“The president, speaking in an interview, said in response to a question that while $17 million is ‘an extraordinary amount of money’ for Main Street, ‘there are some baseball players who are making more than that and don’t get to the World Series either, so I’m shocked by that as well.’”

That is, Obama is saying that some bankers are overpaid, just like some athletes are overpaid. Maybe he read my earlier post?

There, I wrote:

“So yes, bankers are like athletes. Their individual contributions are overrated relative to their supporting environments; they are overpaid; they are paid based on where they randomly fall in the probability distribution in a given year; and paying a lot for bankers is no guarantee that your bank will be successful in the future. Team sports, like banking, are an industry where the employees capture a large proportion of the revenues. And one with negative externalities, like upsurges in domestic violence around major sporting events. Neither one should be a model for our economy.”

More generally, Obama is trying to strike a balance: put pressure on Wall Street while not appearing to be wielding a pitchfork himself. This is why he felt compelled to say, “I, like most of the American people, don’t begrudge people success or wealth. That is part of the free- market system.” At the same time he feels compelled to advocate for relatively mild reforms, such as paying bonuses in stock instead of cash, which is at best a partial solution. (Top Wall Street executives were already paid overwhelmingly in stock rather than cash before the financial crisis.)

I’m not sure why he needs to strike that balance. CEOs are overpaid, bankers are overpaid, and bank CEOs are overpaid.  Why not just say it plainly?

By James Kwak

Lucian Bebchuk, Alma Cohen, and Holger Spamann have exploded this myth in a Financial Times op-ed and a new paper. They look at the CEOs and the other top-five executives of Bear Stearns and Lehman Brothers. (All numbers are adjusted to January 2009 dollars.) From 2000 through 2008, these ten people received $491 million in cash bonuses (Table 1) and sold $1,966 million in stock (Table 2); on average, each person took out $246 million in cash. (Both Lehman and Bear had rules that prevented top executives from cashing out equity bonuses for five years from the award date–see p. 16 n. 33.)

At the beginning of the period (2000), these ten people had $1,398 million in stock and options (Table 5; option value calculated conservatively as the current difference between market price and exercise price). So on average, each one had $140 million in stock at in 2000; received $49 million in cash over the next eight years; sold $197 million in stock; and lost the rest in 2008 when their companies collapsed. Dick Fuld began with $301 million in stock, received $62 million in cash bonuses, and sold $471 million in stock before losing his supposed $1 billion.

Let’s put this in perspective (insofar as it’s possible to put these kinds of numbers in perspective) two different ways. First, let’s say you’re a bank CEO with a lot of wealth tied up in stock. Satan comes along and offers you the following deal: if you undertake a strategy with a lot of risk, every year you will get a cash bonus, every year your stock price will go up, every year you will be able to sell some (but not all) of your stock at this higher price, and every year you will get more restricted stock awards–until at some point everything collapses and the stock becomes bankrupt. Would you take that deal? Of course you would. Yes, it means that your losses in the final crash will be bigger than with a more conservative strategy. But it means that you would make a lot more money in the meantime.

Second, let’s say you’re a house flipper in a rising market. You buy a few houses with borrowed money, sell them at higher prices, buy more houses with more borrowed money, sell them at even higher prices, buy yet more houses, etc. Each time you sell you take out some of the money as cash and put the rest back into the housing market. At some point the market crashes and you lose the houses you were holding onto at the end. But in the meantime you stashed millions of dollars of winnings in your bank account. Did you do well by using leverage to maximize your risk in a rising market? Of course you did, even though you lost a lot in the crash.

Now, there are things in life besides money, and Dick Fuld has no doubt suffered tremendously in the past year. And at this point, maybe he would gladly give up that $533 million he took out to see a healthy Lehman Brothers. So yes, there are other reasons why CEOs do not want to see their banks blow up. But holding a lot of restricted stock is not necessarily one of them.

By James Kwak

Buying back stock costs money — real cash money. Why would a company ever do such a thing? The textbook answer is that a company should do it if it doesn’t have investment opportunities that yield more than its cost of capital. The cash in its bank account, in some sense, belongs to its shareholders, who expect a certain return. If the bank can’t earn that return with the cash, it should return it to the shareholders. In this case, though, the interest rate on the preferred shares is only 5%, which is far lower than usual cost of equity. In fact, Bank of America just issued $19 billion of new stock in order to help buy back the government’s preferred stock. The cost of that new equity (in corporate finance terms) is certainly higher than 5%. In other words, Bank of America just threw money away.

