Thursday, September 18, 2008

AAA Ball

For a while there I was keeping my panic down over the fiscal crisis (all the while being pissed at government decisions to bail out private companies that do stupid crap). Then I read this Reuters article: (h/t: Agitator)
Pressure is building on the pristine "AAA" rating of the United States after a federal bailout of American International Group Inc, the chairman of Standard & Poor's sovereign ratings committee said on Wednesday.

But wait, there's more:
Potential upfront costs to the government of maintaining financial stability could reach 24 percent of gross domestic product in the case of a "deep and prolonged recession," the S&P report said.
Which means that taxes will have to go up and spending will have to go down if that's going to fit into our budget. And if we lose our AAA credit rating, borrowing will get even more expensive.

As many people have pointed out, there are a ton of reasons why we're in this mess right now, but I figure I'll rant a little about one of the hidden reasons for this fiscal crisis. For a while the left has been in high dudgeon over executive pay, and I'm not sure I agree. I don't really care if a CEO gets $30 million a year as long as they're doing their job well. But what bugs me is the fact that if the CEO screws up and costs his/her company billions, the executive will get fired - with an absurd severance package. For example, Merrill Lynch CEO Stanley O'Neal left a smoking crater that required Bank of America's largesse to clean up, and he left with $161 million in exit pay. Lehman Brothers CEO Richard Fuld literally destroyed the company, and gets $65 mil for his services. AIG chief Robert Willumstad leaves a pauper by those standards - he gets a mere $12.8 million.

That's absurd. At least Fannie and Freddie's CEOs don't get squat, but that's because they're government-run enterprises whose very existence probably contributed to this whole thing.

What these severance packages do - and don't for a minute think that the CEOs forget their existence when they're in office - is depersonalize the risk that comes from executive choices. Now imagine that you were an executive, and that you were guaranteed a lifetime of luxury even if you completely screw up. Would you take some reckless chances? Of course you would. After all, there's no personal risk to you - you're set either way. If you succeed, you're a visionary, the very definition of success. If you fail, no biggie - you go home to your family with a few extra million in your pocket while your shareholders and the government pick up the pieces.

And so risks are encouraged, which can be a good thing up to a point. But the severance packages are so bloated that they encourage stupid risks, and this entire crisis was based on a lot of companies taking a lot of stupid risks on these subprime mortgages. If the executives knew that a failed risk would cost them something significant personally, they might have thought twice about these securitized mortgages and our crisis would be a lot smaller.

My point is this: Adam Smith's system was based on "enlightened self-interest." The problem with these severance packages is that they distort self-interest to the point where reckless risks and prudent risks appear the same.

Now I'm not 100% confident that government can regulate severance pay well. Hopefully other companies will leave the financial sector saga with the understanding that their massive severance packages are hurting them in the long run, and will scale back on severance pay in the case of disgraceful termination. The problem is that companies' boards of directors set their own pay, and they're not likely to give themselves severance pay cuts. So barring that, I'm all for a shareholder rebellion. To the barricades, stockholders!


Matthew B. Novak said...

Yeah, but most people vote by proxies assigned by their mutual fund companies, or whatever. How are you actually going to get shareholders to do anything? The way to go might be some sort of breach of duty lawsuit against corporate directors. I don't remember my corporations law though, because it was tedious and Delaware-oriented.

-Dave said...

Executive pay is wacky because the shareholders lack power, and the boards of directors at companies are in the same boat as the CEO, so there isn't a check-and-balance internally.

So I agree - the shareholders need more power, and we need more disclosure (and perhaps even regulation) concerning the power of companies to use stock options to accumulate power and squeeze out the voting power of noninstitutionalized shareholders.

Because I'm nearly 100% confident that the government can't even come close to setting some level of efficient wages. But put more power in the hands of shreholders - enough to set them in opposition to the board and CEO on matters like executive compensation - and let them figure out just what they want to offer.