Magazine | October 19, 2009, Issue

Pop Economics

Greed did not cause the financial crisis; bad investments did

President Obama congregated with world leaders at the G-20 summit in Pittsburgh to reform banks’ compensation practices. It is fitting that they chose the hometown of Andy Warhol as the background for this exercise in pop economics: Like Warhol’s famous portrait of Chairman Mao, President Obama’s economics are superficially appealing but best relegated to the 1970s. And Warhol got it wrong: In the future, everybody will be an executive-compensation expert for 15 minutes.

Barack Obama has got it in his head that there was a global financial catastrophe because executive-compensation boards failed to avail themselves of the wisdom of Barack Obama, who has described compensation practices as “shameful” and “the height of irresponsibility.” And he’s not the only one. A Canadian official dispatched to the G-20 told Reuters that executive pay will be reformed in the direction of “deferring bonuses, building in claw-backs if performance deteriorates, focusing bonuses in things like stock.” FDIC boss Sheila Bair agrees: “We need to make sure that incentives are aligned among all parties by making compensation contingent on the long-run performance of the underlying loans.” Ben Bernanke is on board, saying the Fed will “ask or tell banks to structure their compensation, not just at the very top level but down much further, in a way that is consistent with safety and soundness — which means that payments, bonuses, and so on should be tied to performance and should not induce excessive risk.” Tim Geithner’s singing from the same hymnal: “You want compensation to come substantially in the form of equity in the firm that vests over time, that is at risk, that can be clawed back if returns don’t materialize.” And the omnipresent Anonymous Administration Official chimed in: “This is not going to be about capping compensation or micro-management. It will be about understanding what is the best way to align compensation with sound risk management and long-term value creation.”

Paul Krugman struck a characteristically moralistic tone, writing: “In a nutshell, bank executives are lavishly rewarded if they deliver big short-term profits — but aren’t correspondingly punished if they later suffer even bigger losses. This encourages excessive risk-taking: Some of the men most responsible for the current crisis walked away immensely rich from the bonuses they earned in the good years, even though the high-risk strategies that led to those bonuses eventually decimated their companies, taking down a large part of the financial system in the process.”

With all due respect to the sages of the Beltway and the Nobel Prize committee, this is pure mortadella — which is to say, it’s a lot like baloney, but rarefied and expensive. 

As it happens, these pronouncements come on the heels of the first academic study of the question of bank performance and CEO compensation, a paper from the National Bureau of Economic Research published under the refreshingly straightforward title “Bank CEO Incentives and the Credit Crisis.” The authors, Rüdiger Fahlenbrach and René M. Stulz, of the école Polytechnique Fédérale de Lausanne and Ohio State University, respectively, ask the very question invited by Obama et al., and their results do not support the pop-economics conclusions preferred by Democrats, Eurocrats, and the “Capitalism Done It” school of economics. Prediction: The people who vowed to elevate science over superstition in matters of national policy will ignore the economic science and embrace the emotionally gratifying superstition. 

That there exists a discontinuity between the interests of the owners of capital and those of the managers of that capital is not a blisteringly original insight, having crossed the minds of such noted economists as Jesus (cf. Luke 16:1–13) and Joseph Conrad (cf. Nostromo), and figuring in the work of moral philosophers such as Adam Smith, who wrote: “The directors of companies, being managers of other people’s money than their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own.” So we’ve been working on this problem for a while.

The Fahlenbrach-Stulz study is filled with data and regressions and mathematical deliciousness, but the short version is this: Compensation structures didn’t make much difference. The slightly longer version is this: There was not much significant correlation between different executive-compensation structures at banks and the performance of those banks during the financial crisis; and, to the extent that there was any sort of correlation, executives whose financial well-being was most closely bound with that of their banks tended to perform slightly worse, not better, than executives who had less rigorously performance-based pay. 

