Perverse Incentives Are Endemic (TM)
Posted by Marc Hodak on June 24, 2009 under Executive compensation, Unintended consequences | 
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Today’s comp headline: Citigroup to boost salaries, cut bonuses. Did anyone see that coming?
Alas, Citi does need to keep up with UBS and other bonus-restricted banks.
Posted by Marc Hodak on June 15, 2009 under Executive compensation, Invisible trade-offs, Politics, Unintended consequences | Read the First Comment
The government, purveyor and practitioner of the most perverse incentives on the planet, is coming down the road with a cart of new remedies for incentive compensation:
“This financial crisis had many significant causes, but executive compensation practices were a contributing factor,” Geithner said in his statement on Wednesday. “Incentives for short-term gains overwhelmed the checks and balances meant to mitigate against the risk of excess leverage.”
It is, indeed difficult to pinpoint all the potential causes of the financial crisis, and it’s certainly plausible to point the finger at bank compensation. The politicians and media would have us believe that:
A consensus has grown in Washington that compensation incentives based on short-term profit encouraged excessive risk taking at banks and played a major role in creating the financial crisis.
But the manner and degree to which bank compensation is at fault is, in fact, quite speculative. Read more of this article »
Posted by Marc Hodak on June 14, 2009 under Executive compensation, Reporting on pay | Read the First Comment
Apparently, the answer is: just because the Corporate Library said so.
In a recent report called “What is the Impact of PE on Corporate Governance,” the corporate library concluded that their analysis:
…does not support the private equity claim to superior corporate governance as the companies enter the public markets. On the contrary, it indicates that buyout-fund-backed companies exhibit, in higher proportion than average, a number of features that have the potential to benefit executives at the expense of shareholders, including takeover defenses and boards whose independence may be compromised. In addition, the often-made assertion that private equity firms design compensation packages well suited to link pay to performance is not supported by this study. The companies lacked the key compensation structures that are widely believed to link pay to performance.
As someone who designs compensation packages for PE firms, and has often asserted that the designs were especially well suited to link pay for performance, I was interested in the basis for their conclusions. What key compensation structures were PE-backed firms lacking? Who are all those people who believed in them?
The report ended up offering a hopelessly muddled approach to compensation unsupported by any empirical analysis.
Posted by Marc Hodak on June 9, 2009 under Executive compensation, Invisible trade-offs, Reporting on pay | Be the First to Comment
So, you’ve played the populist card on executive compensation, Mr. President. You used it to provide cover for the mammoth, Democratic-payback-mondo-porkfest called the “Stimulus Package.” You used $500K to buy $787B. Well played, sir. But now that card is on the table. You can’t just pick it up again.
So, now we all have a bunch of silly-assed compensation rules that anyone could have predicted would create retention risk at American public banks. Sure, most people were saying, “Screw ’em. Where else could they go?” but we knew otherwise, didn’t we BO? We knew that any bank under TARP would chafe at the pay restrictions, in part because it put them at a competitive disadvantage. We knew that once you set some of the banks free, they would poach the others into submission, those big wounded banks still trapped under TARP, with all that taxpayer investment. Poof.
So here we are, on the eve of a TARP repayment by some banks that you have done everything to slow. But that part of the game is finally up. Now, what do you do?
Of course. You try to maintain some uniformity on the pay restrictions across all the banks, in and out of TARP. So, you’re forced to loosen up some of the restrictions on the remaining TARP banks while imposing new ones on the soon-to-be non-TARP banks. I know where you’re coming from, Mr. President.
Don’t worry, your secret appears safe, for now. The media has not a clue about your strategy or its motivation. Most of them are still at the “where else can they go?” stage. And the regular readers of this blog are plenty smart enough, but there’s only a few dozen of them–not enough to really alert the media. So, don’t worry. Do what you have to do. It’s all you can do, isn’t it Mr. President, as political choices lead to economic consequences that prompt more political choices…
Posted by Marc Hodak on June 7, 2009 under Executive compensation, Stupid laws | Be the First to Comment
Model of current TARP compensation rules
According to our private sources:
The Obama administration plans to appoint a “Special Master for Compensation” to ensure that companies receiving federal bailout funds are abiding by executive-pay guidelines, according to people familiar with the matter.
They appear to be set to name Kenneth Feinberg, a lawyer, whose main qualification appears to be that he had the word “compensation” in his previous title. His job will be to sort out the contradictory, illogical morass that Congress has created for TARP recipients. Good luck Ken.
Posted by Marc Hodak on June 4, 2009 under Executive compensation, Politics | Be the First to Comment
There has been a lot of talk about Say on Pay, i.e., putting executive compensation packages up for shareholder vote. The U.S. government about to force every public company to submit to this policy. This is considered a corporate governance matter, i.e., something for the putative benefit of the shareholders. Unfortunately, debates over corporate governance policies rarely offer analysis of how the shareholders are actually likely to fare under a given policy.
