To get bad performance, you got to pay well

Good pay, bad performance

The better the pay, the worse the performance

CEOs perform worse for better pay
A common meme on Wall Street is that to get good performance, the pay has to be good. Unfortunately for them, many studies show that CEOs tend to perform worse with better pay.

Bonuses of millions and billions
You don't have to search long to find out that good pay does not necessarily give good performance. Just look at the subprime crisis. Whoever did demonstrate such abysmally rotten work as the mortgage dealers? Maybe Bernie Madoff, those guys at Enron. As long as they get their money, why should they care if they lose a lot of money for their customers, for their company, for the taxpayers?
In 2006, more than 100 people in Merrill's bond unit broke the million-dollar bonus mark; Goldman Sachs allegedly paid more than $20 million apiece to more than 50 people. In 2007, personal compensation at Goldman's was 44% of net revenues and almost double net earnings. In 2008, 9 banks paid $32.6 billion in bonuses while they got $175 billion in taxpayer funds. With their asymmetrical compensation system, reward if they succeed, reward if they fail, their behavior is no wonder.

Bankruptcy CEO Fuld making hundreds of millions
When Richard Fuld, former CEO of bankrupt Lehman Brothers, was questioned by the Congress, he claimed that his total compensation was $310 million; 85% of his pay was in Lehman stock and he did not sell the "vast majority". According to former Lehman Brothers employee Oliver Budde, Fuld lied under oath. Among Budde's duties was preparing public filings on executive compensation; in spite of Fuld's claim, Budde estimates that Fuld earned $469 million from stock sales between 2000 and 2008. Budde reported to the SEC and to the Lehman board of directors but all response he got was a standardized form thanking him for his letter. A Harvard University study found that Fuld earned $461 million from the sale of 12.4 million shares of Lehman stock, something that seems to corroborate Budde's claim.
Prolific pro-finance writer Thomas Sowell is looking at things differently. He thinks the Congress is unfair to Richard Fuld, raking him over the coals for his big compensation in spite of making a personal loss of $1 billion. I don't know Fuld's net profit but he did not leave Lehman a man in debt. Even if he did not sell the "vast majority" of his stock and "only" got $310 million, most people would still think it was a huge compensation. If Fuld got $310 million with the stock going down instead of $1310 million had the stock gone up, it was a $310 million profit, not a $1 billion loss. Sowell does not explain why he thinks Fuld should be worth $1310 million; personally I think $310 million is more than enough compensation for bankrupting a bank as big as Lehman.

Greed, performance and severance money
Sowell thinks it is wrong to ascribe high executive pay to greed. Your pay does not depend on what you wish but on what you are offered; what you are offered depends on what the board that hires you thinks you are worth. But several studies have found that if the board thinks it is paying for performance, it is wrong; often the performance is worse for better pay. There are other reasons that makes the board raise the compensation level. One thing is prestige. No board likes setting a target below peer group norms, every CEO should be paid above average. Another thing is, in spite of what Sowell says, greed. A board member may become a CEO so voting for a high CEO compensation can be self-serving. Besides, a high CEO compensation can help pulling up the level for other board members.
Sowell thinks that top executives are worth their money. Let us say that a CEO gets $10 million but saves the company $100 million. His money does not come at the expense of consumers, stockholders and/or employees; on the contrary, those are $90 million better off.
Well, that sounds good. But assume that an average CEO had saved $200 million. Then the CEO had lost the company $100 million. Assume that the CEO had done like most decent banking CEOs during the crisis, assume that he had lost a lot of billions. Would he still be worth his money?
Sowell even thinks that top executives are worth their severance money. After a $7.9 billion loss, Merrill Lynch's CEO got $160 million for quitting. Thomas Sowell thinks this is OK because if the CEO did not agree to quit, his terms of employment might have permitted him to stay; if he stayed, he might have caused another $7.9 billion loss.
Economically, paying $160 million is definitely to prefer to an additional $7.9 billion loss. Disregarding the possibility that their new CEO might perform even worse than the old, what can we learn? That reward does not depend on performance. We learn that any talk about risk in banking is nonsense; no matter how much you lose for your bank, you are still guaranteed a handsome compensation.