In practice, companies buy back stock in order to increase their earnings per share. Fewer shares outstanding and the same earnings mean higher earnings per share and a higher stock price. In theory, this shouldn’t work: the benefit of having fewer shares should be exactly balanced by the fact that the company is now worth less (because it has, say, $45 billion less cash than it had yesterday). But in practice, it seems to work, probably because of signaling. But that doesn’t make sense in this case, either, since these are preferred shares that Bank of America is buying back, which have no claim on earnings. In effect, Bank of America is paying off cheap (5%) debt it doesn’t have to pay off — and to do that, it’s issuing new common shares, which will dilute existing shareholders.

Paying back its TARP money also has the effect of making Bank of America weaker. From a liquidity perspective, it now has about $20-25 billion ($45 billion minus $19 billion raised from new equity minus a few billion from other asset sales) less cash than it did before paying the money back. From a capital perspective, using cash to buy back preferred shares reduces your Tier 1 capital ratio. (I know there is disagreement about this, but the term sheet explicitly said that Treasury’s preferred shares counted as Tier 1 capital.)

So why?

The answer … which most of you know already … is to avoid executive compensation caps. From the Times article:

“It is a particularly delicate time for Bank of America, which has struggled to find a replacement for Mr. Lewis. By paying back the money that it received under the Troubled Asset Relief Program, or TARP, Bank of America will free itself from exceptional federal oversight of its executives’ pay — a thorny issue in recruiting a new chief executive.”

In retrospect, the executive compensation caps inserted by Congress into the stimulus bill back in February are having a perverse effect. Because the caps applied only to financial institutions that took TARP money — and they applied much more heavily to institutions that received “exceptional assistance,” like Citigroup and Bank of America — it tilted the paying field even more heavily against them. This gives them an incentive to take steps that weaken their financial condition, even as conditions in the real economy (to which Bank of America is highly exposed) remain bleak.

I support restrictions on the form of compensation in financial institutions, such as requiring them to be distributed in restricted stock that vests over several years (which is already standard practice at some banks, such as Goldman Sachs) and making bonuses in good years subject to clawbacks in bad years. But those restrictions have to apply to all financial institutions, not just some of them; otherwise, you get this situation where Bank of America is making a silly financial decision because it has to in order to hire a new CEO. (The fact that nobody will be CEO of America’s largest bank because of executive comp restrictions is another issue, but there’s not much we can do about that. I would do it, but I don’t want to move to Charlotte.)

Update: Ted K. pointed out to me that Wells Fargo, which is generally considered less of a basket case than Bank of America, is not paying back its TARP money yet.

By James Kwak

The discussion of the costs associated with our financial system has mostly focused on the paper value of its recent mistakes and what taxpayers have had to put up to supply first aid. The estimated $4,000bn of losses in US mortgage-related securities are just the surface of the story. Beneath those losses are real economic costs due to wasted resources: mortgage mis-pricing led the US to build far too many houses. Similar pricing errors in the telecoms bubble a decade ago led to millions of miles of unused fibre-optic cable being laid.

The misused resources and the output foregone due to the recession are still part of the calculation of how (in)efficient our financial system is. What has somehow escaped attention is the cost of running the system.

In particular, Friedman wonders at the relationship between the value provided by financial services and the opportunity cost involved: “Perversely, the largest individual returns seem to flow to those whose job is to ensure that microscopically small deviations from observable regularities in asset price relationships persist for only one millisecond instead of three. These talented and energetic young citizens could surely be doing something more useful.”

This reminds me of something Felix Salmon wrote about a while back: If profits and compensation in the financial sector go up and keep going up, that’s a priori evidence of inefficiency, not efficiency. Those higher profits mean that customers are paying more for their financial services over time, not less, which means that financial services are imposing a larger and larger tax on the economy. Now, it is possible that they are also increasing in value fast enough to cover the tax, but that is something to be proven.

By James Kwak

So, I decided to call on some reinforcements. Lucian Bebchuk, a leading researcher of executive compensation (book; importat paper discussed here), and Holger Spamann have a new paper called “Regulating Bankers’ Pay” that discusses precisely this issue. They conclude not only that regulation of banks’ executive compensation would be a good thing, but that it may actually be better than the traditional regulation of banks’ activities.

