Thursday, December 18, 2008

Is compensation to blame?

History will look for answers to what caused the problems, but somewhere in that mix, compensation has to be a part of the problem. From increasing an already risky environment, to rewarding lending to questionable borrowers, to creating incentives to increase information asymmetries, compensation practices have to be examined.

From the NY Times:
The Reckoning - On Wall Street, Bonuses, Not Profits, Were Real - Series -
"Merrill’s record earnings in 2006 — $7.5 billion — turned out to be a mirage. The company has since lost three times that amount, largely because the mortgage investments that supposedly had powered some of those profits plunged in value.

Unlike the earnings, however, the bonuses have not been reversed.
and later:
"“Compensation was flawed top to bottom,” said Lucian A. Bebchuk, a professor at Harvard Law School.... “The whole organization was responding to distorted incentives.”Even Wall Streeters concede they were dazzled by the money. To earn bigger bonuses, many traders ignored or played down the risks they took until their bonuses were paid. Their bosses often turned a blind eye because it was in their interest as well."
In other words, when you pay a year at a time and payoffs are not for many years down the road, it seems to be a problem that is exasperated by, while simultaneously exasperating, information asymmetries. Then when you add to this mix the idea that the bonus (or stock option plans) increase in value with risk, you have a recipe that is conducive to excessive risk taking.

For those interested, this is similar in spirit to some of the ideas put forth in John and John's 1993 Journal of Finance article.

People (especially those who want a bonus) will no doubt continue to argue that compensation did not play a role, but I can not even come up with that argument.

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