The Bonus Problem at AIG

People who know me are going to be a bit surprised at this article, since I am basically going to say that we should not be quite so knee-jerk opposed to every bonus being paid out at now-moribund AIG. I certainly was opposed to top executives getting large and generous compensation packages while the companies that they ran were crashing to the ground, but I am not opposed to all bonuses for all employees, simply because a company like AIG has many different divisions and many different employees and not all of them are necessarily undeserving of receiving bonuses.

There is no doubt that appearing to award bonuses in a time of financial crisis and government bailout looks bad, but why should one be willing to overlook some of it? Not even overlook, really, perhaps even support.

First of all, $165 Million in bonuses does sound like a lot of money, and I certainly wouldn’t mind receiving something like that myself. When compared with the $173 Billion of US government assistance, however, this comes to less than 1/10 of 1% of the total, so the brouhaha that is being stirred up over the bonuses is about the application of a tiny fraction of public money that has been contributed to addressing the problem. Politically, this is primarily a symbolic problem about the public’s unease with what seems to many to be “socialism for the rich,” while the less fortunate are at risk of being left out in the cold. It is symbolic in the way that republican pundits have attempted to use a tiny portion of Obama’s budget for “volcano monitoring” - something that sounds silly and frivolous at first blush - as a way to attack the entire budget plan and structure.

So what we are arguing about is really a tiny portion of the overall bailout, and it is mostly a fight over symbols and principles to be applied in the normalization of the financial and economic system.

No bonuses for top executives.

Part of the issue here is that bonuses are commonly understood as extra compensation for superior performance, and in an environment where the company has cratered into the ground, it is hard to imagine any performance that should be rewarded. This is why I’ve always argued that bonuses to the top executive staff should not be paid to recipients of taxpayer bailouts as a matter of principle. These officers were charged with the health and management of the entire company and have clearly failed. To pay out a bonus in bad times runs against the idea that one gets a bonus for good performance, since these officers have performed about as poorly as can be imagined, and still seem to be eligible for extra compensation.

In fact, when asked what is it that top officers do that justifies the enormous compensation packages that they receive, the answer typically comes back as “we get paid a lot because we take on much greater risk than a typical worker does: when we do well, we are paid handsomely; when we do poorly, we are paid much less (or not at all).” The problem here is that paying bonuses in bad times seems to guarantee that even in bad times, one can count on enormous compensation, which fuels the perception that the game is hopelessly rigged.

For the top management, the rules of risk ought to apply - if you get well paid in good times, you need to accept the risk of being paid (extremely) poorly in bad times.

I have heard some market professionals argue that “it’s important to remember that executive base salaries aren’t that much.” The base salaries of many junior professionals are frequently around $120,000 per year, senior professionals higher than that, and so it is not unreasonable to say that the base salaries that “aren’t that much” are still 2-5 times higher than the median US salary (about $52,000/year). So the “but the base is so little” argument isn’t going to hold much water with most of the public. Besides, after hearing from the likes of Rick Santelli about “losers getting into mortgages they can’t afford,” is it so unreasonable to expect those making multiple millions in the good years to have set aside at least some of that for a rainy day?

But are all bonuses undeserved?

So no bonuses for top management that is charged with the health of the entire company. But a large company is composed of several parts, and it is not unheard of for companies to be taken down by some failed segments of their business while other segments have performed acceptably. For example, while the CDS business clearly involved a lot of excessive risk-taking, but there may well have been researchers in the equity segment of the company portfolio managers that managed to do well, even if those benefits were small in relation to the collapse of the other portions of the business. These portions of the business did indeed add value, in the sense that if these employees had not performed well, the damage to the company and the taxpayer bill would be even higher.

These employees are not undeserving of rewards for their efforts, neither from their employers, nor from the taxpayer at large. So if the 0.1% of bailout money is going to induce them to stay on and contribute their sensible insights to the rescue and recovery of the company, I am not going to insist that they be cut off from their incentives, even if I have to pay for it. The overall benefit to the public interest is likely justified.

Now, I don’t know if the bonus money is actually going to people with those qualifications, but I would want to know this kind of information before jumping to conclusions about whether the bonuses are justified or not. Just because the company as a whole did badly, not everyone in the company did badly, and if the company is going to continue to operate, then those who actually did perform should be rewarded according to their contracts.

“Bonus” as a misnomer?

In Latin, “bonus” is the adjective meaning “good,” so like a dog getting a bone, an employee is thought to get a bonus for being good. But in the real world of labor contracts, some bonuses are simply designed to be deferred compensation that gets paid out as a lump sum. In many cases, this is to induce people to leave an existing company, or stay long enough to justify investments like training, or time to get up-and-running. These “bonuses” are not actually awards for good behavior or performance; they are simply lumped into the “bonus” line-item for accounting purposes.

So what we may be objecting to is not the payment of rewards for positive performance when no positive performance is evidenced, but the payout of contractual obligations that just happened to be labeled as bonuses.

