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The Reward for Failure

As the news about year-end bonuses for Wall Street executives and traders trickles in, it seems to be a very good time to examine two of the most high profile failures during the crisis.  The argument for large executive pay usually comes down to a few running themes: 1) great visionary CEO’s with leadership skills are hard to come by and 2) the cost of a good CEO is much less than the value that he creates for the stakeholders in the firm.  Whether you believe in the size of the salaries and bonuses that some executives are paid, there is one creed that just about everyone believes in: you should be paid for success, not failure.  Jamie Diamond, the CEO of JP Morgan, the 4th largest bank in the world, brought home over $19.6M in 2008 which was over 83 times the amount that the CEO of the largest bank in the world took home.

With the US paying out so much to its executives, it is important to question if we are getting what we paid for

With the US paying out so much to its executives, it is important to question if we are getting what we paid for

It can be argued that Jamie Diamond navigated through the financial storm with tenacity and was able to bring JP Morgan out on the other side with a very solid balance sheet.  It can also be argued that the complexity of the products on American banks’ balance sheets are many times more difficult to manage than the more straightforward loans that Industrial and Commercial Bank of China deals with.  Let us just go with those assumptions.  What about the firms that blew up in a spectacular fashion – Lehman Brothers and Bear Stearns.  How did their executives make out?

That was the question addressed by Bebchuk, Cohen, & Spamann in The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008.  It was widely assumed that the executives of Bear Stearns and Lehman Brothers lost a tremendous amount of wealth as the stocks plummeted towards zero.  The truth is less endearing.  It turns out that the top 5 executives at Bear Stearns took home compensation in the form of bonuses and equity sales of nearly nearly $1.5B between 2000 and 2008.   The top 5 executives at Lehman Brothers did not do quite as well with a mere $1B over the same time period.

$1.5B for the executives at Bear Stearns and $1B for those at Lehman

$1.5B for the executives at Bear Stearns and $1B for those at Lehman

Much of the debate around executive compensation will surely focus on whether the compensation packages actually spurred excessive risk taking.  I do not necessarily want the government to impose restrictions or dissuade risk-taking, but instead feel that they should focus on the rewards for successful risk-taking and the punishments for failure.  I believe the authors of the research piece hit the nail on the head when they said:

“Consider the structure of the firms’ bonus compensation. The executives were able to obtain large amounts of bonus compensation based on high earnings in the years preceding the financial crisis, but did not have to return any of those bonuses when the earnings subsequently evaporated and turned into massive losses. Such a design of bonus compensation provides executives with incentives to seek improvements in short-term earnings figures even at the cost of maintaining an excessively high risk of large losses down the road.”

It might seem like a little bit of the “chicken or the egg” dilemma, but I think that if you ignore the benefits of educated risk-taking you throw the baby out with the bathwater and stifle the American entrepreneurial spirit.  Financial firms can and should take financial risk when they feel that the expected rewards compensate them for the risk.  The most dangerous case is when risk-taking is done recklessly because the firms and executives know that there is a safety net if things go badly.

Bebchuk, Lucian A., Cohen, Alma and Spamann, Holger, The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008 (November 24, 2009).Yale Journal on Regulation, Forthcoming. Available at SSRN: http://ssrn.com/abstract=1513522

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  1. Randy Woods says

    This is a good argument for spreading out bonus compensation over multiple years, like stock options that don’t vest for 5 or 10 years or retirement.



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