Section II (PDF pages 11-28) lays out, with simple examples worthy of a Beginners post, what I thought was already generally accepted (but apparently isn’t): leverage, combined with the bank holding company structure, combined with compensation in the form of stock options, combined with deposit insurance, combined with the implicit guarantee on uninsured liabilities, creates large incentives to take excessive risks – defined as actions that have a negative expected value for the bank’s assets, but a positive expected value for bank executives. First of all, in a highly leveraged financial institution, shareholders already have the incentive to take excessive risks, because their downside is limited. This is amplified for executives holding stock options, whose downside is even more severely limited. Finally, explicit or implicit guarantees on liabilities reduce the incentive for creditors to adequately monitor banks’ activities. 

As a result, Bebchuk and Spamann argue that executives’ incentives should be tied not to the value of shareholder’s equity, but to the value of all of the bank’s assets. Wait a second, though – isn’t the whole point of corporations that managers’ incentives should be aligned with those of shareholders? Yes, that is one consideration. But there are two other considerations that matter.

First, banks are unusual in that a large portion of their liabilities is guaranteed by FDIC deposit insurance, which already helps distort executives’ incentives as described above. As the insurer, the government needs to protect itself from moral hazard – and one way of doing that is reducing managers’ incentives to take actions that are good for shareholders but bad for the insurer.   

Second, as we should now know, the incentive to take excessive risks, when shared across all the largest banks, is a major contributor to systemic risk. A systemic crisis leads to both government bailouts to protect non-guaranteed creditors, and to severe collateral damage for the economy at large. Therefore, the government should attempt to reduce those incentives, both to protect taxpayer money and to protect the economy.

Traditional regulation attempts to deter excessive risk-taking by limiting the set of activities that banks are allowed to engage in. Currently, however, bank executives have strong incentives to try to get around those regulations. In addition, Bebchuk and Spamann argue that regulators should at least monitor executive pay structures in determining whether safety and soundness risks exist. Ideally, they would link executive compensation not to the value of common shares, but to the aggregate value of common shares, preferred shares, and bonds. This would take away the incentive to take actions that have positive expected value for shareholders but negative expected value for the assets in aggregate.

The idea is that, in principle, it’s better to give executives the incentive to do the right thing than to give them the incentive to do the wrong thing and then try to hem them in with regulations.

Indeed, if pay arrangements are designed to discourage excessive risk-taking, direct regulation of activities could be less tight than it should otherwise be. Conversely, as long as banks’ executive pay arrangements are unconstrained, regulators should be more strict in their monitoring and direct regulation of banks’ activities.

Would the banks go for incentive compensation tied to the entire balance sheet rather than just common shares? It’s an interesting question. Under Bebchuk and Spamann’s proposal, they could still have enormous bonuses; from this perspective, it’s the structure that matters, not the size. But if the banks insist on tying their bonus packages to common shares, then we know that they are perfectly happy taking excessive risks. In that case, then this passage becomes particularly relevant:

In principle, well-designed incentive pay can improve the management of firms. . . . That being said, our analysis above identified major problems with the current incentive structure for bank executives. From this perspective, scaling down financial incentives may be a good thing. No financial incentives may be better than bad ones. Thus, if incentive compensation remains structured in ways that provide perverse incentives, limits on incentive pay can actually improve matters.

(On a related note, Marketplace and ProPublica ran a story yesterday on TARP recipients that figured out ways to give their executives golden parachutes.)

By James Kwak

This, of course, solves precisely nothing. The problem with “executive compensation” – no, make that just “compensation” – in the financial sector was its structure. Huge end-of-year bonuses tied to short-term metrics, with no corresponding downside risk, motivated people to take on excessive risk in hopes of maximizing those bonuses. And the companies we need to worry about most are not the ones that are most beaten-down today, but the ones that are (relatively) the strongest and will be taking the biggest bets.

So the administration is also thinking about addressing these structural issues. Tim Geithner made a statement on compensation yesterday that lays out five reasonable-sounding principles (compensation should reward performance, compensation should be “aligned” with risk management, etc.). On closer examination, it’s remarkably short on verbs that aren’t prefaced by “should.” For example, “I met with SEC Chairwoman Mary Schapiro, Federal Reserve Governor Dan Tarullo, and top experts to examine . . .” Or, “in considering these reforms, we start with a set of broad-based principles . . .” Or, “by outlining these principles now, we begin the process of bringing compensation practices more tightly in line . . .” (Emphasis added, obviously.)

