The pay puzzle: Part 2, what should happen, company level
By: David A. Smith
[Continued from yesterday's Part 1.]
Yesterday’s post opened the topic of compensating investment bankers and a fortiori investment banks as well, taking as initial text Steven Brill’s New York Times profile of TARP paymaster Kenneth Feinberg.
Put up your dukes, Feinberg!
Brill is full of admiration for Feinberg’s jawboning down the bankers’ actual paychecks, and pays much less attention to the negotiations also taking place about structure, contenting himself with superficial rhetoric questions like this:
When governments intervene to impose taxes or put limits on bonuses, for example, companies tend to increase salaries or introduce new perks. When the issue is left to the companies’ boards, endless questions peck away at the seemingly simple idea of paying executives based on performance. If pay is based on what an executive’s peers at other companies get, how is a peer group defined? Why penalize and demoralize talented employees if the firm’s stock or profits are down because the economy as a whole collapsed, or because the company incurred a short-term loss while making a sensible long-term investment? Besides, as a general matter isn’t it just plain silly to worry about spending a few extra million to keep the leaders at the top happy when they’re making decisions with billions at stake?
We, on the other hand, are made of sterner stuff. Yesterday we covered three ideas:
1. Align time horizons between bank earnings and pay.
2. Measure the right metrics of financial performance.
3. Align incentives in payment formulas.
Want to try any of these?
Today we have three more, and we can dig into the reasons why what we’d like to have happened hasn’t happened yet.
4. Match compensation structures to newly invented risk slices
In my world, some people are paid on an eat-what-you-kill basis — their compensation is entirely contingent on them delivering something. Normally this is applied to commission salesmen, but if the payment is in cash, we get back into the agency risk associated with bad lenders and bad loans. And that doesn’t work at all with investment bankers and financial product designers.
Or does it?
You’ve won – aren’t you happy?
It’s common enough in securitization for the originating bank to take the majority of its compensation in the last tranche – the B piece or C piece that is left over after the senior pieces have been sliced off and sold.
What are those tips worth?
If the loan pool performs, quite a lot
There’s a certain Willy-Wonka justice in all this; if you’re paid in parts, and the parts is rotten, then you get the indigestion.
Gloop!
This can actually be done, and without too much complexity. Any time an activity adds value by creating a new commodity, pay the creator with a piece of the commodity. Land developers have been paid in lots (no less than Frederick Law Olmsted was once so compensated), sharecroppers in a portion of their grain, and hedge fund managers in a portion of the yield earned on their investments.
Willing to be paid in kind: Olmsted in 1857
If derivatives, CDS’s, CDO’s, and so on, are such great investments, create a tranche reserved for the managers, and preclude its sale for several years – at least through the seasoning period.
This one has been properly aged
For instance, consider this structure used at AIG:
My friend (who did not want his name used because, he says, “being associated with AIG is not safe for my family”) is a mild-mannered math whiz who worked at a unit of AIG Financial Products that, he says, had nothing to do with the small London-based credit-default-swaps group that sank the company. Over the last half-decade, he made millions every year from a bonus pool composed of the profits supposedly made by Financial Products.
But he had to leave roughly half of his bonuses in the pool for five years so that the payouts could be adjusted for any subsequent gains or losses from Financial Products’ trades. (That’s an extreme version of what’s called a “claw back,” another reform that Feinberg’s guidelines would require.) When the credit-default-swaps unit went bust, he personally lost tens of millions in that pool. (Which would also mean that he took home tens of millions over those five years.)
Observe that this structure was already in place at AIG, and yet AIG is the sickest of the sick:
5. Mandate risk disclosure
“Let’s face it – this isn’t the worst thing you’ve caught me doing.”
– Tony Stark, aka Iron Man
Nothing to worry about here
If we cannot forbid risk-taking (and we can’t), and we want to enable the market to innovate (and we do), then investment banks will always be taking risks. But we ought to know what they are, oughtn’t we – particularly if public companies are involved?
So much sense does this make that we’ve been trying it for years, ever since one of the last decade’s biggest invisible stories, FIN 46, which sought to compel risk transparency and became so entangled with complexity as to render the original purpose unachievable … and worse, clouded by the misapprehension that it was working, when it wasn’t.
“Respondents were consistently incisive, reproachful and vehement in their criticism of FASB’s year-long process of developing and vetting FIN 46, conveying in strong, pointed language their dissatisfaction with FASB’s responsiveness to the securitization market and their disappointment with the final Interpretation, which many construe as an overly broad, ‘over-reaching’ measure which is treating a very specific abuse (inadequate and misrepresentative corporate disclosure).”
As you can imagine, this led to contortions by which entities sought to avoid having to consolidate.
A total of 470 participants from the
That was the invisible story. FIN 46, which sought to make things more transparent, in fact made them more opaque. While investors basked in the illusion of transparent consolidation, in reality they were absorbing ever more risk.
Aftermath. FIN 46, now renamed as FAS 167, is now a permanent part of the landscape, but the puzzles it poses remain unsolved. Consolidation is still a bete noire in accounting and CFO circles.
You still haven’t dealt with me
6. Regulate the ability of publicly-traded entities to take on financial risk
In the first possible principle, I suggested aligning the time horizons of managers and financial counterparties – lenders, equity investors, and stockholders. Yet that principle – enforced financial partnership over long intervals like multiple years – is antithetical to another principle on which our equity markets are founded – namely, liquidity.
Anyone who’s ever owned a publicly traded stock knows that markets move fast – much faster than government — and that they are constantly incorporating new information, sifting it in a marketplace of ideas whose aggregate expression is a single number, the price of the last stock trade.
How the markets keep score
Yet markets are notoriously inexpert in pricing abstract risks, new risks, and low-probability ‘black swan’ risks. In fact, everything about the publicly traded company discourages taking the long view. Moreover, corporations that trade in the public markets are by definition taking vast sums from ordinary investors – and when these publicly-owned companies go upside down, Joe Sixpack gets hurt … which means Uncle Sam rides to his rescue, with costs and consequences for all of us, as we’ve seen with the bailouts of numerous companies, mostly questionably GM and Chrysler.
Remind me what public purpose we served by putting money into GM?
There is a solution to the challenge of public companies taking on risk – make them collateralize it. Already, regulated financial institutions are required to maintain particular capital ratios, under both Basel II accords and FDIC/ Treasury/ OCC rules – and these, in turn, are tied directly to the assets on their balance sheets, as valued under FAS 157 or otherwise.
In a world where every financial institution is effectively a bank, and every bank is a Bank of Glass, one could assign to every financial instrument a risk assessment (even a crude metric would do), and then require that the issuing institution hold in high-credit liquid instruments (e.g. Treasury bills) capital equal to the total assessed risk. In effect, this would institutionalize and automate the post-TARP stress-testing done to the TARP recipients.
There’s our six options – sensible, right?
Well, some of them are silly
All rights, that’s too silly
Now, finally, we can settle down with our fat Steven Brill article, and discover the four big reasons why it’s hard to implement any of the compensation structuring reforms just presented.
[Continued tomorrow in Part 3.]
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