4

Heads—They Win a Ridiculously Enormous Amount; Tails—They Win Just an Enormous Amount

But what about the executives of Bear Stearns, Lehman Brothers, or Merrill Lynch? Their investments were much less diversified than those of the equity holders. Year after year, the executives were being paid in cash and stock options until their equity holdings in their own firms became a massive part of their wealth. Wouldn’t that encourage prudence?

Let’s go back to the poker table and consider how the incentives work when the poker player isn’t just risking his own money alongside that of his lenders. He’s also drawing a salary and bonus and stock options while he’s playing. Some of that compensation is a function of the profitability of the company, which appears to align the incentives of the executives with those of other equity holders. But when leverage is so large, the executive can take riskier bets, generating large profits in the short run and justifying a larger salary. The downside risk is cushioned by his ability to accumulate salary and bonuses in advance of failure.

As Lucian Bebchuk and Holger Spamann have shown, the incentives in the banking business are such that the expected returns to bank executives from bad investments can be quite large even when the effects on the firm are quite harmful. The upside is unlimited for the executives while the downside is truncated:

Because top bank executives were paid with shares of a bank holding company or options on such shares, and both banks and bank holding companies obtained capital from debt-holders, executives faced asymmetric payoffs, expecting to benefit more from large gains than to lose from large losses of a similar magnitude….

Our basic argument can be seen in a simple example. A bank has $100 of assets financed by $90 of deposits and $10 of capital, of which $4 are debt and $6 are equity; the bank’s equity is in turn held by a bank holding company, which is financed by $2 of debt and $4 of equity and has no other assets; and the bank manager is compensated with some shares in the bank holding company. On the downside, limited liability protects the manager from the consequences of any losses beyond $4. By contrast, the benefits to the manager from gains on the upside are unlimited. If the manager does not own stock in the holding company but rather options on its stock, the incentives are even more skewed. For example, if the exercise price of the option is equal to the current stock price, and the manager makes a negative-expected-value bet, the manager may have a great deal to gain if the bet turns out well and little to lose if the bet turns out poorly.1

George Akerlof and Paul Romer describe similar incentives in the context of the S&L collapse.2 In “Looting: The Economic Underworld of Bankruptcy for Profit,” they describe how the owners of savings and loans would book accounting profits, justifying a large salary even though those profits had little or no chance of becoming real. They would generate cash flow by offering an attractive rate on the savings accounts they offered. Depositors would not worry about the viability of the banks because of Federal Deposit Insurance Corporation (FDIC) insurance. But the owners’ salaries were ultimately coming out of the pockets of taxpayers. What the owners were doing was borrowing money to finance their salaries, money that the taxpayers guaranteed. When the S&Ls failed, the depositors got their money back, and the owners had their salaries: the taxpayers were the only losers.

This kind of looting and corruption of incentives is only possible when you can borrow to finance highly leveraged positions. This in turn is only possible if lenders and bondholders are fools—or if they are very smart and are willing to finance highly leveraged bets because they anticipate government rescue.

In the current crisis, commercial banks, investment banks, and Fannie and Freddie generated large short-term profits using extreme leverage. These short-term profits alongside rapid growth justified enormous salaries until the collapse came. Who lost when this game collapsed? In almost all cases, the lenders who financed the growth avoided the costs. The taxpayers got stuck with the bill, just as they did in the S&L crisis. Ultimately, the gamblers were playing with other people’s money and not their own.

But didn’t executives lose a great deal of money when their companies collapsed? Why didn’t fear of that outcome deter excessive risk-taking on their parts? After all, Jimmy Cayne, the CEO of Bear Stearns, and Richard Fuld, the CEO of Lehman Brothers, each lost over a billion dollars when their stock holdings were virtually wiped out. Jimmy Cayne ended up selling his six million shares of Bear Stearns for just over $10 per share. Fuld ended up selling millions of shares for pennies per share. Surely they didn’t want this to happen.

They certainly didn’t intend for it to happen. This was a game of risk and reward, and in this round, the cards didn’t come through. That was a gamble the executives had been willing to take in light of the huge rewards they had already earned and the even larger rewards they would have pocketed if the gamble had gone well. They saw it as a risk well worth taking.

After all, their personal downsides weren’t anything close to zero. Here is Cayne’s assessment of the outcome: “The only people [who] are going to suffer are my heirs, not me. Because when you have a billion six and you lose a billion, you’re not exactly like crippled, right?”3

The worst that could happen to Cayne in the collapse of Bear Stearns, his downside risk, was a stock wipeout, which would leave him with a mere half a billion dollars gained from his prudent selling of shares of Bear Stearns and the judicious investment of the cash part of his compensation.4 Not surprisingly, Cayne didn’t put all his eggs in one basket. He left himself a healthy nest egg outside of Bear Stearns.

Fuld did the same thing. He lost a billion dollars of paper wealth, but he retained over $500 million, the value of the Lehman stock he sold between 2003 and 2008. Like Cayne, he surely would have preferred to be worth $1.5 billion instead of a mere half a billion, but his downside risk was still small.

When we look at Cayne and Fuld, it is easy to focus on the lost billions and overlook the hundreds of millions they kept. It is also easy to forget that the outcome was not preordained. They didn’t plan on destroying their firms. They didn’t intend to. They took a chance. Maybe housing prices plateau instead of plummet. Then you get your $1.5 billion. It was a roll of the dice. They lost.

When Cayne and Fuld were playing with other people’s money, they doubled down, the ultimate gamblers. When they were playing with their own money, they were prudent. They acted like bankers. (Or the way bankers once acted when their own money or the money of their partnership was at stake.)5 They held a significant number of personal funds outside of their own companies’ stock, making their downside risks much smaller than they appeared. They each had a big cushion to land on when their companies went over the cliff. Those cushions were made from other people’s money, the money that was borrowed, the money that let them make high rates of return while the good times rolled and justified their big compensation packages until things fell apart.

