The power of good sense Joe Grundfest brought to the SEC has long gone – unfortunately.
October 6, 2009, 11:30 am NYT Dealbook
Joseph A. Grundfest is the W.A. Franke professor of law and business and co-director of the Arthur and Toni Rembe Rock Center for Corporate Governance at Stanford Law School.
Public policy reflects the common wisdom. Legislation cannot pass the House of Representatives unless half the members support it. It takes a 60 percent supermajority to avoid a Senate filibuster. Can wisdom get more common than that?
This process works well when the common wisdom is correct. But when the populace and politicians share a collective need for scapegoats then all bets are off. The common wisdom can then reflect a self-serving desire to deflect responsibility more than a reasoned analysis of the causes and consequences of our recent economic failure. The incentive to define a common wisdom that identifies scapegoats is all the more valuable if it helps us avoid the need to make painful and fundamental changes that we would rather avoid.
Consider the debate over executive compensation. The common wisdom is that rapacious bank chief executives made off with millions of dollars because their compensation was not tied to performance: they were able to take the money and run. This common wisdom is politically and emotionally convenient because it suggests that by changing compensation arrangements for bank C.E.O.’s, a deal that doesn’t hurt any of us who aren’t bank C.E.O.’s, we can help avoid a future economic calamity.
The facts, however, don’t support this common wisdom. Recent research by Rudiger Fahlenbach and Rene Stulz documents that bank C.E.O.’s had substantial amounts of wealth invested in their own firms. The average value of stock and options held in bank shares was more than ten times the value of the chief executives’ 2006 compensation. The average value of C.E.O. shares held as of the end of 2006 was $61.5 million, and the average C.E.O. lost about $31.5 million of this portfolio — slightly more than half the value of their equity holdings. C.E.O. compensation patterns also had no correlation with several different measures of bank performance.
If bank C.E.O.’s had seen the crash coming, they would have engaged in a wide variety of actions designed to protect the values of their own portfolios. But that’s not how they behaved. The evidence is instead that these bank C.E.O.’s were also blindsided by the speed and magnitude of the financial crisis, and that they paid dearly for their inability to anticipate the crash.
The implication of these facts is that bank C.E.O. incentives cannot be blamed for the credit crisis or for the performance of banks during that crisis. Instead, C.E.O.’s managed their banks in a manner that they authentically believed would benefit their shareholders. The evidence is also that these C.E.O.’s did not think that their strategies posed significant risks to their institution’s survival or to the federal taxpayer. Sure, they were miserably wrong, but they didn’t know they were making a huge mistake that would cost them, their shareholders and taxpayers a huge fortune.
In that respect, these very highly paid C.E.O.’s were no different from the overwhelming majority of civil servants working at the Federal Reserve, the Securities and Exchange Commission, and many other financial regulatory agencies in the United States and abroad. These civil servants had extensive access to all the portfolio information known to the regulated banks and brokerages.
Regulators who had access to information from many different banks and brokers were also far better informed than individual bank C.E.O.’s who had access only to their own bank’s information. Regulators also had incentives to be skeptical of bank portfolios; their pay didn’t depend in the least on any bank’s financial performance, and regulators would be professionally rewarded if they were able to blow the whistle on a problem before it caused the failure of a federally regulated financial entity. Yet, despite superior information and drastically different incentives, regulators also missed the problem.
The best evidence is therefore that compensation incentives were not correlated to any understanding of the danger that lurked in our economic system. Compensation reform might make sense for a ton of reasons — some political, some moral, some vengeful — but no one should think that these reforms will reduce the risk of a future financial meltdown.
And therein lurks the danger of the common wisdom. We cannot enact legislation or adopt regulation that diverges too far from the common wisdom; otherwise it will not be supported by the majority. But large portions of the common wisdom are immune to reason because they serve emotional or political objectives. These emotional or political components of our common wisdom are doomed to lead us astray in the long run, but they are exceptionally effective in the moment. The error of our ways becomes broadly apparent only with the benefit of hindsight as the force of time reshapes the common wisdom, and as further experience generates facts that were unknown at the time we decided to act. This is, in a sense, the difference between journalism and history.
If we were truly invested in solving the problems that led to our recent economic crisis, we would be making fundamental economic changes that would require no small degree of self-sacrifice. As one example, we would be reconsidering the huge subsidies to housing that are embedded in our tax code and in countless legislative enactments. We wouldn’t be racing after every scatterbrained idea that might make homeownership more affordable, regardless of the true underlying economics. But that would require self-sacrifice, and that’s not as much fun as blaming a bank C.E.O. you’ll never meet.
What can we do to solve this problem? Not a thing I can think of. It is part of the fabric of the human condition in a democratic society. We have adopted foolish regulatory responses to serious economic and social problems in the past, and we are about to do so again. We can only hope that the common wisdom doesn’t lead us to pay an uncommonly high price.