The beauty of TARP pay caps

June 2nd, 2009 by Rick Drain

テつAs you know, the US government provided funds to quite a few financial companies under a $700,000,000,000 plan called the Troubled Asset Relief Program, or TARP.テつ Shortly thereafter we learned that at least two companies had paid their traders and executives multi-million-dollar bonuses.

What’s wrong with that?テつ Normally nothing, or at least it’s none of the government’s business.

These two companies, however, were insolvent and would have failed absent government money.テつ The US taxpayer effectively was a controlling shareholder.テつ The questions arose, “You did what with our money?テつ Performance and retention bonuses for a busted company?”テつ The public was incensed and felt they’d been conned, cheated, and robbed.

Congress passed a law somewhat limiting the bonuses that can be paid in companies that have TARP money.テつ Simple enough:テつ don’t misuse our money.

Management and commentators offered a variety of defenses:テつ the limits were too punitive, it was nothing but the public seeking petty revenge, it violated the sanctity of contracts, etc.

Let’s review:テつ before they got the public money, those companies were dead (at least two,) or badly hurting.テつ Having one’s company die can be very punishing, and all ‘sacred’ contracts are open to re-negotiation in bankruptcy.テつ That perspective is missing from the defenders’ arguments.テつ Further, I can’t recall hearing any of the execs saying ‘thank you’ for the bailouts. Too many of them simply believe that they deserve a ton of money, regardless of where the money came from or why their companies were in trouble.テつ Further, they were only too happy to take the money, since it was free.テつ Yes, to the managers it was free;テつ that it cost the shareholders quite a bit was not so important to the managers.

The beauty of the pay bonus caps was that they provided an incentive for the managers to get their companies off the public dole.テつ The managers wanted their super-size bonuses back.テつ That’s required them to raise a lot of equity, diluting the older shareholders severely.テつ But hey, that’s the shareholders’ problem, and once free of the TARP restrictions the managers can go back to their lavish self-compensation.

The English businessman and economics journalist Walter Bagehot wrote of the central banks’ role that they should “lend freely at a penalty rate” in a financial crisis.テつ Lend freely, to keep the system from locking up in panic, but at a higher-than-normal rate so that managers will do their best to avoid needing the help.テつ The Fed certainly lent freely, but because of the severity of the credit crunch they were not able to use interest rates per se to apply the penalty.テつ Hitting on the bonus caps put the penalty where it was most effective.