January 19, 2009
Is there a problem? And is there a solution? My answers: yes, and yes.
Here are some numbers for the compensation received in 2006 by some of the folks who helped get us into our current mess:
- Bear Stearns: $34 million for CEO James Cayne. The acknowledged direct cost to the taxpayers from Bear's demise so far is $2.7 billion; ten times that number may be a more reasonable assessment of the actual cost.
- Lehman Brothers: $27 million for CEO Richard Fuld. The financial freeze that followed the collapse of Lehman is seen by many as the key event that turned the recession of 2007-08 into the frightening freefall currently under way.
- Citigroup: $25 million for CEO Charles Prince. Citi's stock price has since fallen from $50 a share to $3.50.
- Countrywide Financial: $43 million for CEO Angelo Mozilo. According to Ashcraft and Schuermann, Countrywide was at that time the nation's leading issuer of subprime mortgage-backed securities and the third biggest originator of subprime mortgages.
That these individuals should have profited so richly from running their companies into the ground, and bringing the rest of us down with them, offends anyone's sense of justice. But it also raises a profoundly important question from the perspective of economic efficiency, in that the above numbers constitute a prima facie case that there were powerful economic incentives for these individuals to make decisions that were in fact not in their companies' or society's best interest.
That the incentives for CEOs need not necessarily coincide with those of the shareholders is a well understood phenomenon that is a special case of what economists call the principal-agent problem. This arises in situations when an agent (in this case, the CEO) has better information about what is going on than the principals (in this case, the shareholders) who rely on the agent to perform a certain task. One way to try to cope with these problems of asymmetric information is to tie the agent's compensation directly to performance.
What caused that principle to go so badly awry in the present instance? I believe there was an unfortunate interaction between financial innovations and lack of regulatory oversight, which allowed the construction of new financial instruments with essentially any risk-reward profile desired and the ability to leverage one's way into an arbitrarily large position in such an instrument. The underlying instrument of choice was a security with a high probability of doing slightly better than the market and a small probability of a big loss. For example, a subprime loan extended in 2005 would earn the lender a higher yield in the event that house prices continued to rise, but perform quite badly when the housing market turned down. By taking a leveraged position in such assets, the slightly higher yield became an enormously higher yield, and while the game was on, the short-term performance looked wonderful. If the agent is compensated on the basis of current performance alone, and the principal lacks good information on the exact nature of the risks, the result is a tragically toxic incentive structure.
I therefore read with interest the following story in last week's Wall Street Journal:
As annual-meeting season approaches, investors are focusing squarely on executive compensation.
Frustrated with managers who walked away from the financial crisis with tens of millions of dollars despite big shareholder losses, some investors want to limit pay and overhaul compensation practices. They say some practices encouraged executives to take big short-term risks, with little downside when the bets went bust.
Some shareholder activists view the financial meltdown and recession as a "once-in-a-generation" opportunity for change, says Patrick McGurn, special counsel at proxy advisers RiskMetrics Group Inc....
The American Federation of State, County and Municipal Employees has submitted 36 proposals, 32 of which address pay practices. AFSCME wants 10 companies to require executives to hold a majority of their stock and stock options until two years after retirement or termination. The union is also asking three firms to adopt "bonus banking," in which a portion of executives' annual bonuses would be withheld for three years, then recalculated based on updated corporate results.
My interest in this issue is not so much to exact revenge on those who created our current problems, but instead to ask, how can we change the incentives so that this kind of problem is not repeated again? And that in turn leads me to wonder, why limit the proposals above only to a handful of companies?
Posted by James Hamilton at January 19, 2009 03:19 PMdigg this | reddit
Ah yes, AFSCME.
Posted by: Nemo at January 19, 2009 04:25 PM
You raise an important topic. It is an area in which markets need to exercise creativity.
Is there any potential for streamlining the rules for hostile takeover of firms being "looted" by management? My understanding is that many rules such as the need to declare intention once you've acquired 5% of the stock tend to protect management from takeovers--takeovers which in times past were prompted by a wasteful management.
Posted by: Bryce at January 19, 2009 04:33 PM
Hourly worker here. I have lost a large sum of my retirement savings, my home value has fallen, I am not out of work yet but I went from 40+ hours to a forced 32 hours starting this week. I have not consumed more than I can afford, my only debt is my mortgage which is not subprine, and I am sure there are millions like me.