At its heart, there are only two proposals: first, “say on pay” legislation, which requires non-binding shareholder votes on executive compensation packages and, according to Geithner, “would encourage boards to ensure that compensation packages are closely aligned with the interest of shareholders;” and second, new standards for independence of board compensation committees. 

If you’re wondering how a non-binding shareholder vote could possibly solve the problems with executive compensation, you’re not alone. I think “say on pay” is slightly better than nothing, because there is a chance that in some cases the additional attention will shame boards into more reasonable packages. But in general, shareholders’ ability to influence corporate governance is pretty weak. Outside shareholders, even major institutional investors, face many challenges: fragmentation of ownership, which makes it hard to build a big enough coalition; the control of information by management and the board; the usage of compensation consultants to insulate pay packages from criticism; and the tendency of small shareholders to either not vote or vote the way the board recommends. Even if dissident shareholders can muster a “no” vote, the likely outcome would be a cosmetically modified package that is simply harder to understand – or no change at all (non-binding, remember?). 

Independent compensation committees are also a nice idea, but without many teeth, at least in the proposal floated yesterday. They key question is, what incentive do the compensation committee members have to really crack down on executive compensation? The proposal draws a parallel to Sarbanes-Oxley and audit committees. But audits turn out to be right or wrong, and if there is a restatement, that is deeply embarrassing to the people involved. Excessive compensation is a matter of judgment, and it’s hard to see compensation committee members ever being held personally liable for giving away too much money.

Over at The Hearing, Brett McDonnell is similarly underwhelmed, although he does suggest some additional ideas, such as allowing regulators to evaluate the effect of compensation on safety and soundness requirements.

This reluctant approach to regulating executive compensation should come as no surprise. In his press briefing the day he announced the Public-Private Investment Program, Geithner responded to a question about TARP executive compensation conditions by saying, “the comp conditions will not apply to the asset managers and investors in the program.” When the Washington Post reported on April 21 that that was not what the lawyers were saying, Treasury rushed out a new FAQ (see the April 21 FAQ) trying to assuage investors’ fears.

This looks to me like a strategic choice. The administration has decided that the economy depends on the banks, and therefore it needs to keep the existing bankers happy. Or it has decided that executive compensation is just not such an important issue, and it would rather focus on others. (What, though? The Wall Street Journal reported on Tuesday that the administration is backing off plans to consolidate regulatory agencies.) Or, more likely, both.

These are reasonable positions, even if I don’t agree with them. But they are more evidence that the financial sector of 2010 will look more like the financial sector of 2006 than anyone would have thought possible just six months ago.

By James Kwak

Alan Blinder does a good job explaining the problem in simple terms in the first half of his WSJ op-ed.  However, I’m not optimistic about his solution: 

It is tempting to conclude that the U.S. (and other) governments should regulate compensation practices to eliminate, or at least greatly reduce, go-for-broke incentives. But the prospects for success in this domain are slim. (I was in the Clinton administration in 1993 when we tried — and failed miserably.) The executives, lawyers and accountants who design compensation systems are imaginative, skilled and definitely not disinterested. Congress and government bureaucrats won’t beat them at this game.

Rather, fixing compensation should be the responsibility of corporate boards of directors and, in particular, of their compensation committees. . . .  The unhappy (but common) combination of coziness and drowsiness in corporate boardrooms must end. As one concrete manifestation, boards should abolish go-for-broke incentives and change compensation practices to align the interests of shareholders and employees better. For example, top executives could be paid mainly in restricted stock that vests at a later date, and traders could have their winnings deposited into an account from which subsequent losses would be deducted.

Why am I not optimistic? Disney.

In 1995, Disney Chairman and CEO Michael Eisner hired his longtime friend Michael Ovitz to be president of the company. Ovitz was the founder of one of Hollywood’s most powerful agencies, but had no experience even working in a company like Disney, let alone managing it. Eisner negotiated his friend’s employment contract, which included a $1 million annual salary and 5 million options, vesting in annual increments beginning in 1998. In addition, if Ovitz were fired within his first five years (but not if he were fired for “gross negligence,” and not if he resigned voluntarily), he would be given – in addition to his salary for the remainder of the contract – $1o million, $7.5 million per year remaining on the contract, and his first 3 million options.

