Limiting Banker Pay - Another Downside

By Kindred Winecoff

A while back Alex and I went around on whether limiting the pay of bankers would make the system more stable. Jeffrey Friedman and Wladimir Kraus are asking the same question:

The real scandal of bankers’ pay contributing to the financial crisis is that nobody, literally nobody, has offered a shred of evidence that it did contribute to the crisis. Yet public opinion, the financial press, and the regulators have decided that it did, and drastic new regulatory policies are being constructed on that basis. Moreover, when we consult what evidence is known, it seems that bankers, far from deliberately courting disaster so as to boost their pay, unintentionally took risks that jeopardized their own wealth.

We can see some of the results in the huge hits taken by key bank executives, such as Richard Fuld of Lehman Brothers (LEHMQ.PK), who lost $1 billion by retaining his Lehman holdings until the bitter end. Sanford Weill of Citigroup (C) lost half that amount. Ohio State economists Rüdiger Fahlenbrach and René Stulz have shown that banks whose CEOs held a lot of their banks’ stock fared worse in the crisis than banks with CEOs who held less stock. The CEOs who held stock in the riskier banks must have been ignorant of the risk, or they would have sold their shares.

Ignorance, not a perverse pay structure, also seems to have been at work at Bear Stearns. William D. Cohan’s "House of Cards" suggests that before losing about $900 million in stock when the bank imploded, Bear Stearns CEO James Cayne had no idea that anything was amiss. In fact, he was obsessed with the construction of a huge new headquarters building that would testify to the permanence of Bear Stearns, formerly the upstart of investment banks.

The available evidence seems to show that bankers were trying to be prudent:

Indeed, 93 percent of the mortgage-backed securities purchased by banks either were rated AAA or—better yet—were insured by Fannie Mae (FNM) or Freddie Mac (FRE), with implicit federal guarantees. It turned out to be a mistake to trust the AAA ratings, but in making this mistake, bankers again demonstrated that they were not seeking short-term profits to boost their annual bonuses. Had that been the bankers’ aim, they would not have bought AAA-rated mortgage-backed bonds, which, being “safe,” paid a lower interest rate than AA- and lower-rated bonds. Bankers who were indifferent to risk because they were seeking higher return should have bought the more-lucrative, riskier bonds, but they did so only 7 percent of the time.

Alex might say "So what? The fact is that the crash happened, and now the government is on the hook for all these bad bets. Therefore the government should limit pay." My response is that it would depend: if the government assumed the contracts made by financial institutions, this should include compensation contracts as well. If the government didn't want to assume those contracts, they should have made that a condition of taking TARP money rather than re-writing the rules after the fact. There's a better case for limiting compensation contracts made after the government investment, but to my knowledge those are not the contracts under discussion.

Even more concerning to me is the fact that the internal practices of these firms have now become politicized. How is that a good thing for the firms themselves or the investment that taxpayers have made in them? Indeed, despite the president's assurances, we've already seen fairly drastic meddling in the auto industry which has led them to make poor business decisions for the sake of political expediency. Is that really what we want?

Finally, while none of us want to see another financial crisis, it will happen. When it does, we are now incentivizing banks to refuse any government assistance. This could make future crises much worse, and unnecessarily so. The government may also be handicapping itself: if it believes, or behaves as if it believes, that the real cause of the crisis was the incentives created by compensation contracts then it may miss an opportunity to reform the regulatory structure in other ways that could actually have positive effects.

Comments

[kgeechee:]

So I take it your view is that any CEO who fits this description: "Bear Stearns CEO James Cayne had no idea that anything was amiss" is worth paying a gazillion $$$$ a year PLUS an obscene bonus his equally 'in the dark' rank & file employees will not made that much in their life time COMBINED!

Dare we ask if ANYONE understands the problems? Greed on Wall Street is NOT the answer.

Nov 08 11:16 AM

[Tom Armistead:]

The answer is the banks are too big. The bigger the business, the bigger the bucks the top dog has to receive.

Cut GS, JPM, etc into ten equal size banks or trading houses and put one man at the top of each making one tenth of what Blankfein, Dimon et al make and that problem is solved.

From there you could go on to CDS, manipulation of markets, derivatives, fraudulent conduct, high frequency trading, front running, naked short-selling, insider trading, twisting, scamming, lieing cheating and stealing generally.

The retail investor has been slow to stick their head out of the bunker and get back into the game. Well doing something to level the field, and getting the government out of the game, would do wonders in that regard.

The only proper role for the government is as a referee, impartial, well versed in the rules, and equipped with an ample supply of red cards.

Nov 08 01:56 PM

[greedcanbgood:]

Tom,

What measure would you use for breaking up a bank that is “too big”? What is the threshold of "too big"? Also, would you also put size restrictions on other privately held corporations, requiring that they don’t grow beyond a certain point? WAY too much government here. There is VERY little that the government does well and I don’t trust them to set limits like this. Let’s face it, it wasn’t the allure of size that caused this problem, it was classic Minsky economics at work. You can limit their size but eventually they will find more creative ways to make money which eventually will lead to another bubble.

I'm with you on the rest of your ideas though. ;-)

Nov 09 10:50 AM

[Dkovensage:]

If the bankers were stupid enough to take risks that would endanger their own fortunes, they deserve to be paid less. Truth be told, how many world changing ideas can the average CEO come up with in a lifetime? I don't mind paying for performance, but nobody performs at the multi-million dollar level every year. Many are simply coasting on their laurels. In addition, people who sit on other corporate boards while they are ostensibly running their own companies are shortchanging their company and the company on whose boards they sit. One job done well at a time. Excellence from multitasking is a myth. The wealthy need to get a grip on reality. How much money is enough? As an investor, I care very little about whether my CEO's egos get massaged by the trappings of their work place and other perks. I need a man or woman who is used to the idea that one gets a bonus and large salary for value received by the investors.

Nov 09 10:51 AM

[PizzaMan:]

It's not that the amounts paid to these people had that much of an impact on their companies. It's an expression of outrage on the part of the public. I see firms that have failed turn around and give bonuses to their management. What did they do they deserve a bonus?

I just don't see how the financial products division of AIG should be getting any kind of bonus at all. They created the shortfall that brought down a HUGE corporation, only to get a reward. How could a bonus be justified (other than it was in a contract)?

You point out how Mr. Fuld lost value when Lehman went under. I'm real sad about that. How much value was lost by his shareholders? I suspect that the ex-CEO is still much better off these days than most of the shareholders of ex-Lehman.

Nov 09 06:01 PM

[slam stocks:]

Banks executives should not be rewarded for failing to deliver. While employees across the country accept sacrifices to ensure the survival of the company, the executives need to be leaders and show by example to sacrifice the most.

Some of the largest bank executives in Brazil, Canada, China, Europe, India and Japan earn a fraction of the US counterparts, yet, their banks are frequently listed among the strongest and most stable operations in the world. They have no bank crisis. The shame of their corporate greed "to perform God's work" in the banking sector has hampered the growth in the US economy domestically and abroad.

Nov 11 01:41 AM