And just so the record is clear, many of us DO want "to exact revenge on those who created our current problems"! We want them hanged.
Posted by: BLOGDE at January 19, 2009 04:58 PM
It is simple. Tie performance incentives (stock options) to the average maturity of the investment decisions made. If a company is to profit from decisions that have a 10 year hold period (ie illiquid commercial business assets), then tie up performance incentives for ten years and only reward upon getting out unscathed.
As an investor, I have to wait for the same reward, so why should the CEO or manager be any different?
Oh and yes... Pay them hourly a reasonable rate for their 'base.'
Posted by: Michael Krause at January 19, 2009 06:24 PM
Arnold Kling notes that the financial innovations took advantage of regulatory arbitrage.
Posted by: Sean at January 19, 2009 06:51 PM
Outlawing poison pills so that shareholders can transfer their capital to more able or at least more honest hands would be a good start. Without that, nothing else will likely work because the executives can continue to use large political contributions to buy themselves protection from regulation, legal oversight, and their shareholders. If shareholders cannot sell their business out from under inadequate management, the inadequate managers become the effective owners of the capital of the business. Boards of directors easily become the creatures of management and its partner in dispossessing the shareholders.
Posted by: mrrunangun at January 19, 2009 08:24 PM
The line has always been that compensation is based on competitive comparisons. What seems to be the underlying culprit is the tax system. Treat stock options differently... both for the recipient and the company. Better yet, don't allow options as compensation. Then limit bonuses as a percentage of the base salary.
If a CEO is truly worth $25 million annually, make it 80% salary and 20% bonus... and explain it to the rest of the employees who really make things happen.
The only highly visible CEO during this recent financial chaos who strikes me as underpaid is Alan Mulally at Ford who has taken a crippled corporation (thanks to Jaques Nasser) and positioned it for surviving not only the downturn, but thriving when the recovery comes.
His tenure at Boeing and now at Ford seem to indicate that he is actually a competent leader rather than a manipulator... which is what seems to be prevalent in the financial world. Too bad there aren't more like him around.
Posted by: Bruce Hall at January 19, 2009 09:15 PM
The problem is an assymetric payoff for investment bankers. Bring back the partnership i-bank. That kind of structure will sort itself out.
See my full comment at: http://humblestudentofthemarkets.blogspot.com/2009/01/proposal-for-reforming-wall-street.html
Posted by: Cam Hui at January 19, 2009 10:53 PM
I am with Michael Krause on this. In the insurance industry, certain markets have "long tail" claims associated with them. Under normal compensation schemes, a manager is incentivized for their performance in a fiscal year. This would result in the manager pumping sales in Year t, but never having to account for the accrued claims in Year t+1.
Warren Buffet's solution (at GenRe and GEICO), your bonus is based on your performance 3 years ago...
Posted by: Wolffman at January 19, 2009 10:55 PM
I am a retired CEO and an investor. And I have lived in the middle of this problem for decades.
The principal-Agent problem is very real, and selfish manipulation and gaming of the system is far too common, and it is a tool that destroys. Congress exacerbated this problem when (through tax policy) they forced compensation to be tied to performance. Thus, the increased use of stock options since stock price is presumed to be reflective of performance. However, in the short run the stock price can be reflective of manipulation.
The only solution I see to this problem is to pay senior execs partially (and meaningfully) in common stock, and not allow that stock to be sold for a long time, or on a slow schedule such 10% per year for ten years. That way they will have a stake in the enduring health of the company, and manipulation will be of reduced value.
Posted by: Zephyr at January 19, 2009 11:21 PM
Hello and thank you for your blog.
I agree with calls from some of the commentators above for compensation to be deferred over longer tenors that roughly match the commitments made under the CEO's tenure.
However I also wonder if most of the problems related to CEO mis-management and over-compensation could be corrected with more stringent accountability of board members (particularly those sitting on certain committees, such as the audit committee). It surprises me that none of the board members of America's failed banks are being sued or at least publicly rebuked for their complete lack of proper representation to shareholders.
I suspect that in America, as in most countries, board members of the largest institutions are politically connected untouchables with little interest or intellectual affinity to the average minority shareholder.
