This is directly related to my post regarding principal-agent incentive issues from March 16:
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I can’t disagree with that. Which reminds me of yet another great quote (this time from Keynes): “Worldly wisdom teaches that it is better to fail conventionally than to succeed unconventionally.”
I think a lot of folks kind of knew in the back of their minds that we COULD be headed for trouble. But, like Chuck Prince – he of “so long as the music’s playing we have to dance” fame – there are too many financial jobs that are evaluated and compensated based on short-term performance measures. In other words, it simply pays too well to fail conventionally as things are currently structured.
I like Jim Grant (of Grant’s Interest Rate Observer), for example, but Jim would have been fired from running a bank back in 1998 for being unwilling to underwrite loans. (He’s unconventional, you see.) This “dancing” issue is a huge problem because (1) everyone presumes they’ll be able find a chair when the music stops, and (2) you get fired if you stop dancing too soon.
Anyhow, on a related issue, we obviously need regulatory overhaul with the banks, etc. But what we REALLY need – and what’s REALLY at the root of our problems – is a system of misaligned incentives, specifically getting paid in the short-term for instruments that are risky and display a long-term payout.
Mortage brokers getting paid today to underwrite mortgages that would explode later. Lenders getting paid today to underwrite construction loans that would explode later. Traders getting paid today to execute strategies that would explode later. Wall Street securitization desks getting paid today to securitize and sell mortgage securities that would blow up later. Insurance underwriters (think AIG Financial Products unit) getting paid today to underwrite risks that would blow up later.
While we need regulatory changes big time, it’s pretty clear to me that these changes will be all for naught if they don’t address incentives. If we’ve learned one thing from this whole debacle it’s that, for better or worse, people respond to incentives.
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You can’t address principal-agent problems without addressing incentives. They are part and parcel of the same issue.
