Boneheaded Compensation Plans #1

Dec 19, 2008

In a New York Times op-ed piece this morning, Paul Krugman rails about the excessive compensation that “Wall Street” has extracted from the economy over the last few years. He makes the interesting observation that over the last few years, the share of GDP going to the finance sector has risen from 5% to 8%.

In a $10 trillion economy, that is a LOT of money. Krugman goes on to speculate that much of that increment has gone to dramatically increased executive compensation in that sector, a speculation that is probably accurate. And what have we gotten for all that extra pay? Uhhh, not much. To say the least.

And what is the cause of this excessive compensation? Well, greed, of course. But so what? Market systems run on greed, a natural human behavior, and the job of senior management (and stockholders) is to ensure that greed is properly channeled into useful behavior. What’s really wrong is something just as fundamental: BONEHEADED COMPENSATION PLANS! (Sorry if I’m using overly technical terms here.)

Consider, for example, a bank executive overseeing mortgage lending. A bonus plan based simply on total loan production – an approach that I’m sure is widespread – would reward him for sheer volume of loans produced, no matter how schlocky (again with the technical terms) the loans were. Suppose instead, though, that the bonus is structured so that some of the bonus is earned when the loan transaction closed, but the remainder is paid as the loan gets paid back. Such a plan would (a) encourage the executive to focus on loans to better credits and, as an added plus to the bank, (b) encourage employee retention, since the executive would stop receiving the bonus if he went to another company. And the executive’s behavior would be much more in line with what the bank’s interests really are.

For a depressingly high percentage of executive bonus plans that in retrospect were outrageously generous, the cause is nothing more evil than just unclear thinking and poor communications. The solution isn’t rocket science; it just takes a little focus, and the recognition that people behave the way you pay them to behave.

The good news is that there are creative solutions. For example, today’s Wall Street Journal reported that a significant portion of this year’s bonuses at Credit Suisse Group would be paid in the form of various illiquid, junky assets like corporate loans. This “lump of coal in the stocking” approach has a certain rough justice, especially since those assets could turn out to be more valuable than their current book value.

And folks, the title includes “#1” because I’m certain there will be many more posts in the area of boneheaded comp plans. Thank God for boneheadedness!

“Painting with Numbers” is my effort to get people talking about financial statements and other numbers in ways that we can all understand. I welcome your interest and your feedback.

Purchase your copy of painting with numbers today