I believe more could be 'fixed' with structural changes, as opposed to an additional patchwork of regulatory requirements a la Sarbanes-Oxley.
Posted by: stefan at January 19, 2009 11:54 PM
I'm confused by your compensation numbers.
According to the link you provide, the totals you report include grants of restricted stock and options. For example, you report that Richard Fuld received $27 million in 2006, but at least $20 million (and maybe more) of that amount was in restricted stock and stock options which (I presume) turned out to be completely worthless. So you are grossly overstating the degree to which he "profited richly" in 2006, and ignoring the huge amount of potential wealth he personally lost when Lehman went under.
Now I'm still not saying he was worth what he was paid....it certainly appears that he blundered, to put it mildly. But it seems highly misleading to ignore this distinction in a post about compensation levels and incentives. In particular, it is emphatically not true that Fuld was "compensated on the basis of current performance alone." It would appear he had very large incentives to avoid the failure that occurred.
(If you think I am misunderstanding the WSJ link, can you explain how?)
Posted by: ed at January 20, 2009 01:51 AM
There's a lot of confusion around whether stock options are reported on the basis of option value in the year of grant, or exercise value in the year exercised.
In any event, all realized executive compensation is effectively an option in the sense it isn't subject to claw back in the event of decline in the firms' stock value later on.
Posted by: anon1 at January 20, 2009 06:20 AM
What do you think of the different studies that have been done showing a connection between executive compensation and certain indicators of corporate performance?
http://www.nber.org/papers/w14145 (Executive compensation was relatively flat in the 70s and 80s, despite increasing firm size. This helped lead to an increase in executive compensation surge later on, as opposed to traditional explanations such as the principal-agent problem or rent extraction).
http://pages.stern.nyu.edu/%7Exgabaix/papers/ceoPay.pdf (the six-fold rise in CEO pay between 1980 and 2003 can be fully attributed to the six-fold increase in market capitalization of large companies during that period.)
I think the problem with companies that were railroaded in the subprime mess and subsequent credit freeze was more of a situation of exuberance (belief that they could stay heavily exposed to the housing market for a longer period of time) rather than one where managerial incentives were not aligned with shareholder incentives.
With the proposals by angry shareholders you could plausibly see future executives wary to take certain positions (reducing the pool of talent) or pursuing sub-optimal strategies out of fear that a new technology will not take off or fear out of further market disturbances.
Posted by: Lance at January 20, 2009 06:54 AM
A very interesting topic. Kevin Murphy (currently at USC) has done a lot of work in this area. I once used his data on how well CEO compensation is tied to performance for a research paper. I found that CEO's who ranked higher in pay for performance made better decisions (increased shareholder value) in regard to acquisitions.
I do not know if Dr Murphy has updated the pay for performance data or not. But it would be interesting to see how the CEO's listed above would have ranked in his hierarchy of pay for performance.
Posted by: GWG at January 20, 2009 06:55 AM
I agree with the general direction of the post, but believe the treatment of executive compensation is too lenient. Justice should be served to those who profited from risks that are costing us all. Pay should retroactively taxed at a 100% rate from all who averaged more than $1M USD per annum in pay over the past 5 years or any part therof at any bailed out financial institution or public company. They were part of a criminal conspiracy to defraud the public and should be treated as such. Ideally, this would be treated as income tax in arrears and the full power of the IRS would be brought to bear.
On a go forward basis, executive should be foused on a long term basis by a 100% tax on the short term pay and perks above 50x the median US wage. Long term performance based rewards tied to common shareholder equity returns above and beyond a benchmark index over a 10 year period would be taxed at the same rate as normal income. There should be no upper limit placed on the dollar value of such grants that may be awarded.
Posted by: Vladamir at January 20, 2009 07:09 AM
The problem is how to get shareholders to give a hoot.
How about Vanguard sets up an index fund that merely invests in the subset of the Wilshire 5000 that compensates their executives primarily through long-term payoffs (like I've recommended in the past, and Michael Krause recommends in these comments)?
Posted by: Dan Weber at January 20, 2009 07:29 AM
Executive compensation is offensive, but I don't think it was a major driver of the current collapse: go back in time and replace the CEOs with different, lower-salaried folks but keep the risk models and bubble conditions in place, and I suspect the outcome would be close to identical.
