Everybody Does It

Published: May 29, 2009

By Jim Lichtman
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A recent conversation about the bonuses paid to some employees at AIG like Jack DeSantis, led to this question:  ‘Don’t you believe in honoring contracts?”

In fact, I do believe in honoring commitments and obligations.  However, when a multi-billion dollar company like AIG runs into multi-billion dollar debt, asks for and then receives $182.5 billion in financial support from the federal government, I not only don’t believe you should hand out promised bonuses of the size and scope of AIG’s, but I also believe that it is unethical to accept such a bonus given the current economic circumstances and source of the money.

The auto industry is going through their own economic meltdown, not to mention receiving billions in their own asked-for bailouts from the government.  What were they to do with the billions of contractual agreements with the United Auto Workers Union?  When the Union saw the fire heading their way they recalibrated in light-speed.

My point: If it’s good enough for thousands of auto workers, why shouldn’t it be good enough for AIG?

But the problem on Wall Street runs much deeper than the bonus structure.

In an op-ed from yesterday’s (May 28) Wall Street Journal (Crazy Compensation and the Crisis), Alan S. Blinder writes with incredible clarity about an overlooked aspect to this mess.

“Despite the vast outpouring of commentary and outrage over the financial crisis, one of its most fundamental causes has received surprisingly little attention. I refer to the perverse incentives built into the compensation plans of many financial firms, incentives that encourage excessive risk-taking with OPM – Other People’s Money.

“What, you say, hasn’t huge attention been paid to executive compensation — especially those infamous AIG bonuses? Yes. But the ruckus has been over the generous levels of compensation, or the fact that bonuses were paid at all, not over the dysfunctional incentives that inhere in the way many compensation plans are structured.

“Take a typical trader at a bank, investment bank, hedge fund or whatever. 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.

“Whoever dreamed up this crazy compensation system?

“That’s a good question, and the answer leads straight to the doors of the top executives of the companies. So let’s consider the incentives facing the CEO and other top executives of a large bank or investment bank (but, as I’ll explain, not a hedge fund). For them, it’s often: Heads, you become richer than Croesus ever imagined; tails, you receive a golden parachute that still leaves you richer than Croesus. So they want to flip those big coins, too.

“From the point of view of the companies’ shareholders — the people who provide the OPM — this is madness. To them, the gamble looks like: Heads, we get a share of the winnings; tails, we absorb almost all of the losses. The conclusion is clear: Traders and managers both want to flip more coins — and at higher stakes — than shareholders would if they had any control, which they don’t.

“The source of the problem is really quite simple: Give smart people go-for-broke incentives and they will go for broke. Duh.”

“…For now,” Blinder says, “excessive risk-taking is being held in check by rampant fear. But when fear once again gives way to greed, most traders and CEOs will have the bad old incentives they had before — unless we reform the system.

“…These wacky compensation schemes have puzzled me for nearly 20 years.”

So, my question as well as Blinder’s has always been “WHY do they do it this way?”

“…a smart and famous hedge-fund operator,” Blinder writes, “told me that the reason his firm paid its traders that way was ‘because everyone else does it’…”

Everybody does it!”  This is not only Blinder’s big reveal on Wall Street’s compensation compulsion, but it also happens to be the number one response from my “baseball card” collection of top excuses for acting unethically that I’ve heard from managers, workers, and company officers for years.

The response itself shows a great lack of critical thinking.  (It should be noted that the CT center of the brain has always been seriously overstimulated whenever large amounts of money are available.)

Back to Blinder: “If the costs of foolish compensation schemes remained bottled up inside firms, they would not be a cause of public-policy concern, although shareholders should still worry. But that is plainly not the case. Most of the world’s financial system collapsed after an orgy of irresponsible risk taking, and the consequences for the real economy have been devastating. We are all now living through a world-wide recession of a magnitude that economists thought was only for the history books.

“What to do? 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. These boards, I’ll remind you (and please remind the board members), are supposed to represent the interests of stockholders, not those of managers. Quite plainly, many were asleep at the switch, with disastrous consequences. 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.

“Comprehensive reform of the financial system will probably take years. The problems are many and complex, and the government’s to-do list is not only long but also a political minefield. Yet fixing compensation incentives does not require any government action. It can be done by financial companies, tomorrow. Too bad they didn’t do it yesterday.”

Okay, so who is this Alan Blinder, you ask; what are his credentials and what gives him the right to pontificate like the great and powerful Rush-Bo on the pages of the Journal?

Mr. Blinder is a professor of economics and public affairs at Princeton University and a former vice chairman of the Federal Reserve Board.



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