What about the executives of other companies? Cayne and Fuld weren’t alone. Angelo Mozilo, the CEO of Countrywide, realized over $400 million in compensation between 2003 and 2008.6 Numerous executives made over $100 million in compensation during the same period.7 Lucian Bebchuk, Alma Cohen, and Holger Spamann have looked at the sum of cash bonuses and stock sales by the CEOs and the next four executives at Bear Stearns and Lehman Brothers between 2000 and 2008. It’s a very depressing spectacle. The top five Bear Stearns executives managed to score $1.5 billion during that period. The top five executives at Lehman Brothers had to settle for $1 billion.8 Nice work if you can get it.

The standard explanations for the meltdown on Wall Street are that executives were overconfident. Or they believed their models that assumed Gaussian distributions of risk when the distributions actually had fat tails. Or they believed the ratings agencies. Or they believed that housing prices couldn’t fall. Or they believed some permutation of these many explanations.

These explanations all have some truth in them. But the undeniable fact is that these allegedly myopic and overconfident people didn’t endure any economic hardship because of their decisions. The executives never paid the price. Market forces didn’t punish them, because the expectation of future rescue inhibited market forces. The “loser” lenders became fabulously rich by having enormous amounts of leverage, leverage often provided by another lender, implicitly backed with taxpayer money that did in fact ultimately take care of the lenders.

And many gamblers won. Lloyd Blankfein, the CEO of Goldman Sachs, Jamie Dimon, the CEO of J. P. Morgan Chase, and the others played the same game as Cayne and Fuld. Goldman and J. P. Morgan invested in subprime mortgages. They were highly leveraged. They didn’t have as much toxic waste on their balance sheets as some of their competitors. They didn’t have quite as much leverage, but they were still close to the edge. They were playing a very high-stakes game, with high-risk and potential reward. And they survived. Blankfein’s stock in Goldman Sachs is worth over $500 million, and like Cayne and Fuld, he surely has a few assets elsewhere. Like Cayne and Fuld, Blankfein took tremendous risk with the prospect of high reward. His high monetary reward came through, as did his intangible reward in the perpetual poker game of ego. Unlike Cayne and Fuld, Blankfein and Dimon get to hold their heads extra high at the cocktail parties, political fundraisers, and charity events, not just because they’re still worth an immense amount of money, but because they won. They beat the house.

But does creditor rescue explain too much? If it’s true that bank executives had an incentive to finance risky bets using leverage, why didn’t they take advantage of the implicit guarantee even sooner, investing in riskier assets and using ever more leverage? Banks and investment banks didn’t take wild risks on Internet stocks leading to bankruptcy and destruction. Why didn’t commercial banks and investment banks take on more risk sooner?

One answer is that when the guarantee is implicit, not explicit, creditors can’t finance any investment regardless of how risky it is. If a bank lends money to another bank to buy stock in an Australian gold-mining company, it is less likely to get bailed out than if the money goes toward AAA-rated assets (which are the highest quality and lowest risk). So some high-risk gambles remain unattractive. That is part of the answer. But the rest of the answer is due to the nature of regulation. In the next section, I look at why housing and securitized mortgages were so attractive to investors financing risky bets with borrowed money. Bad regulation and an expectation of creditor rescue worked together to destroy the housing market.

NOTES

  1.  Lucian A. Bebchuk and Holger Spamann, “Regulating Bankers’ Pay,” Georgetown Law Journal 98, no. 2 (2010): 247–287, http://ssrn.com/abstract=1410072.

  2.  George Akerlof and Paul Romer, “Looting: The Economic Underworld of Bankruptcy for Profit,” Brookings Papers on Economic Activity 24, no. 2 (1993): 1–74, http://ideas.repec.org/a/bin/bpeajo/v24y1993i1993-2p1-74.html. See also William Black, The Best Way to Rob a Bank Is to Own One: How Corporate Executives and Politicians Looted the S&L Industry (Austin: University of Texas Press, 2009).

  3.  Cohan, House of Cards, 90.

  4. Cayne sold down from his largest holdings of about seven million shares to six million. Some of those sales presumably took place near the peak of Bear Stearns’s value. Others may have occurred on the way down, and, of course, the sale of his six million Bear Stearns shares at the end did net him $61 million.

  5.  One of the standard explanations for the imprudence of Wall Street was the move from partnerships to publicly traded firms that allowed Wall Street to gamble with other people’s money. There is some truth to this explanation, but it ignores the question of why the partnerships were replaced with publicly traded firms. The desire to grow larger and become more leveraged than a partnership would allow was part of the reason, but that desire isn’t sufficient. I’d like to be able to borrow from other people to finance my investments, but I can’t. Why did it become easier for Wall Street to do so in the late 1980s through the 1990s? Partly because of the increase in the perception that government would rescue lenders to large risk-takers.

  6.  Mark Maremont, John Hechinger, and Maurice Tamman, “Before the Bust, These CEOs Took Money off the Table,” Wall Street Journal, November 20, 2008, http://online.wsj.com/article/SB122713829045342487-search.html?KEYWORDS=mark+maremont&COLLECTION=wsjie/6month (subscription required).

  7.  Ibid.

  8.  Lucian Bebchuk, Alma Cohen, and Holger Spamann, “The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000–2008,” working draft, Harvard Law School, November 22, 2009, http://www.law.harvard.edu/faculty/bebchuk/pdfs/BCS-Wages-of-Failure-Nov09.pdf.