Bank CEOs get paid in lots of ways. They get salaries — shocking salaries by the standards of those of us who work outside of Wall Street or Major League Baseball. But those salaries aren’t a big part of their overall paydays. Among the executives studied by Fahlenbrach and Stulz, salary was about 10 percent of total compensation. Executives get cash bonuses, too, but for the most part they are paid in stock: either in the form of regular grants of shares in the companies they manage or in the form of stock options. People who hate Wall Street hate stock options, and they argue that options give executives an unhealthy incentive to push up stock prices in the short term at the expense of the long-term interests of the corporation and its shareholders. You know the story: The CEO loads the firm up with debt, engages in a couple of meretricious transactions, slathers on a rich layer of accounting chicanery, and then cashes in just before the company nosedives and little old ladies with blue-rinsed hair get thrown to Arizona coyotes when their retirement funds evaporate. That’s Barack Obama’s story. But the facts don’t back it up.

The CEOs didn’t dump their stock, and most of them took huge hits to their personal net worth. Fahlenbrach and Stulz found that the typical CEO had employer stock in his portfolio equivalent in value to about ten years’ worth of compensation. This is what is meant by “aligning executives’ interests with those of shareholders” — you make executives shareholders. In fact, the typical bank CEO owned about 1.6 percent of the outstanding shares of his company’s stock, which is a huge amount when you consider that we’re not talking about the First State Bank of Humptulips, Wash., but about Merrill Lynch, Bank of America, etc. Dick Fuld lost a billion dollars when Lehman went toes up, and Sandy Weill lost a half-billion dollars when Citigroup turned ass-over-teakettle. Yes, they’re rich guys, but having a billion dollars at risk goes a long way toward aligning incentives. 

In fact, the CEOs were more conservative than they might have been: Most of the mortgage-backed securities they loaded up on were AAA, but they could have sought higher returns by stocking up on riskier AA or BBB investments. And those credit-default swaps that everybody is lamenting were, it bears keeping in mind, insurance policies on those investments.

Further, if you look at how much money the bank CEOs lost personally, at their transactions before the crisis, and at other indicators of how they were balancing their own interests with those of the shareholders, the populists’ one-word explanation of the crisis — “Greed!” — sounds silly. CEOs did not dump their shares before the crisis. On average, bank CEOs lost $2.7 million on the shares they sold and, more significant, $28.8 million on the shares they held on to. That’s a lot of schmundo, even for Wall Street types. As Fahlenbrach and Stulz report: “Had CEOs seen the crisis coming, they could have avoided most of these losses by selling their shares. They clearly did not do so.” Why? Out of a sense of solidarity with their shareholders? Slim chance, Sunshine. CEOs got pantsed because they thought they were making good investments on behalf of their shareholders — investments that prudently balanced risk with profit opportunities — and they were wrong. Spectacularly wrong. 

Normally, spectacularly wrong investments are a problem only for those who made them. Weep not for Dick Fuld and the ten-digit crater in his checking account. But the bankers’ bad decisions became a global crisis because they all made similar bad decisions at the same time. And the explanation for that fact is not greed but homogeneity — one source of which is regulation. While Barack Obama, Barney Frank, and the rest of the gang are taking a proctoscope to executives’ paychecks, the substantive problems are going, at best, unaddressed. Stephen Spruiell and I have argued in these pages that politics was the main actor in creating the housing bubble, and Jeffrey Friedman of the University of Texas recently made a persuasive case that Basel rules encouraged banks to load up on mortgage-backed bonds by giving those securities a more attractive risk weighting than that assigned to the mortgages themselves. Greed is a Deadly Sin, but it does not seem to be what caused the crisis. Regulation — the nitty-gritty, boring specifics of it — has been at least as much of a problem as it is a potential solution.

You’ve heard a thousand moralistic speeches about Wall Street greed and outlandish executive compensation. You probably have heard not one speech about Basel risk-weighting rules. But shouting “Greed!” does about as much to explain the financial crisis as shouting “Beelzebub!” or “Mister Snuffleupagus!” If we allow our policies to be shaped by Obama’s millimeter-deep pop economics, by economic superstition rather than by economic fact, we are setting ourselves up to solve “problems” such as CEO pay that are not, probably, problems — certainly not national political problems — while substantive concerns go unaddressed. Denouncing CEOs in jactitations of populist rage is a fruitless exercise, but one that makes you feel good, for a short, sharp moment. There’s a biblical word for that, too (cf. Genesis 38:9), and it ain’t “usury.”

 

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