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Bloated CEO compensation wasn’t the cause of the economic collapse according to a study cited by Floyd Norris in the NYT. Maybe not, but giant bonuses for incompetent management and dangerous traders make people really angry, especially when it comes out of our wallets.
The paper, which is surprisingly clear, was written by two European professors at Ohio State, René M. Stulz, and Rüdiger Fahlenbrach (abstract here, download available ), to test the hypothesis that the compensation to CEOs was not aligned with the interests of shareholders, and encouraged excessive risk-taking. It concludes that the compensation packages at banks were heavy on stock and option grants, and that the CEOs held a substantial amount of the outstanding stock of their institutions. As a result, their interests were aligned with shareholders.
Norris draws this conclusion:
… there is plenty of evidence that no one who counted — traders, chief executives or regulators — understood the risks that were being taken.
The professors identify this problem (p.1):
A plausible explanation for these findings is that CEOs focused on the interests of their shareholders in the build-up to the crisis and took actions that they believed the market would welcome.
Citizen rage was not related to alignment with shareholder interests. It is caused by the horrifying results, and the blindingly obvious incompetence that caused the debacle. CEOs and traders didn’t comprehend the risks they were running. Traders tried to game the system. CEOs were ignorant and incompetent in letting them do it without understanding what they were doing. Worse, CEOs were managing their institutions to please the market. That market consists of their peers in the stock-trading business, in other words, people just as ignorant and arrogant as they were.
People understand compensation for good results. What they can’t understand and won’t forgive is pouring money into the pockets of failures like the Wall Streeters. They got rich at our expense, what with the likes of Enron and the phony California power crisis, WorldCom with Citigroup’s Smith Barney cheerleading all the way into bankruptcy, asset bubbles in housing, fake trading in stocks and commodities and all the rest. When it became clear that it was all a mirage, the anger exploded, and while the occasional bright shiny object distracted the media, the hostility seethed below, enough to influence a Congress normally in the pockets of Wall Street. The recent report by Andrew Cuomo, Attorney General of New York, was enough to push something through Congress.
The House passed a law Friday that according to the NYT
…gives the Securities and Exchange Commission, among other federal regulators, nine months to propose rules for regulating compensation packages at institutions whose assets total more than $1 billion.
When TARP passed, a lot of angry people complained about the failure to control compensation at these large banks, because it only dealt with a few top executives. This bill has the potential to defuse the entire situation by limiting all compensation to all of the market participants, including the greedheads at Goldman Sachs, whose bonus pools dwarf the payouts to shareholders whose money is at risk of their trades.
Norris is right to point out that regulations won’t do the job, and that the Professor’s solutions aren’t likely to work either:
I asked Professor Stulz what he thought of the bill. “It is hard to believe that regulators will be better at devising compensation plans with proper incentives,” he said. “Properly designed capital requirements are a much more efficient approach to regulate the risk of financial institutions than fiddling with compensation.”
Indeed, much of the financial “innovation” of recent years consisted of bankers coming up with ways to evade capital requirements. The regulators are now trying to deal with that, but their efforts are handicapped by bankers warning that they will maker fewer loans if capital rules are tightened.
Blackmail, much? There is a great way to control these perverse practices. Taxes. Tax the company and tax the income of the trader. Taxes will discourage pointless paper transactions and high frequency trading. It won’t be perfect, but at least it will cut the deficit, and help with the enormous problem inflicted on this country by the financial elites.
Congress could characterize it as reparations in the class war.
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It sounds like the study Norris cited asked the wrong questions.
Thanks for explaining this masaccio. I’d seen the article by Norris and skimmed it but you’ve laid out the points that I thought about but couldn’t quite articulate.
Lets see if I have this straight. The two professors are saying that the CEO’s are blithering idiots. Is that correct? So much for them being the best and brightest.
Oh and by all means, let’s do some taxing. We seem to have had quite robust economies in the fifties and sixties when the marginal tax rates were much higher than they are right now.
And let’s close a few hundred corporate tax breaks as well.
Didn’t understand the risks, or just didn’t care as long as the profits kept rolling in? Or didn’t care to understand?
