"[F]or almost half a century after the Great Depression, pay inside the financial industry and out was roughly equal. Beginning in 1980, they diverged. By 2007, financial sector compensation was more than 80% greater than in other businesses--a considerably larger gap than before the Great Depression.
Until 1970, the New York Stock Exchange, a private self-regulatory organization, required members to operate as partnerships. Peter J. Solomon, a former Lehman Brothers partner, testified before the FCIC that this profoundly affected the investment bank's culture. Before the change, he and the other partners had sat in a single room at headquarters, not to socialize but to "overhear, interact, and monitor' each other. They were all on the hook together. "Since they were personally liable as partners, they took risk very seriously,' Solomon said. Brian Leach, formerly an executive at Morgan Stanley, described to FCIC staff Morgan Stanley's compensation practices before it issued stock and became a public corporation: "When I first started at Morgan Stanley, it was a private company. When you're a private company, you don't get paid until you retire. I mean, you get a good, you know, year-to-year compensation.' But the big payout was "when you retire.'
When the investment banks went public in the 1980s and 1990s, the close relationship between bankers' decisions and their compensation broke down. They were now trading with shareholders' money. Talented traders and managers once tethered to their firms were now free agents who could play companies against each other for more money. To keep them from leaving, firms began providing aggressive incentives, often tied to the price of their shares and often with accelerated payouts. To keep up, commercial banks did the same. Some included "clawback" provisions that would require the return of compensation under narrow circumstances, but those proved too limited to restrain the behavior of traders and managers.
Studies have found that the real value of executive pay, adjusted for inflation, grew only 0.8% a year during the 30 years after World War II, lagging companies' increasing size. But the rate picked up during the 1970s and rose faster each decade, reaching 10% a year from 1995 to 1999. Much of the change reflected higher earnings in the financial sector, where by 2005 executives' pay averaged $3.4 million annually, the highest of any industry. Though base salaries differed relatively little across sectors, banking and finance paid much higher bonuses and awarded more stock. And brokers and dealers did by far the best, averaging more than $7 million in compensation.
Merrill paid out " 141% [of its revenues in compensation] in 2007--a year it suffered dramatic losses.
As the scale, revenue, and profitability of the firms grew, compensation packages soared for senior executives and other key employees. John Gutfreund, reported to be the highest-paid executive on Wall Street in the late 1980s, received $3.2 million in 1986 as CEO of Salomon Brothers. Stanley O'Neal's package was worth more than $91 million in 2006, the last full year he was CEO of Merrill Lynch. In 2007, Lloyd Blankfein, CEO at Goldman Sachs, received $68.5 million; Richard Fuld, CEO of Lehman Brothers, and Jamie Dimon, CEO of JPMorgan Chase, received about $34 million and $28 million, respectively. That year Wall Street paid workers in New York roughly $33 billion in year-end bonuses alone. Total compensation for the major U.S. banks and securities firms was estimated at $137 billion.
Stock options became a popular form of compensation". These pay structures had the unintended consequence of creating incentives to increase both risk and leverage, which could lead to larger jumps in a company's stock price.
As these options motivated financial firms to take more risk and use more leverage, the evolution of the system provided the means. Shadow banking institutions faced few regulatory constraints on leverage; changes in regulations loosened the constraints on commercial banks. OTC derivatives allowing for enormous leverage proliferated. And risk management, thought to be keeping ahead of these developments, would fail to rein in the increasing risks.
The dangers of the new pay structures were clear, but senior executives believed they were powerless to change it. Former Citigroup CEO Sandy Weill told the Commission, "I think if you look at the results of what happened on Wall Street, it became, "Well, this one's doing it, so how can I not do it, if I don't do it, then the people are going to leave my place and go someplace else.' Managing risk "became less of an important function in a broad base of companies, I would guess'" (FCIC 2011: 61-64).
While the FCIC discussion of these changes is extensive and useful it is incomplete. First, similar changes virtually eliminating partnerships with joint and several liability occurred in many fields related to finance such as law firms, auditing firms, and credit rating agencies. In each case the result proved disastrous for integrity.
Second, FCIC was inaccurate in asserting that increased risk was an "unintended consequence" of modern executive compensation. One of the express goals of modern executive compensation was to induce CEOs to cause the firm to make significantly riskier investments.
Third, the discussion ignores the role of modern executive and professional compensation in creating perverse incentives to engage in accounting control fraud and to create Gresham's dynamics to suborn professionals that would aid and abet the fraud. Modern executive compensation also provides the means by which the controlling officers loot in a manner that minimizes the risk of prosecution.
The central problem with the financial CEOs that lead the epidemics of control fraud that drive our crises is not that they cause immense inequality but that they destroy wealth and cause intense inequality and increased poverty -- devastating American families and effectively eliminating any realistic opportunity for millions to marry. The other central problem is that they have subverted our politics and created a system of crony capitalism that is the leading threat to our economy and our democracy.
Theoclassical economists are not taking the lead urging the return to private sector ownership structures that classical economists realized provided inherently superior governance. There are three excellent reasons why theoclassical economists refuse to recommend ownership structures they know are vastly superior. The CEOs of our largest financial firms love the current system. Theoclassical economists faithfully serve the interests of these CEOs, not the firms or shareholders.
Theoclassical economists know that it was the CEOs that caused these disastrous changes. It was not the evil government. The CEOs destroyed a system that was vastly superior because it minimized accounting control fraud, optimized long-term investment perspectives, and rewarded the most productive partners who displayed the greatest integrity and skill in mentoring and monitoring their partners. The accounting control fraud recipe causes such firms to become weapons of mass financial destruction and rewards the least competent and moral officers. By producing multiple Gresham's dynamics the control frauds turn market forces so perverse that they drive good ethics out of the marketplace and the professions. Theoclassical economists refuse to admit that Adam Smith was correct that the inherent problem is the perverse incentives and power of CEOs in a corporate ownership structure.
Because the CEOs who lead the largest financial control frauds have used executive compensation to create a Gresham's dynamic among a broad range of financial executives there is no private sector means for honest financial firms to recreate partnerships with joint and several liability that would defer the vast bulk of the officers' compensation for decades. Only governmental action requiring a return to partnerships with joint and several liability and highly deferred compensation can break the destructive Gresham's dynamic that makes it impossible for the private sector to return to vastly superior ownership and compensation structures. This situation is, of course, anathema to theoclassical economists who detest the government and are CEO cultists.
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