Shareholders Alone Can't Correct 'Too Big to Fail'
During a House Oversight Committee hearing in October, a rare bipartisan consensus appeared to be building around a strategy to rein in executive compensation.
"We need to empower the stockholders of public companies to better manage the package of pay and the incentive packages of their key executives," said Representative Darrell Issa of California, the panel's ranking Republican.
"Some constraints on these companies are necessary to protect the safety and soundness of the entire financial system," said committee chair Edolphus Towns, a Democrat from New York. "We need to give the shareholders a way to get this under control."
But while reinforcing shareholder rights may solve other corporate governance problems plaguing the US economy, like sloppy board oversight and managerial incompetence, shareholders are not going to end the bloated pay practices that have sparked outrage over the past year.
Compensation schemes that rewarded risky activity helped usher in the economic crisis. If you can book a huge short-term accounting profit by selling subprime loans, and your own paychecks are tied to those short-term accounting profits, then you don't have to worry about pesky details like whether that subprime loan will ever be paid off--or whether thousands of defaulting subprime loans will bankrupt your company in a few years. If those short-term profits ever turn into long-term pain, your short-sighted bonus metrics will have already made you rich.
It's easy to see why empowering shareholders to deal with bloated CEO pay might be attractive. We've just watched several regulators, from the SEC to the Office of Thrift Suspension to the Federal Reserve, fall down on the job--maybe shareholders who want to see a good return on their investment will exercise more prudence. For many companies, especially at small- and midsize banks, a stronger set of shareholder rights really will help curb corporate abuses. The savings and loan crisis was largely a story of small-bank executives looting their own companies at shareholder expense. The SEC has been far too complicit in allowing management teams to stack the deck against shareholders for far too long, steadily transferring power from those who own companies to those who run them--and blessing whatever lobbying interests the managers might find attractive in the process. In 2007 the SEC issued a rule that made it almost impossible for shareholders to challenge corporate directors in elections, allowing management teams to seal themselves off from shareholder criticism. This past May the SEC proposed amending the rule to allow shareholders to directly nominate directors, but this has not yet been enacted. Congress really does need to restore a set of meaningful shareholder rights.
But at major US banks, the public good and the interests of shareholders are in a fundamental state of conflict. "Too big to fail" financial behemoths have been the source of all the recent bonus outrages; and at "too big" firms, shareholders actually want their executives to be rewarded for taking on excessive risk. It's the smart bet. If the risk pays off, the bank's stock price soars. If the risk backfires, the government will spare shareholders from losses. You can't solve a problem by punting the issue to the very parties who benefit from the imbalance.
It may be hard to believe, but investors have been making this bet for decades. Throughout much of the 1980s the Federal Reserve and other bank regulators bailed out all eight of the nation's largest money-center banks--banks like JPMorgan, Bank of America and Citibank--after all of them got in over their heads making unaffordable loans to developing nations. In the '80s regulators used accounting tricks and funneled taxpayer money through the International Monetary Fund to save the banks, rather than going to Congress for a direct bailout, but the effect was the same, and investors know it. A year after the Great Crash of '08, investors also recognize that the "too big to fail" problem has actually gotten bigger, after emergency mergers designed to stave off collapse turned already giant institutions into great banking beasts.
Nevertheless, the idea of empowering shareholders has been very much en vogue on Capitol Hill, while breaking up the big banks--the only truly viable option to deal with "too big to fail"--has been shut out of the debate. Instead of breaking up the giant banking conglomerates, Congress and the Obama team have made lots of noise about putting them through a special administrative bankruptcy when they fail. This bankruptcy process would allow the administration to shut down a giant firm without wreaking broad financial havoc or bailing out all of its shareholders and creditors. It would be a good plan, if it were a credible threat.
Unfortunately, the market is calling the administration's bluff. The big banks are still able to raise money more cheaply than their smaller competitors, and leverage themselves more heavily. And this too appears to be a smart bet. Read the fine print on the Obama administration proposal: it would allow the government to provide unlimited loans and guarantees, and even purchase unlimited amounts of assets from a faltering financial behemoth--that is to say, bail them out. Policy-makers realize these companies are often too big and too interconnected for regulators to accurately decipher on the eve of collapse, even with special bankruptcy processing. And the "living wills" companies would have to compile won't help, either. Banks intentionally make themselves too big to fail, and by making hundreds of millions of dollars worth of securities and derivatives trades every day, the risks they pose to the financial system are constantly changing. No wonder the government wants to preserve an expansive bailout authority.