This is Wall Street
In 2009, Bank of America bought failing Merrill Lynch. Just before the deal, Merrill paid a bonus of $3.6 billion to its employees, a bonus that BoA knew about but did not disclose; with Merrill getting $6.8 billion federal bailout money (via AIG), this means that the bonus was paid by American taxpayers. SEC made BoA pay a pittance for misleading its shareholders, BoA neither admitting nor denying any wrongdoing.
An annoyed judge questioned the small settlement and the big bonus. BoA's defense was that the bonus was needed to keep the personnel and "This is Wall Street". BoA did not explain why they would want to keep personnel performing so atrociously bad; their only excuse was "This is Wall Street", obviously implying "This is Wall Street, we need to pay absurdly good no matter how bad the performance."
As a contrast to those big banks, there is one group of subprime lenders that does not experience the same losses and high default rates; this group comprises the not-for-profit housing enterprises. They work like the old banks; unlike today's for-profit enterprises, they verify income, they make sure the borrower understands his obligations, they consider stability of employment. They keep their loans on their books to a much greater degree.

How incentives work

Success addictive
Rewards can be addictive. Brain scans show that when players have a chance to win cash, the same parts of the brain are activated as those activated by most addictive drugs; other rewards have similar effect. Activation of these parts of the brain also seems to predict risk-seeking behavior. Maybe that's why casinos surround their guests with reward cues (inexpensive food, free drinks, potential jackpots). And of course, bankers with implicit taxpayer backing really have no reason show any restraint.
There are different types of addictions: drug, gambling, sexual and more. Common symptoms are preoccupation with substance or behavior, continued use despite consequences. Asking for more and more, intense withdrawal symptoms. Blaming others. Not caring about problems, for themselves and for others, only wanting more and more, getting aggressive when confronted. Many of these traits can be found among the men behind the crisis.
Managers behind sustained over performance are different. They take blame for failure but share credit for success, still they are tenacious and driven.

Pay can be detrimental to performance
Better pay can pay off. For routine work. In 1914 when Henry Ford raised minimum daily pay from $2.34 to $5 for qualifying workers, the move proved extremely profitable; reducing employees' turnover and attracting the best mechanics. Still, many experiments demonstrate that better pay can be detrimental to performance. Experiments with monkeys showed that they liked solving mechanical puzzles; if they were rewarded with raisins, they made more mistakes and took longer time to finish.
A test with humans, similar to the monkey test although more advanced, gave similar result. One group was offered no reward. In another group, the participants were offered a reward if they finished among the best 25%. Most people could solve the problem in five to ten minutes; in the test, on average the participants in the group without reward solved the problem more than three minutes faster.
In one experiment in India, students were divided into three groups. They were promised a reward for reaching a certain performance level: for one group a reward equal to the salary of one day's work, for the others rewards equaling two weeks' or five months' work. The result? "In eight of the nine tasks we examined across the three experiments, higher incentives led to worse performance". Even should greed make you try harder, it often makes you work less efficiently.
This indicates there might be two reasons when the reward system fails. Either you find the task interesting; when you are paid, the reward makes the task feel like drudgery. Or you find the reward important and it makes you try too hard. A third reason could be the junkie's craving for immediate satisfaction.

Carnegie, Ford, Rockefeller vs the subprime crisis
It is not fair to treat all rich people the same way. Some of them want, besides money, to be productive. Carnegie, Ford, Rockefeller of days gone were different. They were not obsessed with money, they were obsessed with performing; they made money because they wanted to do a good job.
The subprime crisis is different. Bankers gambling other people's money. Bankers getting high on other people's money. Bankers manipulating the game so they can't lose. Bankers telling the world how great they are, bankers telling the world how happy it is to have them take their money.

© Anders Floderus