Wall Street critics often say that compensation should be in long-term restricted stock so that managers and employees do not have the incentive to take excessive risk, make big money in good years, deposit the cash in their bank account, and then escape to their private islands when their bets blow up the next year. Wall Street defenders like to point to Dick Fuld, who supposedly lost $1 billion by holding on to Lehman Brothers stock that eventually became worthless. You don’t get more of a long-term incentive than that, the argument goes.
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.)
Everybody knows by now that Bank of America is buying back the $45 billion of preferred stock that the government currently owns. While the reason why they are doing this is obvious, I’m going to pretend it isn’t for a few paragraphs.
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.
Benjamin Friedman, in the Financial Times (hat tip Yves Smith), questions the high cost (read: compensation) of our financial sector. But he does not simply say that huge bonuses for bankers are unfair. Instead, he says that the costs of financial services need to be balanced against their benefits.
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
I was surprised at the number of commenters on yesterday’s post who thought that executive compensation is a red herring or a political talking point or “populist pablum.” I agree that some of the outrage over compensation by TARP recipients is a bit overblown. But I also think that the incentives created by current compensation structures were a serious contributor to the financial crisis – which was, after all, largely about banks taking one-sided risks because of asymmetric payouts (lots of upside, limited downside) – and that fixing those incentives is an important task for regulatory reform.
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.
They certainly want you to think they do. Yesterday was Executive Compensation Day in Washington. The Treasury Department appointed Kenneth Feinberg to oversee executive pay at seven companies that have received extensive government aid – AIG, Citigroup, Bank of America, and the car companies and their finance companies. The administration, which always seemed uneasy with the popular outrage over bonuses earlier this year, seems willing to throw the seven sinners to the wolves, while letting the bulk of the financial sector off the hook. Feinberg will only provide advice to other TARP beneficiaries, and banks that pay back TARP money will not even have to deal with that.
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.
In my opinion, one of the biggest contributors to the crisis we know so well was compensation schemes that gave individuals at financial institutions – from junior traders all the way up to CEOs – the incentive to take massive bets. Put people in a situation where the individually rational thing to do is take lots of risk, and they will take lots of risk – especially if they are generally ambitious, money-loving, and predisposed to think that if the market is giving it to them, they must deserve it.
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.
Data from Equilar (methodology), published by The New York Times:
I know this is simplistic, but I just couldn’t resist.
- 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.