Jie Cai and Ralph Walking of Drexel University recently published such an analysis for Say on Pay. The results will startle, well, no one.
Basically, they found that firms “with high abnormal CEO compensation and low pay for performance” benefit under a Say on Pay regime. If the CEO does not fall into the overpaid camp, Imposing Say on Pay will destroy value for the firm.
So, what is the net effect on shareholders if we impose Say on Pay on every public company, where the vast majority of them do not have overpaid CEOs? That’s right–shareholders as a class will suffer. But, hey, it’s a small price for the shareholders to pay so that our politicians can demogogue the issue for a few extra votes. And in the new definition that whatever is good for our politicians is “patriotic,” shareholders of well-governed firms should feel pretty darn proud.
Posted by Marc Hodak on June 3, 2009 under Executive compensation | Read the First Comment
Recent research finds a significant correlation between something called prepaid variable forward contracts and negative relative returns to shareholders.
In layman’s terms, the executives are selling their firms short (after a fashion), and their stockholders are suffering afterward.
Now, executives can’t actually sell their firm’s shares short. That has been illegal since the Erie Railroad scandal in the late 1800s. But executives are allowed to sell their company’s shares that they own, and they are allowed to sell those shares in forward contracts, i.e., an agreement to sell them in the future. Why would an executive do this?
Supporters of the contracts say they help executives with concentrated exposure to company stock diversify while retaining voting rights for the shares until the contract ends.
The problem is that shareholders don’t want their managers to diversify. They like having the pilot in the front of the plane without a parachute. Read more of this article »
Posted by Marc Hodak on May 28, 2009 under Executive compensation | 3 Comments to Read
Finally, a sensible editorial on banking compensation. Alan Blinder waves away the misdirection associated with “how much” bankers have been paid to identify the critical element of “how” they’ve been paid. The answer, as my loyal readers know, is the infamous trader’s option and the trader’s supervisor’s option.
Darwinian selection ensures us that these folks are generally smart young people with more than the usual appetite for both money and risk-taking. Unfortunately, their compensation schemes exacerbate these natural tendencies by offering them the following sort of go-for-broke incentives when they place financial bets: Heads, you become richer than Croesus; tails, you get no bonus, receive instead about four times the national average salary, and may (or may not) have to look for a new job. These bright young people are no dummies. Faced with such skewed incentives, they place lots of big bets. If tails come up, OPM will absorb almost all of the losses anyway.
Blinder suggests what I would consider timid, but sensible reform directed at exactly the right place–the board of directors.
The thing we have working against us is incredible, but understandable conservatism on the part of shell-shocked boards that truly can’t distinguish bold, good mechanisms from bold, schlock mechanisms. I know where they’re coming from. I feel the same way about macroeconomists as I try to get a handle on what’s going on. The thing we have working in our favor is that, the top executives at even public companies actually have a lot of skin in the game, and it’s not just upside. Dick Fuld and Jimmy Cayne didn’t actually want to end up the way they did. If they had any idea of the risks they were actually enabling, they would have looked for a better way. Their surviving competitors are not dummies.
Extra credit for the compensation mavens reading this if they can identify the irony in the title, which was actually coined nearly 20 years ago.
Posted by Marc Hodak on May 27, 2009 under Executive compensation, Reporting on pay | Read the First Comment
The new head of UBS is apparently faced with the same problems that were faced by the old head of UBS. One of the biggies is: how do you remain competitive (and solvent) as a bank without being competitive as an employer? Answer: you can’t. Another problem, then: how do you remain competitive as an employer without upsetting the public?
As in the U.S., the Swiss bank gave up its right to pay high bonuses when it got into trouble and accepted a bailout from their government, which basically capped the bonuses. The Swiss people, kindly and educated as they are, still suffer from the mob’s envy of the highly paid. UBS had a choice between being competitive or making the public happy, and they chose survival.
The “exceptional” salary increases “were necessary to safeguard our profitable business areas and to secure their success,” Gruebel said. “Following significant cuts in variable compensation, we had fallen well behind the market in certain areas, and that is unsustainable in the long run.”
Hmm. Companies being compelled to dramatically raise salaries when they were constrained from paying bonuses…who could have predicted that?
By the way, have you noticed that whenever Bloomberg (the same can be said for the WSJ) have multiple stories about a subject, they always start with the part about executive compensation?
Title reference here.
Posted by Marc Hodak on May 25, 2009 under Executive compensation, Unintended consequences | Be the First to Comment
Damn those finance geeks. The government imposed restrictions on their bonuses, and they turned around and increased their salaries. Who could have predicted that?
It’s as if Wall Street has this mysterious knowledge about the ability of value to be transformed into different kinds of financial claims, and that these claims that can be traded across time…and stuff. Where does this mysterious knowledge come from?
