Monday, April 21, 2008

Compensation Incentives and Financial Instability

It’s official. America’s financial system is a mess once again. It isn’t a good feeling, being the laughingstock of the world. (If you haven’t yet seen the hilarious PowerPoint presentation called “The Subprime Primer” or the even funnier YouTube video, “The Long Johns – The Last Laugh – George Parr – Subprime,” by all means find them as soon as you are done clicking on the ads supporting this blog.) Suffering through an economic recession, caused by the subprime debacle and exacerbated by decades of governmental, corporate, and personal financial profligacy, is even less fun, especially if you lose your job, car, credit rating and/or house during what could become a long and ugly shakeout period.

In the past, Americans have responded to financial and economic turmoil with hasty and ill-conceived reforms. From the Panic of 1792 to the accounting scandals earlier this century, crisis has spawned regulations, some salutary, most not. I hope things will turn out differently this time around. What regulators and reformers need to concentrate on is what really matters, the nature and timing of compensation for everyone from the CEO to the lowliest trader. If the last year or so has shown anything, it is that people do precisely what they are given incentives to do. If you pay people upfront to originate 15- or 30-year mortgages, they will sign up everyone they can, even “ninjas” (people with no income, no job or assets). If you give people outsized annual bonuses based on what they appeared to do for your company that year, they will create, support, and implement crazy, short-sighted schemes. Many people on Wall Street knew that the subprime bubble was unsustainable. But what does that matter when those most responsible for letting it happen raked in seven-figure bonuses for a year, or two, or maybe five? The huge golden parachutes most executives wear these days are inducements to take big risks. If those in charge messed up, their parachutes opened and glided them comfortably to earth even while their former employer bursts into flames.

What rogue traders, accounting scandals, and the subprime mess tell us is that it is as easy to fake financial profits in the short term as it is for Meg Ryan to fake a raging orgasm in a crowded restaurant. (When Harry Met Sally for the uninitiated.) Longer term, the truth becomes known but irresponsible millionaires, and sometimes billionaires, have already been made. That is not to say that some Bear Stearns managers aren’t feeling a bit crimped for cash right now – they owned about a third of the failed investment bank, the share price of which plummeted from $170 to $2 over the last year – but don’t expect to see many of them in soup lines.

It doesn’t have to be this way; there are examples of how to do it right. “Conservative” financial institutions, for example some mutual life insurers, counter short-term thinking by deferring compensation, paying comfortable monthly salaries but reserving big bonuses until profits are actualized, not merely booked. They have long done so for their sales agents, who otherwise would try to saddle them with terminal cancer patients, daredevils, and Alaska crab fishermen, and more recently have extended the idea to executives and board members. Other financial institutions should consider following their example. If they don’t, the government will sooner or later try to do it for them, with predictably unpredictable consequences.

Financial crises and economic recessions are not the end of the world. They are costly, however, so it is important to try to limit their number and extent. In the future, we need more proactive analysis of skewed incentives, unintended consequences, and conflicts of interest and less reliance on reactive monetary and fiscal policies. Will managers and shareholders clean their own house or will they have it scrubbed for them?

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