Perverse Incentives Are Endemic (TM)
Posted by Marc Hodak on October 17, 2008 under Self-promotion | 
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Many people believe that corporate social responsibility is part of good governance. I guess that’s why Forbes asked me to write this article on the subject.
Posted by Marc Hodak on October 15, 2008 under Executive compensation | Be the First to Comment
As everyone knows, the U.S. Treasury has chosen to distribute it’s first $125 billion in bailout funds to the nine banks that didn’t need it–or necessarily want it. So, I’m reading all over that this forced investment comes with a $500,000 limit on CEO pay deductibility. Why is everyone saying this? Because Treasury itself said so in their announcement of the plan.
But when we look at the term sheet upon which this announcement is based, it claims the authority for requiring the compensation restrictions as Sec. 111 of the EESA. Thing is, Sec. 111, which applies when Treasury makes an investment in the firm, doesn’t include the $500,000 tax limit. That’s in Sec. 302, which kicks in only when institutions sell troubled assets to the treasury. So, what gives?
Maybe I’m looking at a wrong version of the quickly evolved EESA? Or maybe I haven’t yet learned to stop questioning Herr Paulson’s authority. He was, after all, able to wring $700 billion out of a reluctant Congress, then turn a voluntary program into a “voluntary” program.
Posted by Marc Hodak on October 13, 2008 under Executive compensation | Read the First Comment
My prior conclusion was that no major bank would wish to directly involve themselves in the TARP program because of the compensation restrictions that came with it. It didn’t even occur to me that the healthiest banks would accept direct investment because they were healthy. Well, they did accept it…in the sense that one accepts an offer one can’t refuse.
According to the bailout law, “acceptance” of this investment comes with the following constraints on pay:
– Prohibition of golden parachutes, while the government has its investment in the firm
– Elimination of incentives for “unnecessary and excessive” risk for executive officers
– Potential claw back of bonuses based on accounting results that turn out to be false
Of these items, the ‘golden parachute’ prohibition is apparently the most onerous. I say “apparently” for two reasons. First, these CEOs would have to agree to have their contracts renegotiated to eliminate their golden parachutes. It’s not clear how the government would compel this even when the investments were voluntary, but it’s even more mystifying given that they weren’t. Alas, I don’t think Jamie Dimon or Lloyd Blankfein will cause too much fuss over this. They know pretty well that JP Morgan Chase or Goldman Sachs are unlikely to risk their departures over a few extra million per year, and they can negotiate that accordingly. If they can’t get it on the back end via a golden parachute, they can get it in current or up-front pay, or somehow via the infinite devices that us compensation consultants can dream up while staying in technical compliance with the wording of this law. Folks, boards and shareholders are rarely the winners in a forced renegotiation with the CEOs they wish to keep. The ones they don’t wish to keep can leave of course…with their golden parachutes (before the investment has been made).
The second reason to use “apparently” is that the more troublesome constraint, I think, will be the elimination of ‘incentives for risk’. Incentives that create greater alignment between managers and shareholders are invariably incentives for risk. The government claims no voting rights with these preferred shares, but they will have to find some way to comply with the law. It will be interesting to see how they do it. Interesting, that is, for us non-shareholders in these semi-nationalized firms.
Posted by Marc Hodak on October 5, 2008 under Executive compensation | Read the First Comment
This is a more up-to-date and (hopefully) better packaged version of my prior write up of the bailout…er, rescue package’s executive compensation provisions. It’s a story of consequences, some intended, some not.
Sec. 111(b)(2)(A): The Treasury Secretary is charged with eliminating “incentives for executive officers of a financial institution to take unnecessary and excessive risks” for firms in which the government has taken an investment position.
Intent: To discourage firms from overly high risk-taking on the part of senior management.
Likely effect: To discourage appropriate risk taking on the part of managers.
Analysis: The relevant consideration in this scenario is not management incentives, but board incentives. Boards are remarkably, perhaps inherently, poor at distinguishing strategic or governance risk. No government-appointed director, even a Goldman refugee who might know better, will risk a major problem arising from a strategy with significant uncertainty. The most risk averse (or economically ignorant) director will drive the board’s appetite for risk. There will be no force to stop the pendulum in the middle. The board will be happy to pay its managers like bureaucrats for bureaucratic results.
