Thoughts on AIG

[Cross-posted at Organizations and Markets]

Nothing has annoyed me more in the last 24 hours than the constant parade of angry, self-righteous, and ill-informed denunciations of AIG coming from Capitol Hill and the mainstream media. No one, of course, likes the thought of a failing, taxpayer-supported firm paying large bonuses to executives. But let’s talk some common sense here.

1. The main lesson is that AIG should never, ever have been bailed out with taxpayer dollars. I said that at the beginning, and I stand by it even more today. AIG should have declared bankruptcy. Under bankruptcy there are well-established, orderly procedures for winding down a firm, distributing the remaining assets among the various legal claimants, and so on. Injecting taxpayer money without any serious thought about the implications of government subsidy and/or ownership for management and governance is just plain dumb. Naturally, that’s what Congress and the last President—people who know exactly zilch about what companies do and how they are run—did.
2. Performance-based pay is a complicated subject. There are dozens, if not hundreds, of theoretical and empirical studies on the effects of performance-based pay on company performance, the benefits and costs of various compensation formulas, and the like. As Jensen and Murphy wrote back in 1990, “It’s Not How Much You Pay, But How.” Of course, the people screaming the loudest right now haven’t a clue about any of this.
3. If I were a bank or private-equity investor putting money into a struggling firm, I would certainly want a say in management—not just one or two ad-hoc, politically correct issues like executive pay, but all aspects of organization and governance. I might well want to increase the firm’s use of variable pay. I might want to increase the size of certain bonuses, if that helps me attract and retain better managers. Of course, it depends on labor-market conditions, the performance of my firm relative to other firms in the industry, the nature of the previous compensation contracts, and so on. The key question: Does paying a particular bonus increase or decrease firm value? I haven’t heard a single grandstanding pol or mainstream journalist come remotely close to asking, let along answering, this question. No, it’s all about “greed” and some dumb Congressman’s moral outrage.
4. As an outside investor, I certainly would not have the right to renege on whatever prior contractual arrangements I happen not to like. I can’t pick and choose, willy-nilly. Employees, contractors, suppliers, bondholders, etc. all have contractual claims on the firm, and my infusion of cash doesn’t allow me to ignore these without legal consequences.

Craig Pirrong has written one of the few sensible commentaries on this (not counting prior O&M posts here, here, and here). Writes Craig:

There are legal provisions under which contracts can be modified (e.g., bankruptcy). If they apply here, then by all means proceed. Unlike the . . . proposals ricocheting around Capitol Hill, these mechanisms embed various procedural protections, require rigorous fact-finding, and can draw upon a variety of precedents. All of these reduce the likelihood of legal error. If these do not apply, then let’s speak no more about it. . . .

One sentiment (I won’t dignify it with the words “thought” or “idea”) that I’ve heard is that since the government now owns AIG, it can do whatever the hell it wants. Uhm, no. A firm is a nexus of contracts, and if you acquire it, you acquire the entire bundle. Not just the contracts you feel like living up to.

Craig also points out that even given the government’s objective (saving the firm), infusing cash to meet creditors’ collateral requirements was exactly the wrong way to do it.