In 1996, one disappointing and controversial year after Ovitz joined, “Eisner and Ovitz agreed to arrange for Ovitz to leave Disney on the non-fault basis provided for in the 1995 Employment Agreement.” Brehm v. Eisner, 746 A.2d 244 (Del. Sup. Ct. 2000). As a result, Ovitz got about $40 million in cash and 3 million options.

Disney shareholders sued the board of directors, both for approving a compensation agreement that gave Ovitz an incentive to try to get fired in the first five years, and for allowing him to leave on a “non-fault basis” rather than firing him for cause (gross negligence). On both counts, the courts, in both Brehm v. Eisner and In re Walt Disney Co. Derivative Litigation (Del. Ch. 2005), held that the board was not liable because of the “business judgment rule.” The business judgment rule says, in essence, that as long as a board of directors does not have a conflict of interest, informs itself adequately, and makes a decision, it cannot be held liable for that decision, no matter how obviously stupid it is or how catastrophic it turns out to be.

The business judgment rule is not a crazy rule; it is designed to allow directors and managers to take risks that may turn out badly without worrying that they may be held personally liable. But one of its effects is to shield boards of directors from any accountability for executive compensation decisions. It’s nice to say that boards “should” implement compensation practices that align managers’ incentives with those of shareholders, but it’s hard to see why this should happen. 

Board behavior is determined by two things: power and incentives. The problem is that even though things have improved a little since Enron and WorldCom, directors are often de facto appointed by the CEO and serve at his pleasure; serving as a director is cushy enough that directors want to keep their jobs; and directors are dependent on the CEO and other managers for information. Although directors nominally represent the interests of shareholders, they can become a kind of insider, captured by the perks of the job and management’s control over the flow of information. From an individual director’s perspective, the high-percentage play is to approve generous compensation packages for the CEO and his lieutenants; that maximizes his chance of holding onto his board seat, and he has no personal accountability for his vote. Blinder describes “executives, lawyers and accountants” running rings around government regulations and regulators; today’s board of directors is an even easier mark for them. 

Blinder says regulation of compensation practices is likely to fail. Having lived through it, he would know better than I. But I don’t think that waiting for better corporate governance is the answer. We will still be waiting when the next crisis hits. 

If anything, I find myself more sympathetic to the views of Goldman CEO Lloyd Blankfein:

We should apply basic standards to how we compensate people in our industry. The percentage of the discretionary bonus awarded in equity should increase significantly as an employee’s total compensation increases. An individual’s performance should be evaluated over time so as to avoid excessive risk-taking. To ensure this, all equity awards need to be subject to future delivery and/or deferred exercise. Senior executive officers should be required to retain most of the equity they receive at least until they retire, while equity delivery schedules should continue to apply after the individual has left the firm.

For policymakers and regulators, it should be clear that self-regulation has its limits. We rationalised and justified the downward pricing of risk on the grounds that it was different. We did so because our self-interest in preserving and expanding our market share, as competitors, sometimes blinds us – especially when exuberance is at its peak. At the very least, fixing a system-wide problem, elevating standards or driving the industry to a collective response requires effective central regulation and the convening power of regulators.

Blankfein’s comments about regulation were not specifically addressed to executive compensation, but the references to “basic standards” in the first sentence and “elevating standards” in the last imply that he would not see compensation as off limits for regulation.

By James Kwak

I know this is simplistic, but I just couldn’t resist.

Some caveats:

• Stock total return is a poor way to measure CEO performance – yet it’s the one that CEOs and boards commonly point to to justify compensation.
• A CEO may have been granted a large stock award in 2008 as a reward for “good performance” in 2007. This could explain the combination of high compensation and poor 2008 performance. However, just think about what that means for a second.
• Most of the large compensation awards are largely restricted stock or stock options. These were valued as of the data of the grant, so if the company’s stock price later fell, the CEO is unlikely to realize the calculated value of the award. But imagine if the stock price had gone up instead: the CEO and the board would be insisting that the award should be valued as of the grant date, not the later exercise date (when it would be worth much more).

Also, I excluded a company called Mosaic, because it’s total return was 257%, so it packed all the other companies into one side of the chart. Mosaic’s CEO earned $6 million.

Update by request: With a log scale.

I had actually already done this chart, so it was an easy request. I’m not sure a log scale is inherently better given the spread of the compensation data; as you can see, now the outliers are on the low end, even when you code people like Steve Jobs (compensation = $1) as $0.1 million. But the story is still the same.