If the United States is taking ownership of AIG (as it has by basically taking it into conservatorship without a regular bankruptcy proceeding), then it really should honor those kinds of contractual agreements, because it is important to retain what talent exists in these organizations.

So what we need to do is separate which parts of the “bonus” package is actual pay-for-performance, and figure out which parts are residuals of deferred compensation that were simply lumped into a bonus line item for accounting purposes. Again, if the company goes into full bankruptcy and ceases to operate, we can get out of these contracts, but unless one is willing to let that happen, those portions of labor contracts ought to be honored.

The Value of Bankruptcy

John Hussman’s commentaries surrounding the crisis have convinced me even more that the government needs to develop or revise a policy for managing large companies that are insolvent or going into bankruptcies. Hussman argues that bailouts as they currently proceed are essentially bailing out bondholders of a company at the expense of the taxpayers. In a bankruptcy, stockholders are wiped out, and some bondholders are wiped out while others take “a haircut” in reduced value or default-with-partial-recovery. Under the current program, bondholders get made whole by taxpayer.

My sense is that there may need to be a standardized “prepackaged bankruptcy” for large companies in critical sectors whereby the stockholders are wiped out and the bondholders also lose some of their capital. The US Government then takes over those companies deemed critical to a functioning economic and financial system, strips out toxic assets, and recapitalizes these banks so that they can perform their normal economic function of allocating capital to businesses and individuals who have reasonable chances of paying it back. In doing so, this creates a chance for the government to renegotiate labor contracts and “rationalize” the bonus process.

This would effectively be a “nationalization,” but not an “expropriation.” Nationalization of companies is a frightening thought to many because it is frequently associated with the expropriation of private capital from rightful owners (as when oil companies were taken over by national governments, or Hugo Chavez nationalized the power sector in Venezuela). In this case, “nationalization” is not a bad thing because 1) private capital has already been erased by the market, and 2) the nationalization is not driven by an ideological position that the government “ought” to own this kind of company, but by a pragmatic assessment that the economy needs certain types of companies, and the government is presently the only capital provider that can realistically capitalize it.

The key here is that bankruptcy has to happen for this process to work, and that’s why a “standardized pre-packaged bankruptcy” for critical companies in strategic sectors is necessary for the administration to promulgate and publicize.

Bank of the United States Reborn?

The United States had a national bank of the US in the 19th century. From the government’s perspective, the most critical objective for the banking sector should be to have banks with clean and transparent balance sheets that are able to lend money at reasonable rates to solvent individuals and businesses and support economic activities that show a reasonable chance of becoming profitable.

Therefore, one solution is simply to forget the existing banking system entirely, and recapitalize a new bank with the appropriate clean balance sheet. This would solve some of the moral hazard problems involved with taking over existing banks, since we would have a bank that can lend, and those banks that took on too much risk will face the consequences of running that risk.

The main challenge is that creating the physical, financial, and institutional infrastructure, and staffing it with sufficient human capital is a process that can take months or years in an environment where action must be taken quickly. Therefore, the idea of letting banks fail, and only afterwards recapitalizing them makes more sense to me, particularly since - in the process - the bonus packages can be renegotiated.

Perhaps, this is what the Treasury has in mind, and the crisis is still moving too quickly to get to the renegotiations. In that case, I think that 0.1% of the bailout going to retaining human capital is not an unreasonable amount to pay; however there needs to be a fairly clear accounting to ensure that “bonus” money goes only to 1) those in units that really did perform well, or 2) those whose “bonuses” were really just deferred compensation. Even many of the deferred compensation cases need additional sifting through to check if they are truly justified.

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EDIT: Added from a separate conversation on 17 March 2009

I don't think AIG is free to guess which contracts it has to honor and which ones it can just break because it feels like it's good PR.

I suspect that AIG saw that these were contractually mandated, and therefore figured that they could be paid without a problem. And they probably liked the idea of paying them so didn't think through the consequences of doing so while on public dole.

However, AIG is presumably not free to break these contracts without the US Government's explicit license to do so, and government did not create the legislation or executive orders required to do that. Moreover, if these contracts were to foreign nationals, even the US Government might not be free to do it without a major incident. So placing ALL of the blame at AIG's door is not really fair.

That said, it is clear that a smart thing for AIG to do would have been to go to the government and say, "We have a problem," we are contractually obliged to pay these bonuses, and it's clearly not going to look good if we do it, yet we may be sued for amounts costing more than $165M if we don't do it, plus generate tons of ill will and make it difficult to attract human capital to get out of this mess. Can you help us work out a compromise or a legal way out." Not having done that fuels the idea that it's the rich stealing from the poor, and that ends up helping no one.

In short, I think AIG was perfectly happy to do the wrong thing, and they deserve mudslinging for that, but there was also not much latitude inside the organization for properly-spirited executives to do what the public wanted.