Perverse Incentives Are Endemic (TM)
Posted by Marc Hodak on April 6, 2009 under Executive compensation, Self-promotion | 
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A very slick, new on-line journal has just come out tackling what is probably the biggest regulatory problem of our time: financial regulation. This journal has great stuff from David Evans and Arnold Kling. And the top compensation expert anywhere.
Posted by Marc Hodak on March 16, 2009 under Executive compensation, Scandal | 2 Comments to Read
You have to hand it to AIG. I teach a History of Scandal class to warn my dear MBA charges how to learn from past mistakes, avoid trouble, sidestep the pitfalls. It’s as if AIG senior executives took my class, then reversed all of the lessons in order to more efficiently get embroiled. Today, they find themselves on the front pages for not one, but two separate scandals. One of them has to do with bonuses:
President Barack Obama voiced outrage on Monday over large bonus payments awarded to top employees of insurer AIG and ordered his treasury secretary to legally block them if possible.
I understand the outrage, really, even though I cleanly lost the race of first to be angry, partly because my understanding of “bonus” doesn’t include guaranteed, fixed compensation, which appears to be the subject of this report.
So, when the President of the United States says he doesn’t want you to get your money, what does that mean? The article was careful to include “legally block them if possible,” which suggests that Big O, who taught constitutional law, is a bit more mindful of the subtleties of this situation than, say, the average Kos commenter. But no one wants the president gunning for them. The government simply has bigger guns and a hair trigger.
Now, people will note that if the government gives you money, they have a right to call the shots. Sure, but they still don’t have the right to break a contract. Especially when they don’t have to (see UPDATE) in order to obtain a fair solution.
Alas, one of the things I let my students know is that once your private situation blows up into a public scandal, the mob will have their own idea of fairness.
Posted by Marc Hodak on March 14, 2009 under Executive compensation, Scandal | 5 Comments to Read
That’s right. The tax dollar whirlpool known as AIG will pay employees of its Financial Products group over $400 million in “retention” bonuses, a group of people that arguably no one else would hire.
The outrage about “Epic fail = Huge bonuses” is understandable. But this isn’t really about bonuses. It’s about guaranteed payments that the media insists on calling “bonuses” when, in fact, they are deferred obligations from contracts that may predate the crisis and current management. Unfortunately for a certain lonely Treasury official, it may not predate his involvement. He is desperately waving the media spotlight off to any another direction.
Posted by Marc Hodak on March 9, 2009 under Executive compensation, Invisible trade-offs | Read the First Comment
When I saw the headline, “Activists Push for Lid on ‘Golden Coffin’ Death Benefits,’ I immediately thought, oh God, what manner of micromanagement are the activists trying to impose on hapless boards now?
Golden coffin is the perjorative term, loved by unions and the media, for a form of tax-efficient deferred compensation. They are somewhat complicated structures, but they have two two salient properties: (1) they can sometimes be low-cost ways of providing senior executives with certain estate-planning or tax benefits that they greatly value, and (2) they provide a stream of payments, instead of a lump-sum, to the beneficiaries–what one might call a form of guaranteed pay.
Boards and the executives they hire clearly like the first property. They probably would be just as happy to provide this perk in the form of a straight salary, but the tax code makes that the most expensive way of delivering marginal compensation to the top five executives. Boards and managers, looking for a more tax efficient way, came up with this deferred compensation method.
Critics are fixated on the second property. Read more of this article »
Posted by Marc Hodak on March 8, 2009 under Executive compensation, Unintended consequences | Read the First Comment
So, is it an “irregularity” or a “misunderstanding?” Those were the terms offered by the BofA and a currency trader, respectively, to describe that trader’s suspected $400M trading loss that had been previously reported as a $120M gain when this operation was still part of an independent Merrill.
Recall that shortly before BofA closed their acquisition of Merrill at the end of ’08, Merrill had paid significant bonuses to certain of its senior executives. One of its $10M men was David Gu, who headed up Merrill’s rates and currency operations. If this report turns out to be more than a misunderstanding, or even an irregularity, this $520M turnaround in the paper fortunes of Mr. Gu’s operations will significantly cut into the profits for which Mr. Gu was rewarded.
Such a turn would bring up the question of clawbacks. How much of a bonus would Mr. Gu have gotten if this unit’s profits were lower by $520M? Will Mr. Gu be on the hook for any of that difference?
A more fundamental question is what Mr. Gu’s complicity might have been in the bogus profit number. I doubt that Gu would have actively participated in fraud on his employer, or even tolerated fraud if he knew about it. But the numbers coming up from his unit are ultimately his responsibility, as are the systems and accounting controls that guarantee the integrity of his reporting. Is it possible that Mr. Gu had less reason to scrutinize the excellent numbers coming from his London currency trading desk than from, say, some poorly performing desks in other areas?