Thanks, Masaccio
FunnyWheelieDiva
People get promoted until they reach a position where they are incompetent, there they stay. Forever.
The Professors apparently thought that this was a further showing that the incentives of CEOs were aligned with shareholders. The meta-management, managing as if “market perception” was the target, was a disaster. The only legitimate form of management is accurate assessment of reality.
The same thing is true of politics. Obama manages as if the important thing is perception, not politics. If he had insisted on a real stimulus package, on real health care reform, on real global warming change, he would have made a real difference.
Ah. The Peter Principle.
Except a lot of what we’re dealing with is from the “Dilbert Principle”
CEO salaries aren’t the issue.. they’re a symptom of a system that rewarded ever increased foreshortening of investment horizons, and shorter expectations for reward. For nearly two decades, the focus of financial innovation in the buyout and M&A game was dedicated to enabling horizon compression – letting people cash out more quickly, enabling owners to get rich and CEOs to collect massive bonuses all the sooner. Ditto in the public equity game – the other side of derivatives to facilitate ever greater liquidity. 7 to 10 yr horizons and 5x cashflow exit multiples became 2 years and 12x soon became 15x and 12 months. Instant wealth and short game gains over long term capital creation. Then boom.
That’s true, unless that person is George W. Bush. He was incompetent at each and every position he held, but was promoted because the family would take kindly to the promoter.
Book Salon upstairs with Seth Jones’ In The Graveyard of Empires: America’s War In Afghanistan hosted by Joshua Foust
One major part of the problem is the cult of the CEO. How many worshipful articles in Forbes, Fortune, Business Week, have you seen? Every week we get lectures from CEOs in the New York Times. Here is today’s paean to the head of Cisco Systems, complete with lessons for the up and comers earned at the feet of Jack Welch, the quintessential deity of the worshipers, whose divorce revealed his disgusting greed, or maybe it’s his arrogant sense of entitlement. Here’s a taste:
Thanks, Masaccio.
Last summer while financial corporate bailouts were the rage, I proposed a retroactive 25% surtax on all Wall Street annual incomes over $250,000 going back ten years when the parasites were slowly killing the host.
Less than a year later, just the opposite has happened with trillions of increased taxpayer debt shoveled into the derivative hell hole to keep up the appearance that the broken system is still afloat.
Stocks moving higher in the past three months only shows that the masters of the universe have confirmed that they’ll never pay for the damage they’ve done to the economy.
Welch is too poor to pay for all that himself?
I don’t think corporations should pick up living expenses unless it’s in lieu of salary or wages. I don’t care how important the @#$@^&^s are: if they’re being paid more than a million a year, they can pay their own living expenses.
He’s not too poor. It’s all part of CEO worship. Kind of like tithes.
Except the people doing the ‘tithing’ don’t even get to feel good about it.
The problem with claiming that executive compensation packages aligned with their shareholder obligations, because the compensation was structured around stock-value, completely ignores the intertemporal choice conflict between an executive boosting their short-term personal enrichment at the possible expense of the long term positions of other investors; especially institutional investors.
I don’t know. The amount of stock the average CEO has is pretty large, even compared to the amount of options, where that intermporal issue is large. The losses on that stock are really high. I think the paper does a good job of showing that the long-term interests of the CEOs line up pretty well with the longer term shareholders.
There is an academic debate about this issue of alignment, as you point out, but the problem doesn’t seem serious in big banks. The paper doesn’t deal with the issues I raise, and, of course, my issues are the real reasons for compensation regulations, even if politically they have to stay sub rosa.
I think one great tool to attack this issue would be a return of the Securities Turnover Excise Tax (STET), a small tax (say, 0.25 of one percent) on every purchase of a stock or derivative or whatever. We had such a tax until 1966, many countries still have them. It would generate hundreds of billions of dollars a year. John Maynard Keynes argued for such a tax as “mitigating the predominance of speculation over enterprise.” To deal with high value program trading, you might want to make it a percentage tax plus ten cents, anything to put a cost on trading as pure short term gambling instead of long term investment. I don’t know how to start a populist groundswell for such an obscure policy, but it’s a policy worth pursuing.
Good idea, thruppence. Maybe also reinstituting taxation on short term capital gains as ordinary income as well.