Not So Fast

So Matt Yglesias thinks it’s actually necessary for a bailout to include provisions for limiting executive salaries.

To roughly summarize, in order to bail out banks that would go under absent a bailout, we need to also provide access to bailout funds to banks that wouldn’t go under without a bailout. To only bail the very least responsible banks out would create a terrible perverse incentives [sic] problem. But on the other hand, to bail out banks that don’t need bailing out would be a horrible waste of money.

Hence the need for executive compensation provisions. If we limited executive pay for bailed out institutions — say by forcing executives to work on government pay scale — then firms’ managers would have a strong incentive to avoid taking taxpayer money unless it was genuinely necessary. Banks that would mere [sic] prefer to get bailed out because it would enhance their profits won’t do it if taking the bailout means a big cut in executive pay. But institutions that would actually collapse absent a bailout will take the deal because they have no choice.

This doesn’t seem to quite add up to me, and I think it’s because Matt is conflating the object of the bailout (bad debt) with the conduit of the funds (the banks who made bad investments). 

In the Paulson/Bernanke plan, the object of the bailout isn’t to save the banks, it’s to fix an insolvency/liquidity issue (depending on who you believe) by resuscitating bad debt, which, incidentally, will have the additional effect of improving the financial standing of the bad debt’s owners. While this may seem wildly unfair — the banks who made the most mistakes will receive the most aid — limiting participation in the bailout by capping executive salaries wouldn’t change the fact that banks who had behaved most poorly will benefit disproportionately. What’s more, by discouraging participation, firms who had behaved prudently and limited bad debt will actually be penalized for their good behavior by being barred from a proportionate payout.

In a system where the government receives equity in exchange for its bailout (the Dodd plan), it’s equally unclear why a limit on executive salaries would prove more equitable, simply because the underlying theory still relies on transmuting bad investments into good ones. The key difference between the two approaches is that the government’s equity stake would guarantee, or at least seek to protect, the taxpayer from losses on the deal. In this case then, encouraging participation no matter the level of investment in bad loans is especially important in ensuring equitable treatment of financial institutions. That is, if the debts are ultimately worth less than they were valued by the government, the more heavily leveraged firms stand to lose the most. If the debts are ultimately worth more than they were valued by the government, the more heavily leveraged firms are rewarded for their sagacity. In either scenario in the Dodd model, taxpayer money goes unwasted.

Finally, if a bailout were to be structured by a government guarantee of the bad mortgages, or even split between buying bad debt and restructuring mortgages (and how do you fairly decide who gets a restructured mortgage and who doesn’t?), the more heavily leveraged companies would still be rewarded. Thus, capping executive salaries has the benefit not only of being a good political bargaining chip, but also of being a bad idea in the first place. Democrats should be celebrating.

On another note, there is simply no way around the fact that someone gets screwed in this deal. Even if you can countenance the socialism of a plan that restructured every bad mortgage to terms favoring homeowners, then those owning homes they can afford are penalized for not having bought homes they can’t. The only “fair” plan would be to leave the markets to their devices, in which case we all get screwed. It seems that fairness just isn’t on the table.


4 Responses to “Not So Fast”

  1. christianliberal Says:

    Yeah, don’t you get the feeling we are being hoodwinked? Bush ran up our nations credit card to the tune of $1 TRILLION for the war in Iraq, and now, in an emergency fashion, he wants to do the same thing for Wall Street. I smell a rat.

  2. The Difference Between Literally and Practically « Yes, Let’s Talk About This Says:

    […] — Tags: bailout, dodd, economy, mortgage, paulson — Jon @ 10:03 am So In response to my post explaining why executive compensation provisions are a bad idea, “Christianliberal” asks: Yeah, don’t you get the feeling we are being hoodwinked? […]

  3. mike Says:

    I’m all for limiting executive pay post-bailout, certainly. If we’re using taxpayer money to compensate these guys (which presumably we are, at least to some degree), and if the government is receiving an equity stake (which hopefully they will) …

    Yglesias had the right idea, even if he didn’t necessarily cite a reason we agree with. I think it’s not about incentive to accept taxpayer money — they’re going to need to do that anyway — it can be about fairness. Be fair to the taxpayer by not throwing his money down a well of G5’s and fourth homes, and fair to the CEO who badly over-leveraged and left his balance sheet looking like shit. Once they repay the loan, they can have whatever compensation the shareholders can agree to.

  4. Fool Me Twice « Yes, Let’s Talk About This Says:

    […] what it’s worth, I never thought limiting executive pay was tremendously important component of the TARP (ultimately, it seemed […]

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