Executive Compensation

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?

Originally published at Econbrowser and reproduced here with the author’s permission.

2 Responses to "Executive Compensation"

  1. Anonymous   January 21, 2009 at 5:35 am

    Try to view it from a different angle: Large global imbalances usually led to increasing corruption of the public sector (remember the recycling of petrodollars in the early eighties) or misappropriation of funds in the private sector (now the banking crisis generated by the chinadollars) and relax….

  2. Guest   January 23, 2009 at 4:00 am

    Why do you call it “exacting revenge”…when you admit that everyone knows it would only be doing JUSTICE?More confused ideas from yet another economist.Equating justice with revenge is just more human intelligence as useful to us as stupidity is.