Posted by Marc Hodak on October 2, 2008 under Executive compensation | 3 Comments to Read
I was up way late last night trying to figure out what all this will mean for executive compensation, so here goes.
There are two sections dealing with compensation governance in this giant bailout bill.
Sec. 111 says that when the government makes a direct purchase of assets, then it must impose certain conditions on the compensation of “senior executive officers” (i.e., the top five NEOs).
Posted by Marc Hodak on September 26, 2008 under Executive compensation | Be the First to Comment
Nicholas Kristof got some ink for his breathless report about Richard Fuld making $17,000 per hour in 2007. For ruining a firm! Isn’t that disgusting!? Oh noes! The greed! The folly! What kind of board would allow something like that!? They must be retarded!! Kristof playfully asks: Wouldn’t you be willing to run a firm into the ground for that kind of dough?
There’s just one little problem with that $17,000 figure. It was based largely on equity that was at risk. Just like most of the half billion that Fuld has earned, and that Kristof ridiculed the board for paying him, over his Lehman tenure. It’s safe to say that that equity value is now gone.
So, let’s see, we’re down about $500 million in 2008, but that was just in the first nine months, so per hour, using Kristof’s formula, that comes to…minus $272,000 per hour. Hmm. I think I’ll pass on that job, Nick.
I understand that when those nine months were over, Fuld in fact lost over 90 percent of his personal wealth. That doesn’t exactly leave him a pauper, and I’m not playing violins for his loss. But Nick, come on down from that pedestal and honestly answer me this, when was the last time you risked 90 percent of your personal wealth on the success of a firm that you ran? Or even for a small, uncomplicated project?
That’s what I thought.
But the real reason I don’t read the NY Times, and the reason I’m over a week late in reacting to Kristof’s column, is illustrated by that paper’s choice of “Editors Picks” from the comments section. Mr. Kristof’s article garnered over 200 sympathetic responses. According to the site, “NYTimes editors aim to highlight the most interesting and thoughtful comments that represent a range of views.” One of their six picks for this article was a “thoughtful” note that referred to CEOs as “fiscal terrorists” for whom it would be “perfect justice to see them hustled off to Guantanamo and their personal assets confiscated.” I guess Kristof knows his audience, as well as his editors.
Posted by Marc Hodak on September 24, 2008 under Executive compensation | Read the First Comment
OK, it’s an increasingly debatable point that the Paulson plan will actually save the economy. But given the market’s reaction, it seems that about a trillion dollars is at stake over coming up with a viable solution to our credit crisis, and various Congressman are willing to hold it up over…a few million of CEO pay.
That’s right, our inept Congress is trying to balance a duck against a building, and call it statesmanship. Actually, what they’re doing is playing chicken with the White House in a game of brinkmanship. Their specific proposals show how truly cynical these populists are:
– Congressman Barney Frank (D-MA), chairman of the House Financial Services Committee, wants the government to restrict the bailout to firms that deny their top people golden parachutes. He probably knows that most of those pay features are contractually obligated. That means he knows that the shareholders will end up losing almost as much fighting to keep those sums as they would otherwise pay out. And they would likely pay them out anyway. Because you see, dear Congressman, in this country the government still does not have the authority to abrogate contracts by fiat.
Frank also wants to institute a “clawback” rule to revoke bonuses paid for “bogus gains,” which will more likely create bogus litigation whose costs far exceed anything the shareholders could hope to recoup.
– Sen. Max Baucus (D-MT), chairman of the Finance Committee, is proposing tax penalties on the compensation of top executives who earn more than the U.S. president ($400,000). That’s right, for every dollar that the shareholders pay to attract a person capable of running their complex, multi-billion corporation above the wage of your average division head, those shareholders will also pay the federal government an additional 35%. Mr. Baucus may be fool enough to think that the executives will be paying that tax, but then again, he may not care, as long as he ends up with the taxes for his committee to fritter away on the next fiasco.
Rep. Jack Kingston (R-GA) says, “Clipping executive compensation is easy right now — everybody wants it.” And, of course, anything that people want, Congress believes it can do with a magic wand. Like fix the economy.
