collar on big business to save capitalism.
Cowboy capitalism, like the USSR, has collapsed because of its own poisoned genes.
As with Marxism, the argument over a regulated capitalist system is essentially over -- the effects of cowboy deregulation having settled the issue. Except, I suppose, for rabid Milton Friedman-ites, who can join the surviving Trotskyites handing out pamphlets on street corners and mumbling ideology through their beards.
It's now clear that the west Europeans have the kind of systems that actually work: they are regulated, supervised, offer comprehensive health care and adequate educational and other social services. As the French like to say, they work to live, not the reverse as the "Anglo-Saxons" do.
There's another big benefit of these systems: societies that actually spend adequate resources on their most valuable resource -- their people -- don't have gazillions of euros to spend on elaborate, expensive and ultimately useless military toys and the adventurism that such things encourage.
They tend to rely more on diplomacy and a realistic vision of the world, not the delusion that somehow advanced aircraft and ever more exotic weapons will solve problems. Their military-industrial complexes have been gelded.
We have all these toys, and they are mostly useless in the close-in ground combat we're experiencing. Bribery has proven much more effective than helicopter gunships in Iraq.
I hope no one tries to invent an ideology to encompass what we need to do. It will only muddle things: if the 20th century proved anything, it's that these intellectual conceits are wrong at best, murderous at worst.
Posted by denis arvay | September 26, 2008 7:52 AM