On Compensation: Perverse and Otherwise

For those on the left put aside for a moment your loathing of corporate greed (as I think you define greed, i.e. making large amounts of money in absolute terms, irrespective of performance). For those on the right put aside, for a moment, your contempt for public sector employee laziness (as I think you define laziness, i.e. jobs and raises divorced from productivity and protected by political forces).

When I look at the AIG bonus imbroglio I see a controversy where there's more to it than meets the eye, especially since the "meets the eye" portion of the story is framed by professional politicians in front of microphones and cameras. Allow me to put you inside a trader's mind. Believe it or not, they're not evil. They are however laser focused on minimizing risk and maximizing return. And they, like everyone else, want what they negotiated (which at least in some AIG cases included getting paid $1/year and a retention bonus for unwinding positions to minimizing the firm's, and thus the U.S. Government's, exposure). Post bailout they weren't asked to make AIG money, they were asked to help AIG lose less. Believe it or not, it isn't easy.

While nearly everyone else may not consider them worth the money, as a compensation matter they're really no different from professional athletes. Teachers are far more important to society than NBA players, but it's much harder to play in the NBA than become a teacher. Moreover, the NBA is designed to reward individual contribution and deliver unambiguous profit. Schools are not. Scarcity and unambiguity drive wealth toward Kobe Bryant instead of my 5th grade teacher.

In the context of trading, ethical and honest means living by the rules ex ante (altering outcomes ex post is, or should be, poison). Two of those rules are:
  1. Make as much money as possible as risklessly as possible as quickly as possible.
  2. If a trader has access to a "heads I win tails you lose" compensation scheme he'll capitalize like there's no tomorrow.
It's management's job to enable Rule #1's upside without exposing the firm to Rule #2's downside. From the AIG trader's perspective, he took one for the team (getting paid $1/year + a contingency payment) despite having more remunerative career choices. In sum, he did what he was asked to do and the company has the capital to consummate his contingency payment (a payment known to the relevant regulators BTW). If the company is insolvent, illiquid or in bankruptcy that's a different matter, which is a big flaw in the model, but most grownups understand this.

If management negotiated a compensation scheme that threatens the viability of the organization, that's management's fault. It's the exact same view unions, public sector and otherwise, have taken for years (if management was on both sides of the negotiating table, which was the case in AIGFP pre-bailout, that's the Board's fault). Now look at this story about the U.S. Postal Service. It's losing money like crazy. Reducing service and retiree obligations can help, but management overpromised to employees so much its survival is in doubt. Don't blame the employees or unions for this, however. Their job is to negotiate the best possible deal for themselves and management is charged with striking a tenable balance. They didn't, so now the organization is in peril.

It's easy to understand the perversity of advocating paying some dude at AIG a million bucks while cutting the hours of a $35,000/year postal clerk. But the AIG trader is harder to replace than the postal clerk and the AIG retention payments in aggregate don't threaten the long-term viability of the company, particularly since it's being wound down (the comp structure at AIGFP helped kill the company, not the absolute amount). At USPS the combined amount of retirement benefits for employees does threaten the organization's future, political protection notwithstanding.

Markets pay up for that which is desired and scarce, even if we don't like it. Calling someone lazy, stupid or greedy doesn't make any difference.


Anonymous said...

Maybe. Of course, when an investor puts 170 billion into a company, they get some say into its policies. Paulson, Geithner, and their cronies apparently do not consider their ultimate boss, the U.S. taxpayer, to be worth exercising this influence.

I work at a company that got into some financial trouble, and I was offered a retention bonus. It was 10% of salary, and I make a lot less than you RightSiders.

As far as good traders being as rare as Michael Jordan, oh give me a break.

Chris Janc said...


First of all, the government DID have its say. It passed legislation explicitly approving these payments. What it is doing now is reacting to outrage after the fact. Geithner & Co understand, as most taxpayers do not, that keeping the traders in place is the best way to minimize potential losses on the positions in place right now.

Pander, one thing that really gets lost in all of this is that the people that collected retention bonuses were being asked to work themselves out of a job. Ask anyone on the street what they would do in this scenario. 9 out of 10 (if not all 10) would likely say that they would start looking immediately for new work as well as evaluate the hours spent at work relative to the pay offered. Without retention bonuses, most of these traders would have left a long time ago. Like it or not, these are wealthy people who could find work elsewhere or trade for their own account and HAD to be incented to stick around. That so many stayed and lived up to their end of the bargain and are now being intimidated into returning their compensation is the shameful part of all of this. I wish more people would recognize this fact.