Many of these public servants are making these proposals under the misimpression that lazy, stupid, or corrupt boards are giving up shareholder money beyond reason or obligation. They believe that most of these CEOs are being treated differently from their rank and file. No, Mr. Frank, we don’t take back lawfully earned income from people when they exit a firm. No, Mr. Baucus, the shareholders don’t appreciate a hidden tax increase as a result of misguided attempts to have them pay their senior officers like civil servants.
Posted by Marc Hodak on September 21, 2008 under Scandal | 2 Comments to Read
I have to admit I’m desperately searching for a good explanation about what went wrong this past month. The problem is complex, and the root(s) of it are, I’m guessing, rather subtler than most people think. But there is one explanation–the most common one out there–that I’m certain is useless: greed.
Blaming the financial crisis on greed is like blaming a raging fire on oxygen. Greed is a pervasive aspect of humanity, visible on both sides of every trade, at every level of society, except perhaps for the guy sleeping in a box near a steaming grate, although I bet he would hungrily grab a better box or squat a warmer grate if he could find it.
I also don’t buy the idea of mass stupidity, complacency, or irrationality. The more likely explanation is perfectly sensible, rational behavior of thousands or millions of people under perverse incentives. The most fruitful line of inquiry is likely to be: What were the incentives? How did they arise? Who did they affect? Why did they manifest the way they did now?
Or, we can shortcut rational inquiry and go for the cheap morality tale and the inevitable witch hunt that follows.
Posted by Marc Hodak on September 20, 2008 under Invisible trade-offs | Comments are off for this article
Everyone heard yesterday morning about the Federal government basically agreeing to bail out the (remaining) financial firms. Everyone got a glimpse of the breathtaking cost of this bailout to the taxpayers. We also heard concern about “moral hazard” as a secondary effect, though that concept is hard for the average person to really get, especially the idea that this secondary effect may be even more economically costly than the nominal cost of the bailout.
What slipped by with nary a peep was the news later that day that GM drew down the remaining $3.5 billion of its credit facility.
To me, this looks a lot like your second kid, seeing the promise that you made to pay off the debt of your first kid, suddenly decide to tap out his own credit.
The Bush administration knew that one of the dangers of bailing out the financial sector is that other sectors were sure to pile on. Detroit was a logical choice. Especially in an election year where Michigan is a swing state. Can Ford be far behind? And Michigan is not the only swing state this close election…
Posted by Marc Hodak on September 18, 2008 under History | Comments are off for this article
On Thursday, September 18, 1873, the Panic of 1873 reached crisis proportions at 11:00am on Wall Street, when H.C. Fahnstock, the New York partner of Jay Cooke (one of the leading gold market participants), announced that Cooke’s office was closed. Cooke, in his Philadelphia office, admitted it was true, and the most prominent banker in the country was suddenly bankrupt.
Robert Sobel, writing like Stephen King in Panic on Wall Street, said the “coal-black steed named Panic” quickly “thundered riderless down Wall Street,” where “a monstrous yell went up and seemed to literally shake the building in which all these mad brokers were for the moment confined.” Along with Jay Cooke, 37 other banks and two brokerage houses closed their doors on this date alone. In the ensuing days, the losses increased and the NYSE was forced to close down for over a week. With the situation growing dire, the secretary of the Treasury decided to infuse the economy with $26 million in paper money and the market eventually re-opened.
Jay Cooke failed over trying to construct a second Transcontinental Railroad, but demand could not support a second line. He was merely a symbol of gross over-speculation in land and securities, followed by the issuance of too much paper money, resulting in higher inflation. (Sound familiar?) The Panic of 1873 started with a bang, as over 5000 businesses failed in the last quarter of 1873, but the Panic lingered long, as another 5,000 failed over the next five years.
Panics hit America every 17 years, on average, for about a century, from 1819 to 1920 (in 1819, 1837, 1857, 1873, 1894, 1907 and 1920). The word “panic” aroused such a negative reaction (in 1894 and 1907) that Herbert Hoover invented a less threatening word for the 1929 event–connoting a small pothole in the road. Hoover called the 1929 panic “merely a depression.”
via: Crossing Wall Street