Posted by: MikeF at January 20, 2009 08:16 AM
JDH, you asked the right question "how can we change the incentives so that this kind of problem is not repeated again?"
1) The CEOs you mentioned above lost a lot of money. They did make a lot, but not nearly as much as they would have had they paid attention.
2) I really think comp has to be long term. I like options, since the shareholders only incur the cost if the company succeeds. Too often options are granted at-the-money instead of deep out of the money and too often CEO's can sell stock that should be restricted for years if not decades.
3) As far as the level of CEO compensation, I think of it as a reward for years of hard work. It creates an incentive for other managers to work hard to get to the top.
4) Stockholders have a great way to influence CEO comp, by voting with their feet and selling stock.
Posted by: MikeR at January 20, 2009 09:12 AM
People should not be buying shares in things they do not understand or giving money to managers to invest in things they do not understand.
If Warren Buffeett will not buy something he doesn't fully understand, why do 100 million Americans do so without batting an eyelid? Remove the capital from these corporations and you will see a different incentive and compensation structure without using a single line of regulation...
Posted by: B at January 20, 2009 09:13 AM
It is really a two-fold problem: over-compensation given the actual(not disclosed) risk taken.
Most of the focus tends to be on the compensation side but I think the bigger issue and the one that is easier to address is the risk disclosure side.
If you limit executive compensation arbitrarily then the best talent will migrate to either private companies or overseas companies with no such limitations on pay.
Doesn't it make more sense to find the holes in risk disclosure and plug them so that shareholders and boards can make informed, intelligent decisions abouth whether the results were truly outperformance or just undisclosed risk taking that juiced absolute returns?
Posted by: BIll at January 20, 2009 11:29 AM
90% marginal tax rate when your income hits $5 million. That would do it.
Posted by: Maynard at January 20, 2009 11:47 AM
I think you're missing the point. Executive comp arrangements incentivized turning a blind eye to the bad risk models. Fix comp, and you give mgmt the right incentive to ask hard questions.
The issue isn't just the absolute amount of compensation, but how it is linked to longer-term performance of the firm.
Posted by: Seth at January 20, 2009 12:24 PM
i watched the citi execs testify before congress. pretty sure it was chuck prince that said a lot of the compensation was in stock and that they abide by some "best practices" from some group that requires holding 75% of that stock.
another report on cnbc said that '07 compensation for (blankfein?) at goldman was bonused largly in stock also.
made me wonder about what "best practices are? i'd rather let the the insiders sell as long as they registered the sale ahead of time.
Posted by: oops at January 20, 2009 01:41 PM
As others have pointed out, this really is an information problem. The shareholders don't understand the conflicts in interest that a bad compensation structure can pose. They blindly trust that the CEO's are working in the shareholder's best interest when the opposite may be true.
What the shareholder really needs is a measure of a companies "alignment" with the investor. The better the alignment, the less risk there is that people within the company might be working against them. You could measure the alignment of the CEO, executive staff, and company as a whole and publish the results. Just like with P/E stats, every time you get a detailed stock quote, you'll see the companies investor alignment numbers as well.
This type of reporting system would put a lot of pressure on companies to structure executive pay in a sensible way. It would also give the company a lot of leverage at the negotiating table when hiring a new executive. You could just punch in the numbers and show how an overly generous compensation package would immediately devalue the stock.
Posted by: ltokuda at January 20, 2009 01:57 PM
Simple solution here:
The SEC should pass a regulation requiring that all publicly traded companies allow their shareholders to vote on the following (binding) resolution each year.
"The total compensation of both the CEO and the CFO shall not exceed $1 million in the coming fiscal year."
Those who dislike government meddling in business have little to complain of here since the government isn't telling any business how to set salaries. The government is just requiring that business owners be allowed to vote on a specific option.
What would happen of such a regulation were in place? Senior executives would complain long and loudly. Many large shareholders --- especially pension funds --- would gladly vote for lower compensation. Many mutual funds would feel pressured to do so. My guess is that the resolution would pass at many companies.
