Some of my readers have asked me to comment on the financial crisis. Much has been written about it, and beyond the political rhetoric, there are some very intelligent analyses of what happened and why. To me, the three obvious root causes were:
John McCain and others have talked about “corporate greed” as a root cause. I find that to be an oversimplification of reality. Greed works when it rewards people for doing things that benefit everyone; it fails to work when it triggers destructive or highly-risky behavior.
In this case, compensation packages caused greed to trigger excessively risky behavior. The simple reason for this was that, in virtually all these cases, the profit from these instruments and transactions came in immediately and financial services executives were rewarded immediately, but the risk was not evident until much later. This gravitation toward excessive risk was made even worse by pay packages that had no meaningful upward limit. Super-sized annual bonuses or stock option grants magnified the misalignment toward excessively risky behavior.
What made matters worse is that these executives could move on to another organization having pocketed the money from these risky behaviors. Moreover, like stock options, upfront bonuses do not align executives with shareholders and bondholders. If someone makes $100 million in profits for his or her firm in one year and pockets a $10 million bonus, but loses $500 million the next year either because of the same transaction or different transactions, they get no bonus, but they do not give the $10 million back. In effect, the fundamental flaw of compensation systems is that they are aligned only on the upside, not the downside.
Similarly, with stock options, someone can take a number of actions to pump up the stock price, exercise options where there have been gains, pocket the gains, and then leave the firm, leaving future shareholders and executives to clean up the mess from the actions that temporarily pumped up the stock price.
As a member of three public company boards of directors, including an independent director membership on two boards, and as a former CEO, I have always been extremely mindful of making sure that executive pay truly aligned executive rewards with shareholder needs. I particularly focused on insuring that none of the companies I served ever had compensation packages and systems that triggered excessively risky behaviors. As a CEO, I stayed aligned with shareholders by not selling stock, even though there were many times when I could have sold and made much more profit than I will ultimately make. I took this approach because I believe that CEOs have to send a message that they believe in their company’s stock, and that insider selling is a very bad message.
Risk is always an element of business decision making, but we should never create environments in which the risky behavior is rewarded to the extent it was here.