Gagging on a Bitter, Multimillion-Dollar Pill

Yesterday, a somber Edward Liddy, the federally installed chief executive of American International Group (AIG), expressed his anger to Congress over the $165 million in “distasteful” bonuses that are headed for the very employees whose recklessness caused the company’s collapse, necessitating $170 billion in taxpayer bailout cash. Nevertheless, Liddy lamented, the bonuses had to be paid.

“We have to continue managing our business as a business,” said Liddy, who is working for $1 a year. And with that, Liddy put those millions in AIG bonuses right behind death and taxes as something everybody hates but nobody can stop — not the company’s chief executive, not the federal officials who rescued AIG from oblivion, not the American taxpayers, who now own about 80 percent of the firm.

Of course, there’s plenty of outrage and tough talk about getting the money back; Liddy said he would ask bonus recipients to return half. But James Post, the School of Management’s John F. Smith, Jr., Professor of Management, says the controversy goes beyond taxpayers taking another multimillion-dollar hit and beyond the “distasteful” rewarding of greed and irresponsibility at AIG. Post says the public’s outrage has the potential to sidetrack further economic recovery plans by the government, and fundamentally change how (and how much) American business executives are compensated.

BU Today put a few questions to Post.

BU Today: Could paying these bonuses be lumped into the same equation used to rationalize the bailouts: yes it’s distasteful and rewards the greedy and irresponsible, but it’s necessary for long-term financial stability?
Post: What’s different here is that this has created huge, bipartisan political criticism that is going to jeopardize further financial recovery efforts. I can’t imagine that the administration could successfully go to Congress and ask for additional financial assistance for the banking industry or AIG at this point.

This is a very small percentage of AIG’s total bailout, but it’s the hypocrisy that the public has seized on — the hypocrisy of telling GM and the United Auto Workers that GM has to break those contracts with the workers, but we have to honor contracts with these guys at AIG.

Also, this political furor is sending a very strong message that goes beyond AIG. I think this is an overarching political signal that executive compensation in this industry is going to be subject to the closest scrutiny. For decades, it’s been impossible to gather political momentum to change the system of runaway compensation and sweetheart deals with CEOs and directors. But this is the time that change will come.

How common among financial services firms is what AIG did — arrange huge, across-the-board bonuses, guaranteed regardless of performance?
It’s been common in the financial services industry to make bonuses a major part of compensation. But I think the prevalence of guaranteed bonuses and the levels of those bonuses vary widely from firm to firm. In areas like trading, Wall Street firms have tried to create a pay-for-performance system, where a successful trader gets paid a lot and an unsuccessful trader gets paid a little. But then the really successful traders have enough leverage to build in guaranteed bonuses. And that’s what creates a perverse incentive. At AIG, you had a whole department that was making the firm a phenomenal amount of money. So the leadership there negotiated guaranteed bonuses for all of the people working in that area.

Were these bonuses negotiated in AIG’s heyday or after the trouble started?
It appears that some of the bonus deals were made back in 2008, before AIG collapsed. But there is also the suggestion that some of these commitments were made after the downward spiral had begun. And that timing clearly makes a big difference. Those that were done in good faith, let’s say, before AIG was a failing business, might have more legitimacy than ones made as the ship was going down.

AIG leadership says these bonuses must be paid because of contractual obligations and so the recipients stay around long enough to undo the complicated damage they’ve done. Does that pass the smell test?
These were contractual guarantees, and it’s really dangerous for us to start saying we can willy-nilly ignore legal contractual arrangements. On the other hand, there are a number of reasons why that claim may not stand up. It may have been based on misleading info at the outset, and there’s a strong case for potential fraud, which has precipitated New York Attorney General Andrew Cuomo to launch a criminal investigation. The argument here is that the guys in AIG’s financial products division had material information about the true financial facts and they failed to disclose. They misled investors, misled the government, misled everybody in sight. In a way, they were playing their own version of the Bernard Madoff Ponzi scheme.

As to the need to keep these people in-house, this is a very technical area. Only a relative handful of people understand these instruments. But there’s no guarantee that these are the right people. In fact about a dozen of them have already left. It also demonstrates how absurd it was that a company like AIG was betting billions on instruments that only a very few people in the world understood. Their senior management was clueless about the risks, and that’s unconscionable. All they knew was that there was a lot of money being made.

Why weren’t these bonuses spotted and blocked as a condition of the successive AIG bailouts?
The question is, does the Treasury Department have its finger on the pulse of the patient, which is the financial crisis? It seems to most of us that $165 million in bonus money is a huge amount, and so we’re shocked that it could go undetected. But it’s also less than 1 percent of the government money given to AIG, so it’s a minuscule part of the big picture. So maybe Treasury had their eyes on bigger problems at AIG. But compensation, the incentive system, is such a fundamental part of what makes these organizations go that we know it’s got to be one of the pressure points. There was a real failure to focus on this.

There are lots of schemes for getting that bonus money back — from taxing recipients to just shaving it off the next block of AIG bailout money. What are the chances of recouping this cash?
There are problems with each of these ideas. The tax idea sounds appealing, but the problem is there’s a real Constitutional issue with using the tax code for political purposes. Treasury Secretary Timothy Geitner’s desire to withhold money from the next bailout installment will have little substantive impact. It’s not even a slap on the wrist — it’s waving a feather when you’re talking about billions of dollars. I think probably the best chance of getting the money back is going to be if Cuomo’s investigation shows there was some fraud in dealing with the information at AIG.

Is the president’s outrage about the bonuses political grandstanding?
I think it’s genuine. In his speeches going back to his inauguration speech, he’s talked about responsibility. He’s used language that really challenges the Wall Street culture. His outrage comes out of his sense that the American public has been betrayed. But I don’t think he does a lot of speaking before he thinks. So I think there was probably also a political sense that he needs to speak the truth.

We’re looking at the destruction of public trust. It has a micro consequence with respect to AIG, but the macro effect is that the whole recovery plan is now jeopardized by the failure to recognize that compensation is this very important political hot button and a litmus test of whether change is really happening at these companies being rescued by taxpayers. They’ve been trying to fix this crisis by doing business the old way, but the world has changed.

Chris Berdik can be reached at cberdik@bu.edu.