Posted by Marc Hodak on March 4, 2009 under Executive compensation, Scandal | Be the First to Comment
The big report today on the cover of the W$J and Reuter’s feed was that Merrill’s top ten paid executives earned $209 million for 2008.
The story (Version 1 – Wall Street Journal): 2008 was a horrible year for nearly everyone; big banks like Merrill were responsible; they would have failed, but they got bailed out by us (taxpayers); their top executives, far from suffering like the rest of us, made millions, or tens of millions (from us!). But the NY AG is investigating the bonuses, so they may be made to pay for their greed. The moral of the story? Greed is alive and well on Wall Street, and we’re getting taken advantage of, except that our valiant public servants may set things straight.
The un-story (Version 2, teased from the same set of facts): Read more of this article »
Posted by Marc Hodak on March 2, 2009 under Executive compensation, Invisible trade-offs, Unintended consequences | 2 Comments to Read
Nassim Nicholas Taleb has written a good description of what is now widely understood to be one of the key perverse incentives that fueled the recent credit bubble–i.e., the trader’s option:
Take two bankers. The first is conservative. He produces one annual dollar of sound returns, with no risk of blow-up. The second looks no less conservative, but makes $2 by making complicated transactions that make a steady income, but are bound to blow up on occasion, losing everything made and more. So while the first banker might end up out of business, under competitive strains, the second is going to do a lot better for himself. Why? Because banking is not about true risks but perceived volatility of returns: you earn a stream of steady bonuses for seven or eight years, then when the losses take place, you are not asked to disburse anything.
Like like many others cognizant of the moral hazards of the trader’s option, Taleb throws up his hands and recommends hiving off the risky portions of banking from the “utility” parts of banking, and heavily regulating the compensation of the latter. So easily said, isn’t it?
Posted by Marc Hodak on February 19, 2009 under Executive compensation, Self-promotion | Read the First Comment
That was my proposed title for this article just published in Forbes, but the editors there, well they have their own mind about things.
Anyway, their Bonus issue is up, and the line-up is great. It includes a colleague, client, collaborator, and competitor (quoted in one of the pieces). Enjoy!
Update: Anyone who says that print media offers the ability to offer more nuanced analysis and discussion of issues hasn’t worked in incentive compensation! My article basically says two things: you have to compete, and incentives matter. Most of the comments basically assume the opposite, which is par for the course on this emotional issue.
Posted by Marc Hodak on under Executive compensation | Be the First to Comment
Whenever a CEO declines a significant chunk of change, as GE CEO Immelt did this past year with regards to his $11.7 million bonus, the reaction is predictable: some react positively, feeling that Immelt is in touch with us regular folks, that feels our pain; others are decidedly more cynical about Immelt’s motives, or about the capitalist system that made such an ‘obscene’ payment possible. The more sophisticated board observer would recognize that Immelt and the board finely executed their respective prerogatives, with the board proposing and the CEO disposing in one of the few areas of goverance where that is the way it’s supposed to be.
My perspective is a little different. I’m left wondering, why did the bonus plan fail so badly?
It failed for two common reasons that bonus plans fail: it was based on the wrong metrics, and the pay-for-performance leverage across those metrics was miscalibrated. Immelt’s $11.7 million came from GE’s long-term incentive plan. This plan was based on performance against four metrics: earnings per share growth; revenue growth; cumulative return on capital; and cumulative cash flow from operating activities.
Taken together, these four metrics are a pretty good basket of indicators. But GE’s plan, as is common, does not take these metrics together–it calculates distinct pay-for-performance schedules for each of them individually, and individually half of these metrics would not be expected to closely relate to shareholder value.
For example, revenues can be bought with extra costs. If a company did this, you would expect to see it in a decline in earnings. In fact, GE just met its maximum revenue growth target, but fell well below it’s minimum earnings target. What do shareholders care about more? If one item on the menu is delicious, but the other is poison, is it an OK meal on average? For bonus plans, the answer is often “yes,” as it was in GE’s case.
So, GE’s long-term plan, suffering from some rather common afflictions, mistakenly created large awards for their managers. Immelt was a mensch for forsaking his portion of the award. The real question is, will he and his board realize what a crappy plan it was that created such an award, and will they bother trying to design something better next time?
Posted by Marc Hodak on February 18, 2009 under Executive compensation, Politics, Unintended consequences | 4 Comments to Read
This is my public service announcement.
Many firms and a few compensation consultants are still trying to figure out what the stimulus plan restriction on executive compensation really mean, and what they should be considering as a result of these rules. Here are the answers.
