Of all the decrees that come spewing
continually out of Washington, there is only one that works every time:
the law of unintended consequences.
This past week, the Obama administration slapped a $500,000 cap on cash
compensation for senior financial executives whose firms receive future
federal aid. That put an official U.S. stamp on the outrage of the
In 2008, Wall Street lost more than $35
billion and triggered trillions more in losses around the world -- but
rewarded itself with $18.4 billion in cash bonuses. That defies the
common-sense judgment that it is good results, not bad, that should be
rewarded; most dog owners know better than to give Fang a biscuit after he
takes a chunk out of somebody's finger.
So Wall Street got its just deserts.
Unfortunately, while this move rightfully punishes yesterday's fools, it
may inadvertently create tomorrow's culprits. The Treasury Department
stated that the pay cap is meant to "ensure that the compensation of top
executives in the financial community is closely aligned not only with the
interests of shareholders ... but with the taxpayers providing assistance
to those companies."
If only it were so simple. "The search for
ways to get around this," says one expert on Wall Street compensation,
"started within minutes of the announcement."
For starters, the limits seem to apply only
to "senior executives" -- the chief executive, chief financial officer and
the like -- and not to many of the people who can earn the really big
bucks on Wall Street, like traders, hedge-fund managers and the mad
scientists who cooked up all those derivatives that almost destroyed the
world financial system. Leaving the compensation of these hot shots
intact, while reducing the pay of the people who are supposed to boss them
around, isn't going to make the investing world any safer.
Outsourcing is another way to get around a
pay cap. In 2003 and 2004, managers at Harvard University's giant
endowment came under withering fire from the ivory tower for earning
upward of $35 million apiece. They soon left to start their own firms,
which were promptly hired by the endowment and got paid a percentage of
assets under management rather than a cash salary and bonus. That new form
of payment stopped the criticism cold -- even though it isn't likely the
managers earned any less. Nor did it reduce risk-taking: One spinoff from
Harvard Management Co., Jeff Larson's Sowood Capital, blew up in 2007,
dealing Harvard a $350 million loss.
Wall Street firms could easily follow in
Harvard's wake, spinning off a trading or underwriting operation as a new
company and retaining an ownership stake in exchange for a share of the
profits and losses. The top dogs at the new firm would no longer face
limits on their compensation, but the shareholders' capital at the
original firm -- including taxpayer dollars -- might be at even greater
risk than before.
Finally, the new rules from the Treasury
Department permit Wall Street's "senior executives" to get incentive pay
in the form of preferred stock that can't be cashed in until the taxpayers
get their money back. But there s no rule yet against cashing all of it in
at that point -- what compensation experts call cliff-vesting.
Thus, managers may be tempted to take
greater risks in hopes of speeding up their preferred-stock payoff. If the
risks go bad, Uncle Sam will eat the losses. "It's the classic trader's
option," says George Wilbanks, a managing director at executive recruiter
Russell Reynolds Associates: "Heads I win, tails you lose." He adds,
"That's my biggest fear: that people are going to swing for the fences to
get to the cliff-vest faster."
Psychologist Elke Weber of Columbia
University has a different take. She doesn't feel that managers will
become reckless now to speed up their preferred-stock payoff. But that
risk could rise rapidly as firms come closer to getting Uncle Sam off
The whole financial fiasco is one big
unintended consequence. Securitization was supposed to spread risk to
folks willing to bear it but instead ended up concentrating it in the
hands of people who didn't understand it.
Wall Street imploded largely because the
inmates -- the star traders and quant geniuses -- took over the asylum.
Paying the wardens less won't put the inmates back in their cells.
Write to Jason Zweig at