I think Brad DeLong has hit upon the right answer of what we need to do about compensation at AIG and firms in need of TARP money:
The engineers of Silicon Valley startups are significantly smarter and work a lot harder than do the traders of Wall Street. Some of the engineers of Silicon Valley make fortunes: they are compensated with relatively low salaries and large restricted equity stakes in the startup businesses they work for, and so if the businesses do well they do very well indeed–in the long run, in the five to ten years it takes to assess whether the business is in fact going to be a viable and profitable going concern. And the engineers of Silicon Valley have every incentive to use all their brains and all their hours to make their firm viable and successful: they get their cash only at the end of the process. They don’t get big retention bonuses if they stick around until the end of a calendar year. They don’t get big payouts if they report huge profits on a mark-to-market basis.
The traders of Wall Street, by contrast, get their money largely up front. If the mark-to-market position is good, they get paid–even though it is almost surely the case that nobody has tried to actually sell the entire position to somebody else. If the strategy produces short-run profits, they get paid–even though not nearly enough time has passed for anybody to be able to assess what the risks involved in the strategy truly are. They get “traders’ options”–we claim that we have made you a lot of money, we claim that the positions and strategies we have left you, the stockholders, with are sound, we claim that we have correctly managed our risks–but we are not interested in putting our own personal money where our mouths are but instead we insist on getting our fortunes up front.
The failure of the major institutions of Wall Street to adopt Silicon Valley compensation schemes in the 1980s and 1990s was always a great worry to regulators and policymakers. The strong view was that the venture capitalists of Silicon Valley knew what they were doing and were acting as prudent and responsible agents of their investors when they insisted on SVCS for their startups. So why didn’t the shareholders of the major banks do the same with their traders, quants, and strategists? The decisive argument in regulatory and policymaker bull sessions about this issue was that this was the shareholders’ business–that if the shareholders of these companies thought that there was good reason to elect board members and CEOs who did not impose SVCSs, the government should be cautious about stepping in. And the argument that “maybe the shareholders know of some good reason not to adopt SVCSs” no longer applies: we are the shareholders, we know of no reason, and we see no reason not to align the interests of our employees at AIG and at TARP-receiving companies with the long-run interests of the U.S. Treasury.
Therefore: punitive taxes on excessive immediate cash payouts paid by TARP and other government financial commitments are, I believe, completely appropriate. But thou shalt not bind the mouths of the kine that tread the corn: traders and financial executives who are willing to work very hard for what are now government-owned enterprises should be offered the carrot of long-term restricted equity stakes: that if they do their jobs well and if the government makes a healthy return because of their skill, forethought, and diligence, they should make healthy returns as well.
Punitive taxes on compensation that takes the form of long-term restricted equity stakes is a dangerous and destructive move. If the compensation bill that emerges from the conference committee does not allow TARP-receiving companies to offer such SVCSs, then Obama should veto it.
And if the traders of Wall Street then quit en masse? If they say that they are going to “Go Galt” if they don’t get their traders’ options to take the money upfront after assuring us shareholders that they have made us a lot of money, that their positions and strategies are sound, and that they have prudently managed the risks? Well, then that tells us something about what they really think the true value of their work product has been.
The Senate can and should step in here and offer a bill of this sort. That would take the worthy impulse behind the House bill and temper it in a more workable, more constructive way.