Dispatches from the Creation Wars

All of the outrage over bonuses for AIG employees has really distracted attention away from the more important issue, which is not whether bonuses should be paid by companies that get government funds but the very nature of corporate bonuses in the financial sector. The Obama administration appears ready to address that larger issue:

Treasury Secretary Tim Geithner will try to cut down on risky behavior by financial institutions by asking them to tie bonuses to the long-term health of the company rather than short-term gains, according to people briefed on his plans.

As part of a broad financial-regulatory plan to be unveiled this week, the administration wants to put in place reforms to get financial incentives for employees closer in line with the actual results of the company. Basically, it’s what bonuses used to be before Wall Street went wild in recent years.

It does not look like they want to place actual limits on bonuses, which would be a bad idea, but want to push for bonuses to be based more on the long-term health of the company and less on immediate results:

Long before the recent focus on AIG bonuses, the administration was looking at how risky behavior in the financial system was driven in part by incentives for executives to take risky bets for a quick return.

But President Barack Obama has no plan to try to cap bonuses, according to the people who were briefed. The administration said it simply plans to update regulations, not control what people are paid.

The mechanisms could include increased disclosure, increased oversight or a bigger role for risk managers in the company…

The new rules will focus on “systemically important financial firms,” said a government official with knowledge of the proposal. “The principals of reform are aimed at getting the financial incentives of employees closer aligned with the interests of their overall institutions.”

Many financial experts have argued that Wall Street pay practices were partly at fault for the stock market meltdown of 2008. That’s because many firms created a “preverse incentive” for traders by paying annual bonuses well before the results of traders’ market moves were known – in effect paying them for taking on risk instead of for producing positive returns.

On my radio show last week I spoke with Mary Kane about how the corporate bonus structure in so many companies puts the incentives in all the wrong places. But I think it goes even deeper than that. Beyond the bonus structure, I think the existence of the stock market also places incentives in favor of short-term bubbles rather than long-term financial stability and profitability for the company.

I first got an inkling of how those incentives operated after a company I worked for in the 1990s, Papa John’s Pizza, went public. I oversaw several stores for a franchisee and I can recall conversations with people from the corporate office comparing our franchise stores to corporate run stores. For example, they would point to double digit sales increases in corporate stores, but they had to spend double digit figures on advertising to get those increases so the stores weren’t actually making a profit.

The problem was that they were more interested in increasing year to year sales than in making money because they had made projections for sales increases in their reports for the stock market. Once they became publicly traded, the focus was primarily on propping up the value of the stock and if they missed those sales projections then the stock might drop. So they would spend 13 or 14% on advertising to get a boost in sales that didn’t cover that investment. But at the franchise level, where we were not publicly traded, the focus was on keeping each store profitable. And that’s a much more sustainable business model.

But I think the whole stock market works this way. So much of the market these days runs on short term speculation rather than on long term investment in a healthy company that all of the incentives push the company’s executives to create bubbles. And bubbles have to burst.

The same is true of executive pay and bonus arrangements that focus on short term results. The incentives are all wrong and they encourage the creation of short term booms in stock value rather than in maintaining the long term financial health of the company. And that is one big root of the current problems.

Ordinarily I’d be of the opinion that companies that think that way should be allowed to think that way because eventually the market is going to force them out of business. But since we don’t let financial companies go out of business anymore, we require taxpayers to bail them out to the tune of trillions of dollars, I think the government damn well has a say in fixing those incentives.