There would then be significant (downward) pressure on executive salaries across the board. If you're the CEO/CFO of a big company, there are very few employees who you think should be paid more than you are. Of course, this won't allow you to pay people (much) less than they could get elsewhere, but the number of people for whose services the "market" is willing to pay more than $1 million per year is small. The very best baseball players, rock stars, entrepreneurs and Wall Street traders would still make millions, but only because any attempt to lower their pay would cause them to go elsewhere with their talents.
Some would say that this plan won't work since the companies whose shareholders agree to pay more than $1 million per year (whether they be public or private companies) will snap up all the "best" executive talent. Maybe. But, our ability to measure executive talent is so limited that it would be hard for any company to easily identify a CEO candidate who is significantly better than many other candidates for the job.
There is a sense in which such a scheme, if implemented, would amount to implicit collusion among the employers of senior executives. Perhaps. But collusion in the service of class warfare is no vice.
Posted by: David Kane at January 20, 2009 05:20 PM
On April 2, 2002 The University of Chicago hosted "Lessons from Enron." Attended and listened to the wonders of option incentives and "alignment" of management incentives with shareholder interests which panelists agreed ought not be undermined as no doubt it was the source of substantial legacy and chair endowments.
How can there be economic efficiency when academic standard-bearer interests are aligned with inefficient but legacy rich management interests?
The real issue is now that the entire "long-term" investing for retirement has exposed the fatal timing flaw (can't arbitrage aging) whether the entire "investment" system can be re-aligned so that true investors armed with risk/reward judgments do the investing and the rest of us saps "save" but the tax incentives are the same.
Posted by: dd at January 20, 2009 06:31 PM
Yes, we all got Enron'd again, ..and yes, the "free market" wonders of deregulation, crooked overpaid CEO's and financiers, leaves one to surmise that there should be some fat cats in jail. The problem is, the guys that watched 'em do it are the ones who should be putting them in jail. The foxes have been guarding the hen-house.
The only way to fix it is to clean house in Congress, and good luck with that. People are too stupid to realize their government is totally corrupt. This is not the last time this will happen. It is called The Silent Weapon, and it brought to bear through implementation of The Shock Doctrine.
Posted by: Hubertg at January 20, 2009 09:29 PM
What is striking is that executive compensation is so out of whack in the US. It is a kind of American exceptionalism. Executives from similar but foreign firms make much less: the chief executives of Honda and Toyota have earned only a fraction of what CEO's of GM and Ford have earned. The same is true for BP or Shell in comparison with ExxonMobil. IMO, the problem is primarily cultural and the changing power structure in US firms since the 1980s: American executives have often been regarded as demi-gods on whom the fate of the whole company rests.
Posted by: Nescio at January 21, 2009 04:43 AM
RiskMetrics Group Inc - aren't these the wonderful people who brought us VaR (Value-at-Risk)? Shouldn't they be paying restitution to the taxpayers?
Where were the Boards of these companies while the CEO was fleecing the shareholders?
Nobody has ever had a gun put to their head and been forced to buy stock of Financial Services firms. Nobody - ever.
Vote with your dollars and stop it with the entitlement mentality. Equities are very risky, everyone should know that going in or shouldn't be investing. No one put a gun to your head - take your losses like an adult. And never ever invest in large banks again, got it? In the long-run, they always lose because they do not really understand the risks they are taking.
And don't call for government solutions to the exec comp problem - they will only create more problems.
We do need better government for sure, but that does not necessarily mean more government. How about smarter, smaller government? And more personal responsibility? A cultural shift is in order.
Posted by: Russell at January 21, 2009 04:45 AM
I'm with you, Nescio. I am reminded of a passage in "The Third Wave" where Toffler referred to budding corporate managers as the new clergy. But I don't think he saw the mess the new clergy would create.
Posted by: Footwedge at January 21, 2009 06:26 AM
And where is the proof that their incentives weren`t aligned? Observing from when things didn`t go wrong yet.
Posted by: Vasja at January 21, 2009 08:51 AM
Well...not for nothing, but has anyone looked at the wealth that Cayne, Fuld, et. al. LOST when their equity went to zero? Cayne made $34mm in 2006, and lost about $865mm over the next couple of years based on the 5,660,000 shares he held when the company was forced to sell itself to JPM. So if you look at Cayne's career on balance, he employed tens of thousands of people for a couple of decades, managed a far-flung investment banking empire that launched thousands of companies, and probably made less than $100mm in the bargain.
