The Advisors' Blog

– Prof. Christine Hurt, U. of Illinois

Here is something I recently blogged on the “Conglomerate Blog“: In finalizing a draft of a symposium piece on executive compensation last week for some very patient editors, I had a chance to read the 500-plus page Final Report of the Financial Crisis Inquiry Commission. Just to give you a sense of whether executive compensation is an issue there, note that “systemic risk” is used 29 times in the 410 page majority opinion. The term “compensation” is used 79 times. Here are some takeaways:

At least in “dicta,” the Final Report seems to understand that incentive compensation skews the decision-making of those outside of the “top five” executives on which most reform legislation and reformers are focused. The Final Report mentions the compensation schemes of financial institutions, Bear Stearns, Fannie Mae and Freddie Mac, Lehman Brothers, and even mortgage originators. The report seems to understand how incentive compensation gives the recipient an “option,” so that option theory kicks in and those with no downside take on additional risk. Most importantly, in several places it seems that the Commission understood it was not just the CEOs, including its “Conclusions” section:

Compensation systems — designed in an environment of cheap money, intense competition, and light regulation — too often rewarded the quick deal, the short-term gain — without proper consideration of long-term consequences. often, those systems encoursaged the big bet — where the payoff on the upside could be huge and the downside limited. This was the case up and down the line — from the corproate boardroom tot he mortgage broker on the street.

But the Commission still chose to focus on sticker-shocking salaries of CEOs and other officers. The Final Report mentions the takehome salaries of at least 23 named individuals, in addition to giving aggregate salaries for various groups of individuals and institutions. The Commission seems to be very interested in reporting that individuals at financial institutions, which were struggling by 2008 and some of which failed, had very nice salaries. However, even if there compensation was in the multi-million dollar range, that compensation did not push these multi-billion dollar companies over the edge. So the dollar amount has little mathematical value here. Now generally we might be appalled because we believe that the CEO must have done a horrible job if the firm went into trouble, and why should we pay horrible CEOs all that money? That is in interesting question, but the question posed to the Commission was what caused the financial crisis, and the report doesn’t do that great of a job linking these high salaries to the crisis except in the most general way: because so much money was at stake, executives became too comfortable with excessive risk, which caused the financial crisis. I think this argument goes to far in suggesting that incentive compensation with no downside makes CEOs immune to risk. CEOs do get fired, much more often I would guess than getting their pay cut. Stock price drop doesn’t give traders or mortgage originators a reputational hit, but it does give CEOs one, and their reputation has a pretty high market price.

The Final Report seems to have a lot of facts about the evils of compensation, but not a lot of theories. In addition to wanting us to know the salaries of various corporate officers, the Commission has a small section titled “The Wages of Finance: “Well, this One’s Doing It, So How Can I Not Do It?”” (Yes, the report has a very readable, narrative-based feel to it, but that makes it seems less than objective.) In this small section, the Commission weaves together a lot of factoids that don’t make a whole. First, the income gap in the U.S. is large, but the gap between financial industry salaries and regular industry salaries is bigger and has grown since the 1980s. (Margaret Blair has also written about this here.) Again, this seems damning to the industry, but I’m not sure why. The financial industry executives are paid more than executives of any other industry. Again, ok. This tells us nothing about what caused the financial crisis.

The Commission also points out what we already knew: most compensation is performance-based compensation. Why? Because reformers told us this was how to tie pay with performance. So, section 162(m) of the IRC limited the deductibility of non-performance-based compensation. And guess what, most compensation became performance-based compensation, which we now think leads to short-termism. If we tie compensation to profits on an annual basis, then we become fixated on profits right now, no matter what. Who could have guessed that?

The Final Report also reminds us that our investment banks used to be partnerships. This is an interesting point and one that others have made. The Commission believes this is a bad thing because now the executives have no skin in the game, get their big payouts every year, not the residual. So bankers became more risk-seeking with shareholder’s money. However, the report also points out that the compensation systems of these banks were the same after going public — distributing half the revenues at the end of the year. So, the report needs to tie that bow together if it’s making a compensation argument.

Finally, the Commission mentions that regulators cannot possibly compete in the labor market with financial whizzes. Why would anyone go work for the government if they can make millions in the private sector? Not sure what conclusion that leads us, too, then.

Broc’s note: Here is a brief blog entitled “The Most Important Sentence in the FCIC Report” from The Corporate Library.