The Problem With Financial Services Compensation (AIG/Pay Czar Edition)

The Financial Times reports that the so-called pay czar Kenneth Feinberg, who is in charge of overseeing compensation at TARP recipients, is going to crack down on some of the bonuses paid at AIG:

The Obama administration’s pay tsar has indicated he will take a tough stance on executive pay at AIG, the state-controlled insurance group that sparked outrage over its bonus payments earlier this year.

Kenneth Feinberg, the “special master” for pay at companies that have received government support, has raised concerns inside and outside AIG by putting pressure on the company to alter some pay plans.

People close to the situation said regulators had expressed fears that a crackdown on AIG could impel executives to leave, further harming the company’s prospects and the chances of taxpayers’ money being repaid.

While I think the pay levels in the financial services industry are to a significant degree unwarranted, using pay as a quick and dirty way to appease the masses and try to forgo the needed heavy lifting of real reform and meaningful oversight is likely to be ineffective.

First, let’s parse the latest AIG brouhaha. We have the claim made that if the government dares meddle with AIG’s pay, quelle horreur, the US taxpayer might not get its dough back. Sounds like a threat, now doesn’t it?

Reality check, please. In case you were not paying attention, the US is NOT going to get its money back from its little AIG rescue operation. When AIG came to the Federal government a year ago, in desperation, it agreed to a deliberately punitive interest rate (11.50%) because it was confident (or deluded) that it could sell some divisions and pay off the borrowings pronto. Its tune quickly changed, the deal was retraded several times, with the net result that AIG got MORE money and had the terms of its loans made MUCH more favorable.

So let us pause here. If any private sector lender had a borrower pull that stunt, the rates on the old money would have stayed in place and and the incremental money would have been on vastly worse terms. 15%-20% plus even more intrusive oversight would be entirely reasonable.

So let us not forget the first premise: whatever results AIG is reporting are misstated. They reflect an indefensible subsidy from the US taxpayer, one vastly in excess of the already egrigous subsidy of bailing them out without taking control. The extent of government support to AIG means it owns the place from an economic standpoint, yet is perversely loath to act like one.

Second ugly issue: the longer that AIG has been hocking its operations, the more the notion that there is a ton of equity value waiting to be unlocked looks dubious. Yeah, the deal market isn’t what it used to be. But private equity buyers have been sitting on the sidelines, and they need to put money to work to justify their existence. If AIG won’t take the price that PE buyers will offer, that suggests that AIG has an inflated idea of what its subsidiaries are worth (and by the way, this is a pretty common syndrome). Moreover, at least with some operations, it appears that AIG was engaged in reinsurance relationships among its subs, which means in aggregate they may not have been as well capitalized as they seemed.

Third ugly issue: talent? Surely you jest. My one buddy at AIG was terribly circumspect and very senior (responsible for a $100 billion portfolio). He joined shortly before Hank Greenberg departed. He was looking for a new job as soon as Greenberg left. Not that he had a close relationship with Greenberg; he didn’t. But he could see that the place became unmanageable overnight. Greenberg had run AIG like a French court. All decisions of any consequence, and plenty that weren’t, came to him. There was no way to get things resolved in his absence. And there was no one who had his detailed knowledge of the businesses to step into the breach.

My colleague said, “It is like being in a car with both axles removed. The car is still moving forward, but the wheels are about to fall off.” That was two months after Greenberg was history. Anyone with an iota of self preservation instincts and options was looking for a job. (I will concede that there may be some capable individuals that out of a sense of misguided loyalty lashed themselves to the mast of this sinking ship, but at this juncture, they are likely to be exceptions).

Now narrowly speaking, one can argue that Feinberg is 100% correct to be scrutinizing AIG pay. In the waning days of the Bush Administration, AIG kept brazenly enlarging the number of recipients of retention bonuses. At one point, it added 2700, who received much lower amounts on average than earlier recipients. I speculated at the time that this was done for the sole purpose of lowering the average amount received to make it less offensive.

But if you widen the lens, the critics are right, for all the wrong reasons. Yes, AIG might well lose people that it doesn’t want to because its pay is not “competitive”. And why is that? Because the whole bloody financial system is getting massive subsidies (super cheap borrowing rates, fancy Fed facilities, now explicit backstopping), but only current TARP recipients are being put through the wringer! Goldman and the others who were allowed to slip the TARP leash should be subject to the same level of scrutiny as AIG. They were every bit as dead as of October 2008, and their current high profits are the result of an engineered super favorable environment and a failure to make them carry vastly more in the way of equity capital.

But that conundrum raises a much bigger issue. Pay is the wrong way to tackle this problem. It’s a lazy, crowd-appeasing, intellectually dishonest approach. The out of line pay is a symptom, and any attempt to treat symptoms as causes is likely to be ineffective, more likely dysfunctional.

The fact is that policy has encouraged and enabled financial firms to run massive risks with way too little in the way of risk reserves. Not only have they gotten good at playing the regulatory game, but they have also become highly skilled at shifting risks onto chumps (AIG being the poster child).

Now why is trying to control this through pay not such a hot idea? First, one hundred years of performance appraisal systems have proven them to be abject failures (aa 1992 paper by
Patrick D. Larkey and Jonathan P. Caulkin, “All Above Average and Other Unintended
Consequences of Performance Appraisal Systems,” did a brilliant job of dissecting why, but it was too heretical to get published. You can read a few key points here in the section “The Illusion of Meritocracy”). Second, comp systems are supposed to solve what is called a principal-agent problem. You the person hiring someone to work on your behalf wants to make sure they are operating in accordance with YOUR best interests in mind, not theirs.

But what did we learn from 20 years of executive rewards schemes that had lots of equity incentives that would supposedly align the interest of top brass with that of shareholders. We got instead an explosion of CEO pay and companies that are so fixated on quarterly earnings that they are reluctant to invest in growth. How did that come to pass?

BECAUSE THE AGENTS AND NOT THE PRINCIPALS DESIGNED THE PAY SCHEMES!  The foxes were running the hen house. Oh, sure, we had some fig leaves, it was the HR department that hired the compensation consultant, and the board (nominated by the incumbent management) that signed off on it, but it is pretty clear that a comp consultant that did not deliver a CEO-wallet-fattening plan was unlikely to get much repeat business.

And is anything going to be materially different? No. The conventional wisdom is that having employees take a high level of pay as equity is a magic solution, conveniently forgetting that Bear and Lehman both featured very high levels of shareholding among its top management and employees. Feinberg is only intervening in outliers, to collect a few scalps. He is in a very difficult position and is trying to make the best of it.

The financial services industry now has an unimaginably rich deal: privatized gains and socialized losses, and with tons of leverage too, which amps up the apparent profits and hence the pay levels these looters can claim they deserve. The way to attack this problem is to constrain the level of risk assumption. That in turn requires understanding the products and the markets, something the authorities have completely abdicated. With so much “talent” looking for jobs, now would be the perfect time to invest in catching up.