AIG’s Bonus Debacle

Published on March 23, 2009

Anyone reading this who is a taxpayer in the United States is, in effect, a shareholder of AIG due to the Federal Government’s infusion of $173.3 billion in bailouts over the past six months.  These bailout funds have resulted in the near total nationalization of AIG with the Federal Government owning nearly 80% of the business.  Putting aside the question of whether the government was correct to bail out AIG in the first place, it is very important to look at the potential problems that now exist as a result of government ownership and the political, rather than economic, calculations driving the operations of the company. 

The Bonus Fury

Normally, shareholders of a company want to make smart hiring and compensation decisions for the business with the goal of profit maximization in mind.  While there are still plenty of businesses that can operate with high levels of turnover and relatively unskilled labor, this is clearly not true in finance, technology, and numerous other industries. 

The question for AIG shareholders should be what compensation policies and practices will do the most to salvage value at the company.  Much of this will depend on two key factors that have been all but ignored in discussions of the bonus situation.  First, the wind down of the derivatives portfolio must be well managed by highly trained individuals who have an in depth understanding of extremely complicated instruments and the mind numbingly intertwined nature of the counter parties involved.  Second, the value of AIG’s ongoing insurance subsidiaries will be based on how underwriting decisions are made going forward and will depend on intelligent underwriting practices by highly competent individuals.  Retention of key personnel is obviously critical in both areas.

Fairness or Results?

Is it “fair” that many of the individuals who made unwise decisions have to be paid retention bonuses in order to ensure that proprietary knowledge remains within the firm?  It is both unfair and unseemly that individuals who had a part in the debacle should now profit from the fact that the company still needs them to unwind the derivatives book.  However, the fact that this may be “unfair” does not necessarily mean that it is not logical for AIG to pay out such retention bonuses if the end result is a maximization of shareholder value. 

There is much talk of the individuals involved being greedy and not caring about much other than themselves.  For the sake of argument, let us assume that these individuals are all in fact greedy and care for nothing other than their own financial well being.  To the extent that these individuals are needed, does it not follow that it is necessary to ensure that greedy individuals have an incentive to stay?  If they are as evil as many would have us believe, is it realistic to think that they will stay out of a sense of altruism?  Clearly not!  The question then becomes whether such individuals could be easily replaced.  If not, the logical thing to do is to pay out the bonuses regardless of whether it is “fair” or not in the interests of protecting the ongoing value of the enterprise.

It’s All About Politics

The reality is that decisions are being made not in the interests of maximizing shareholder value but in order to score political points.  Clearly, no one likes to see these payouts and the gut reaction of most people would be to fire everyone who was involved in the situation.  But sometimes doing things what make us “feel good” ends up being the exact opposite of intelligent behavior.  However unseemly, it is far better to pay out the funds than to suffer the consequences of a mass exodus of individuals possessing significant proprietary information that is necessary to successfully wind down the derivatives that would have brought AIG to its knees without government assistance. 

Those who would score political points here are doing nothing to protect AIG’s owners — and that would be all United States citizens.   It is perhaps too much to expect politicians to do much more than propose what feels good to most people which is an excellent reason to rapidly move toward privatizing the parts of AIG that still have intrinsic value.  This would also be the best outcome for the taxpayer since the proceeds would be available to partially offset the cost of the cash infusions of the past six months.

AIG’s Bonus Debacle
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