The real issue on executive pay

Floyd Norris recently wrote the article It May Be Outrageous, but Wall Street Pay Didn’t Cause This Crisis.  Once again I am shaking my head.

While it is true that the amount people were paid did not cause the crisis many are calling the recession, and I also agree with the thesis of the article that CEOs have many incentives to make the company perform well (though the golden parachutes are hard to believe from the outside looking in), I was sorry Mr. Norris didn’t offer a better solution to the problem.

This situation reminds me of an old story my father used to tell me of a scientist testing how far a frog can jump after he blows a whistle.  The first time he blows the whistle, the frog jumps four feet (and that’s what he writes in his journal), then he ties one of its legs (preventing movement), blows the whistle and the frog jumps two feet.  This time the entry in his journal reads “frog with three legs jumps two feet”, and the experiment continued.  After tying three legs and blowing the whistle, the scientist observed “frog with three legs jumps six inches” and then he proceeded to tie the fourth leg and blow the whistle.  Nothing.  Once again he blew his whistle and again, nothing.  What conclusion did the scientist draw from this final stage of his experiment?  “Frog with no legs can’t hear.”

What’s that got to do with executive compensation on Wall Street?  A lot in my opinion because the conclusions people are coming to are just plain wacky and there’s a line of evidence and history a mile long that points to the real issue.  OK, issues.

First of all, I am all for good old fashioned capitalism.  Someone earns a big profit, they should be able to get a big fat paycheck.  That simple math has worked for a long time.  Earning a big profit in sales is one thing, $100 of real money comes in, and you will probably pay them about $20 for that.  $100 million comes in, they get about $20 million.  Simple math.  And if I go to Las Vegas and bet that the Green Bay Packers are going to win every game in their football season, on a $50 bet, if I am right, I stand to win millions of dollars, but it’s a really risky bet, so there’s a good chance I will lose my $50.  The issue, as I see it, is that Wall Street is encouraging traders to take huge risks (hard to compare with an undefeated Packer season, which would be priceless in my opinion, but stay with me), they win in the short term – say $100 million, get their $20 million bonus, and then months later the $100 million in winnings vanish – or worse turn into a huge loss, but the trader gets to keep the $20 million.

That’s the part of the structure that needs to be overhauled.  Encouraging and rewarding risky behavior with no accountability for failure.

It’s unrealistic for Wall Street to ask for bonus money back, so they need to change the upstream rules and processes that drive the behavior.  The specific action that’s needed is far better risk oversight, from home loan debt risk, to the insurance industry risk of not being able to cover claims.  This is knowable math, and people who take outrageous risks should be terminated or risk jail time (and not jail camp, real jail).

Who is going to reign in these off-leash traders?  Well, that’s where it gets a little more interesting.  Ideally, the CEO and the board should be able to review the risk of their portfolios and give team feedback about how well their risk aligns with the goals of the organization.  This isn’t hard, everyone has Excel, run the report and manage against it.  But the CEOs and the boards are not doing this.  Even after all of the public shaming of AIG, we are again seeing kooky profits and bonuses at big banks, and it looks like “deja vu all over again” (as Yogi Berra would say).

So how do we control this?  I hesitate to suggest regulation and oversight, and I am not sure the consumer protection agency is the right answer, but I do think forced transparency of risk is a good idea because it’s knowable and they should have a handle on it at this point anyway.

Rrrribbit.

-Ric