But few Democrats are willing to acknowledge this problem, while Republicans insist--astonishingly--that the status quo is just fine. And neither party is facing up to the fact that outrageous paydays are connected to "too big to fail," not just to shareholder accountability. Representative Towns and Issa made the case for expanding shareholder rights at the October House Oversight Committee hearing, while Senator Chuck Schumer and House Financial Services Committee chair Barney Frank have pushed for the same plan elsewhere. The most recent proposal comes from Senate Banking Committee chair Chris Dodd, as part of his massive bill to overhaul financial regulation.
There are basically two ways to limit risky pay. First, you can tax the living daylights out of big paychecks--say, anything in the eight-figure range. (The sheer size of executive pay is a critical part of the risk-reward calculation; if you can't get rich taking outrageous risks, then the risks aren't worthwhile.) Second, you can insist that the vast majority of compensation be tied to the long-term health of the firm. If an executive can't cash out her stock options for five or six years after she receives them, she has a much lower incentive to score short-term profits by taking on loads of long-term risk. This second path is basically what pay czar Ken Feinberg just imposed on seven bailout recipients, although Feinberg settled on a shorter time frame. The Dodd legislation, by contrast, would empower regulators to crack down on any pay practices that endanger the financial system. If regulators wanted, they could impose a set Feinberg-like restrictions on CEO pay at any bank, not just bailout recipients.
And Dodd also offers several other pro-shareholder plans that would do a lot of good. But Dodd would not break up the banks whose failure might endanger the broader economy, while his plans to regulate CEO pay include at least one fatal loophole. Take a look at Section 956 of the bill. It says that companies will have to disclose to shareholders whether their employees (read: executives) are allowed buy derivatives to hedge against any decline in the value of the company's stock. That means bankers can bet that their stock holdings are going to dive, and win big.
If a CEO gets paid in stock that can't be cashed out for five years, that's good. But if the CEO can buy a derivative protecting himself against any decline in the value of that stock over the next five years, this time requirement becomes utterly meaningless. Even if the stock loses value thanks to his reckless leadership, he still gets paid as if it were still booming on those short-term profits. It's a slap in the face for anybody interested in actually putting a stop to dangerous pay practices.
What's worse, Dodd's legislation effectively eliminates the SEC's ability to regulate or ban the use of derivatives to secure giant bonuses. Companies will only have to tell shareholders they allow their employees to buy derivatives to hedge their stock compensation. They don't even have to say when employees actually do it, which employees do it or how much they scored on the scam. But by explicitly protecting derivatives trades by insiders, Dodd renders his other language empowering regulators to crack down on risky pay practices empty, requiring nothing but an extra sentence of pointless boilerplate text in one SEC filing each year.
But even if Dodd's gaping loophole were closed, the truth is, tying executive pay to long-term performance would only fix the compensation problems at firms that are small enough to actually fail. Executives will still be willing to take big risks with their own long-term stock holdings if they know the government will bail them out. And the bailouts themselves will in turn secure windfalls for those executives.
When we express outrage over banker pay, we are partly discussing a dangerous practice--compensation tied to short-term profits created an appetite for excessive risk-taking on Wall Street. But we're also talking about deep-rooted democratic conceptions of fairness and equality. About 40 million Americans were living in poverty in 2008, according to the latest Census figures. It's just obscene that some people, particularly bankers charged with allocating economic resources, could take home multimillion-dollar paychecks in that environment. If we cede the bonus debate to the realm of ownership rights--that is to say, shareholder rights--we're missing a critical moral dimension to the issue. Systemic risk aside, people simply shouldn't be allowed to get wildly wealthy while a huge portion of the population lives in poverty. The best solution to that problem is a heavier tax on upper-echelon incomes--including grotesque bonuses--which can be converted into public benefits.
So we have to tie CEO pay to the long-term performance of companies, rigorously tax giant paydays and break up "too big to fail" financial institutions. These aren't fascist or socialist takeovers. They aren't even particularly progressive: progressive taxation, regulating dangerous industries and trustbusting were key elements of Republican President Theodore Roosevelt's domestic policy. But the first two can't succeed without the third. Even executives who know they're risking big losses on their own long-term stock will be willing to take outrageous gambles if they think the government will bail them out. If President Obama and Congress don't end "too big to fail" as part of their financial overhaul, they will codify excessive pay on Wall Street and set the economy up for another crisis.