By James Kwak

The AIG bonus saga neatly encapsulates many of the problems that we have identified with the financial system and with the bailout to date.

• The bonus contracts – which have still not been released to the public – reflect the instinct of Wall Street to favor its employees over any other stakeholders. In the companies I worked at, it was common practice that all bonus plans were contingent on overall company performance: if the company had no money, you didn’t get any, either. Even our commission plans for sales people included the caveat that the plan could be changed by the CEO at any time for any reason. The fact that AIG did not similarly protect itself shows the Wall Street habit of putting itself first, or a failure to recognize the possibility of a bad year, or, most likely, both.
• The failure of the Treasury Department and the Federal Reserve to review and renegotiate the bonus plans as a condition of federal assistance last fall – despite the fact that the plans had been public knowledge since May – reflects the rushed, ad hoc nature of the deals that were struck. Or it reflects the understanding in Washington that the ways of Wall Street had to be respected. Or, again, both. And the failure to even say anything about the bonus plans since the initial bailout – even just to get ahead of the obvious public relations fiasco – reflects an overall strategy that amounts to hoping that problems will go away.
• The seeming inability of the government to do anything but throw up its hands reflects the failed strategy of the bailouts so far: provide as much cash as needed, but do everything you can to minimize the impact on the companies being bailed out. The fact that this is happening at AIG – the one the government has owned 80% of since September – shows that any “nationalization” so far has been a red herring. In a bankruptcy, or a government conservatorship, employees and other creditors would not have a legal right to all of their money. In the current situation, by contrast, AIG management can choose whom it wants to make whole, which is what makes self-dealing and other sweetheart deals possible. In this context, $165 million in employee bonuses pales against tens of billions of dollars of collateral provided to counterparties – beginning with Goldman Sachs. Yes, this was to cover open trading positions. But if AIG had gone bankrupt or had been taken over, it’s not clear that Goldman would have been first in line.
• The testaments to “the best and the brightest” – here, referring to the people of AIG Financial Products – reflect, I don’t know, either absolute, brazen obscenity, or a world-historical example of making the mistake of believing your own hype. The fact that people on Wall Street believe that they are the best among us is bad enough. The fact that people in Washington are willing to accept it is worse.

However, this scandal may yet serve a purpose. One characteristic of both administrations’ responses to the crisis has been to devise subsidies for the financial sector that are too complicated for even conscientious readers to make out, such as the asset guarantees for Citigroup and Bank of America, or the preferred-to-common conversion for Citigroup. Employee bonuses, by contrast, are strikingly easy to understand.

The key issues throughout this crisis have been political as much as economic. In this case, the Obama administration has been taking a difficult political position – propping up financial institutions in their current form and insisting everything will be OK – when it would have been easier to play the populist card. This was by no means an inescapable choice; according to news reports in February, David Axelrod and Rahm Emmanuel were in favor of being tougher on the banks. Perhaps the AIG bonus scandal will force the administration’s hand toward the decisive action that we need.

Why not say that all bank compensation above a baseline amount – say, $150,000 in annual salary – has to be paid in toxic assets off the bank’s balance sheet? Instead of getting a check for $10,000, the employee would get $10,000 in toxic assets, at their current book value. A federal regulator can decide which assets to pay compensation in; if they were all fairly valued, then it wouldn’t matter which ones the regulator chose. That would get the assets off the bank’s balance sheet, and into the hands of the people responsible for putting them there – at the value that they insist they are worth. Of course, the average employee does not get to set the balance sheet value of the assets, and may not have been involved in creating or buying those particular assets. But think about the incentives: talented people will flow to the companies that are valuing their assets the most realistically (since inflated valuations translate directly into lower compensation), which will give companies the incentive to be realistic in their valuations. (Banks could inflate their nominal compensation amounts to compensate for their overvalued assets, but then they would have to take larger losses on their income statements.)

We can dream, can’t we?

The usual defense of this sort of behavior is that you have to pay the market price for talent, the bonuses for top people are only a small fraction of the value they contribute (not a particularly good argument this year), and so on. And this is, not surprisingly, what John Thain was able to muster up in his defense on CNBC:

If you don’t pay your best people, you will destroy your franchise. Those best people can get jobs other places, they will leave. . . . you have to– pay market prices at the time.