Is $100mm a lot of money? It sure is! But in 2006 Mr. Market thought his contributions over the years were worth more like a billion dollars.
I come to bury Caesar, not to praise him, but most of these CEOs are honest if grasping, and talented if not quite talented enough for the complex environment the market abruptly evolved into over the last 15 years or so. But what is the alternative? How many people do you think will take those jobs for $100,000? You think they'll be very good?
Posted by: Mike at January 21, 2009 12:28 PM
Refer to Raghuram Rajan, former chief economist of the International Monetary Fund. ("Bankers' pay is deeply flawed", FT, January 9 2008).
By paying huge bonuses on the basis of short-term performance in a system in which negative bonuses are impossible, banks create gigantic incentives to disguise risk-taking as value-creation.
It is the same for all business. The MBO and annual perfomance incentive schemes that all companies adopted as "best practices" (at the advice of consulting companies like McKinsey) is deeply flawed.
Management simply follow the WIFM (What's In it For Me) principle - just as rogue trader Jerome Kerviel did at UBS by taking risks that multiplied his salary many fold ($37 billion of other people's money gone). Furthermore, supervisors may turn a blind eye - they can also benefit from succesful bets of rogue junior employees with nearly no risk at all (they stand to get huge bonuses on the upside and may even keep their job on the downside if they can claim innocence and show that their report was evading observation).
The logic goes;
Since I stand to lose nothing (except my job) and I can likely I can find another (in a booming market) then I may as well make a high risk bet that has a low probability of a nasty failure.
In essence, this is like an engineer saying we can build an Oil platform to only withstand a 25 year storm and cross fingers that the hundred year storm won't happen on your watch...
Or like moving with your family to a nice beachfront property in California and hoping that the "big one" won't get you. You trade off th elow probably but nasty risk of the lives of your family in order to enjoy teh nearly assured great weather and a beautiful beach.
Or like buying a house with no downpayment and crossing your fingers it can be flipped for a tidy profit in 6 months...
Or like fudging the data on your lab experiments in order to please the pharmaceutical company that sponsored your research, knowing full well there is money for a further three studies lasting five years if the new drug looks promising...
The problems run deep. Very deep indeed. It is not simply an "executive" issue but the ethical standards of an entire generation.
Posted by: Anon at January 21, 2009 03:43 PM
How about something like:
a. Lowest hourly wage paid for any input related to the company (including subcontract work done overseas at below US minimum wage)
time 2,000 (hours in a year for 40 hour week)
divided by 5% (to provide a floor to bound inter-company inequality)
b. times (1 + ((taxes cash paid on profits) divided by (costs))).
a. This provides more equal work layers, which will improve quality control, and make positive changes and increased efficiency adoption faster.
b. Managers are thus rewarded for increasing profits, lowering costs and for being responsible corporate citizens by paying taxes to compensate for the inevitable market failures such as asymetric information to their benefit, negative externalities and some unethical practices that are inevitable in large corporations.
I know this is is naive, simplistic and flawed, but can't imagine anything worse than the current system where the managers are rewarded for avoiding accountability and rewarded for creating long term failures and taking social resources away from progress and increased efficiency.
Posted by: Zero X Owner at January 22, 2009 03:14 PM
To fix the problems, you first need to understand how the problems are caused. There is a lot of misinformation - and high-level thinking - out there about how these pay packages came to exist.
More often than not, they exist because of broken board processes (and board advisors afraid to stand up to their clients, ignorant directors). I have laid out the history of many of these broken processes in my "Open Letter to Journalists" on CompensationStandards.com - see http://www.compensationstandards.com/nonMember/files/letter.htm.
Posted by: Broc Romanek at January 25, 2009 05:19 AM
I think it was a right decision to limit CEO salaries at 500K for the companies that are getting taxpayer money. In general I strongly disagree with government intervention in private business matters, but since these companies are utilizing my money and your money and the money that belongs to all Americans, we have the right to limit their payroll, especially after the embarrassing facts of CEOs using bailout money for lavish parties, private jets and unreasonable bonuses. Once they pay us back the money owed, they can have all the bonuses and salaries they want.
Posted by: David Dzidzikashvili at February 9, 2009 05:43 PM