Executive Compensation

Is there a problem? And is there a solution? My answers: yes, and yes.

Here are some numbers for the compensation received in 2006 by some of the folks who helped get us into our current mess:

• Bear Stearns: $34 million for CEO James Cayne. The acknowledged direct cost to the taxpayers from Bear's demise so far is $2.7 billion; ten times that number may be a more reasonable assessment of the actual cost.


• Lehman Brothers: $27 million
  for CEO Richard Fuld. The financial freeze that followed the collapse
  of Lehman is seen by many as the key event that turned the recession of
  2007-08 into the frightening freefall currently under way.


• Citigroup: $25 million for CEO Charles Prince. Citi's stock price has since fallen from $50 a share to $3.50.


• Countrywide Financial: $43 million for CEO Angelo Mozilo. According to Ashcraft and Schuermann,
  Countrywide was at that time the nation's leading issuer of subprime
  mortgage-backed securities and the third biggest originator of subprime
  mortgages.

That these individuals should have profited so richly
from running their companies into the ground, and bringing the rest of
us down with them, offends anyone's sense of justice. But it also
raises a profoundly important question from the perspective of economic
efficiency, in that the above numbers constitute a prima facie case
that there were powerful economic incentives for these individuals to
make decisions that were in fact not in their companies' or society's
best interest.

That the incentives for CEOs need not necessarily coincide with
those of the shareholders is a well understood phenomenon that is a
special case of what economists call the principal-agent problem. This
arises in situations when an agent (in this case, the CEO) has better
information about what is going on than the principals (in this case,
the shareholders) who rely on the agent to perform a certain task. One
way to try to cope with these problems of asymmetric information is to
tie the agent's compensation directly to performance.

What caused that principle to go so badly awry in the present
instance? I believe there was an unfortunate interaction between
financial innovations and lack of regulatory oversight, which allowed
the construction of new financial instruments with essentially any
risk-reward profile desired and the ability to leverage one's way into
an arbitrarily large position in such an instrument. The underlying
instrument of choice was a security with a high probability of doing
slightly better than the market and a small probability of a big loss.
For example, a subprime loan extended in 2005 would earn the lender a
higher yield in the event that house prices continued to rise, but
perform quite badly when the housing market turned down. By taking a
leveraged position in such assets, the slightly higher yield became an
enormously higher yield, and while the game was on, the short-term
performance looked wonderful. If the agent is compensated on the basis
of...

more...http://www.rgemonitor.com/us-monitor/255207/executive_compensation