In the Sunday NYT, Yale Professor Robert Shiller discusses one of the recommendations of the Squam Lake Report — holding back some executive compensation to align their risk with taxpayers (Help Prevent a Sequel. Delay Some Pay.)
Here is their recommendation:
“The Squam Lake group recommends that companies be encouraged to withhold a good part of the compensation of their top executives for a number of years, and that it should not take the form of stock options. That would give them incentives to consider some of the long-term consequences, and intrinsic value, of their decisions.
The holdback should be for a pre-announced dollar amount, and the contract should specify that it will be lost if the company goes bankrupt or gets a government bailout. That way, the economic cost of a bankruptcy or bailout is placed partly on the executives who make decisions.”
The thought process behind this is that risky corporate activities should also become a risk to the firm’s executives. The case the Squam Lake economists make is that by holding back some of the executives’ personal assets, risky behavior becomes their problem, not just the taxpayers’. The hope is that “this will transform executives’ thinking about risks — and may help prevent another disaster.”
I sincerely doubt it. Similar disincentives were already in place — and they failed miserably.
At each and every one of the companies that went bust due to their excessively risky speculations — from AIG to Bear to Citi to Fannie Mae to Lehman to WAMU — every executive had huge amounts of stock, stock options, and future salaries at risk. Lehman’s Dick Fuld reputedly lost over $500 million dollars in stock value, and a few of Bear Stearns execs lost close to a $ 1 billion dollars each in asset value.
The mere threat of future losses has already proven insufficient to moderate behavior. Holding back $100s of 1000s of dollars — or even millions of dollars — is a meaningless inconvenience to the people whose net worth is measured $100s of millions or billions of dollars.
There are better alternatives.
While researching Bailout Nation, I did discover one group of Wall Street firms whose senior management took a very measured approach to managing risk. They managed to engage in risk taking and speculation in a fashion that was responsible, and avoided trouble.
The group? Wall Street partnerships.
There is a simple explanation for this: Unlike corporations, Partners have “joint and several liability.” Every partner is fully liable, up to the full amount of the relevant obligation, for the actions of every other partner. This has the effect of focusing the minds of management on exactly what the worst case scenario of their behavior can wreak. Imagine if a partnership like Lazard Freres (since gone public) or Brown Brothers Harriman embraced risk the way their publicly traded brethren did. The liabilities form the losses falls first tot he partnership. Once those assets are exhausted, the creditors can proceed to recover losses from the personal assets of every partner. Bank accounts, Houses, boats, vacation property, 401ks, cars, jewelery, watches, etc. are all fair game for creditors.
Not surprisingly, none of the Wall Street partnerships got into trouble, and I argue the full personal liability for losses are why. Execs at publicly traded Wall Street firms only risk was their future earnings and stocks. The actual losses fell to the shareholders, bondholders and eventually, the taxpayers.
Risking minor amounts of future earnings, relative to massive, trillion dollar losses, is vastly disproportionate. It did not alter behavior in this crisis, and it will not prevent the next crisis. The amounts of money lost, relative to their existing wealth, failed to moderate behavior. The losses amounted to little more than tears in the rain.
If we want to prevent senior management from acting recklessly, then we need to impose costs that are proportionate to the losses they caused. Personal partnership liability for senior management would have prevented the past crisis, and it will prevent future crises.
The question isn’t if this will work — we know it already does. The only issue is whether we have the political will to impose this liability on our reckless, irresponsible executive class . . ..
Help Prevent a Sequel. Delay Some Pay.
ROBERT J. SHILLER
NYT, June 18, 2010
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