Yes, there is a market for labor, and compensation is the price set by that market. And maybe it’s even a free market. But it’s certainly not a well-functioning market (one where price = marginal cost, for example, or where the surplus is divided between the parties, or where the right incentives are created).

Lucian Bebchuk and Jesse Fried have a basic overview of some of the problems with the market for executives (in which the price is executive compensation) in “Executive Compensation as an Agency Problem,” which deals primarily with CEO compensation. The basic problem is the old principal-agent problem: how do you get an agent to act on behalf of his principals, instead of looting them for his own gain? Bebchuk and Fried spend most of the paper criticizing an “optimal contracting” model, in which “boards [of directors] are assumed to design compensation schemes to provide managers with efficient incentives to maximize shareholder value,” arguing instead for their preferred “managerial power” model, in which managers use their power over the board to maximize their own compensation while simultaneously weakening its links to their performance and making it as hard to understand as possible, in order to minimize shareholder outrage. Having observed the way CEOs get selected and compensated, and having read Rakesh Khurana’s book on CEO searches, and most importantly having a pulse, I’m surprised there is even a debate about this, but the paper is from 2003, so maybe the debate is over by now.

According to Bebchuk and Fried, the basic dynamic at work is that directors like being on boards (it’s a lot of money for not much work, and it’s prestigious), CEOs control who is on the board of directors, CEOs control the information that goes to boards, and board members have weak incentives to act on behalf of the shareholders (they generally don’t own much stock). The only real checks on CEO pay are public outrage (hence the usage of hard-to-understand things like deferred compensation and pension benefits) and large and powerful shareholders. This leads to certain outcomes that are hard to justify on the theory that boards are negotiating in the interests of the shareholders, most strikingly the tendency to give large, gratuitous “goodbye payments” on top of already-generous negotiated severance packages. Note that John Thain’s demand for a bonus was only withdrawn after it was leaked to the Wall Street Journal (cue the public outrage).

Now, this paper primarily applies to compensation of CEOs (and their close friends, whom the CEO can take care of). But a similar problem applies to all Wall Street compensation. Just like CEO compensation depends on the myth that there is a small group of people with the ability to be CEOs, Wall Street compensation depends on the myth that there is a small group of people with the ability to work on Wall Street. (A myth that is pretty well belied by the fact that every year a flood of college and business-school graduates whose only common trait is that they all want to make money comes to Wall Street, and during the boom they all made lots of money.) That compensation is set by top executives and approved by the board, all of whom are bought into the myth of their own uniqueness; the shareholder, be he a teacher on Main Street or a mutual fund manager in Greenwich, doesn’t have a seat at that table. Put another way, compensation should theoretically be determined by the owner of the company – the person who gets the profits after salaries and bonuses are paid – but that person has been cut out of the negotiation by the weakness of our corpoorate governance practices.

Theoretically the market for labor could be what forces prices up; if one company paid below-market bonuses, the story goes, its top people would defect for competitors. But there are problems with this argument. First, all that means is that you have a market failure: when you have a small number of players, it’s easier and cozier for everyone to continue paying the same large bonuses (at the shareholders’ expense) than to pay the level a free market would ordinarily dictate. Second, what would be wrong with top people defecting? Wall Street’s most prestigious investment bank, Goldman Sachs, is also the one that was least willing to hire from the outside and most likely to promote from within – which is one way of saying that you think that people are overpriced on the open market. Third, if bonuses are a function of the threat of people leaving, why are bonuses this year (when there are no job opportunities) the same level as in 2004 (when they were plentiful)?

Weak shareholder control over executive compensation is, of course, common to all industries. The big difference is that while the CEO of Tyson Chicken (for example) doesn’t devote much energy to enriching the people who work on his chicken farms, the CEO of Merrill Lynch did devote energy to enriching the people on his trading desks. While most companies are run for the benefit of a few senior executives, Wall Street firms are unusual in that they are run for the benefit of a large class of professionals. It’s almost a form of sharing the wealth. Except this year there wasn’t much wealth, and what little there was arguably wasn’t theirs to share in the first place.

Update: Bebchuk has an article in the Wall Street Journal arguing that the executive cap limits announced this week aren’t strict enough.

Update: Lloyd Blankfein, CEO of Goldman, has an op-ed in the FT recommending restrictions that go beyond what the Treasury Department proposed, including long-term vesting schedules and addition limits on when shares can be sold. A friend of mine who used to work at Goldman tells me that Goldman already has some of these vesting and delivery restrictions in place.