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Berkshire Hathaway
On Learning Things the Hard Way

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By rclosch
April 7, 2009

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The miracle of Capitalism is that it works at all. Its main virtue, we have been told, is that it is better than the alternatives. To the extent that it does work it is because of its ability to adapt and change, whereas competing ideologies are so dependent on dogma that they become fossilized shortly after conception. Important as this ability to chance is, it does not come easy. Capitalism is no pushover; it is more like a very stubborn mule, so for progress to continue the occasional application of a very large 2x4 is necessary.

I would like to write (as I get time) a series of posts, about how our system will benefit by what we will learn from our current Economic trauma. What follows is my first attempt.

The compensation Bubble

As time passes AIG and last month's bonus controversy may be forgotten, but it has at least temporally, served to focus attention on one of the primary causes of this country's and the World's credit explosion. It is to be hoped that we all can benefit from the potential enlightenment provided by AIG's mistakes. AIG has provided us with a large, prodigious 2X4. One that properly applied may be responsible for the kind of meaningful change that makes our system better than the alternatives.

Mr. Buffett has often repeated his opinion that good management is more dependent on the application of a proper compensation package than on the ability of a company to hire a master of the universe to steer the ship. He and his partner Charlie Munger have railed against outrageous CEO compensation for as long as I can remember, and specifically warned on several occasions of the dangers inherent in allowing derivative traders to mark their trades to their own models. This being functional equivalent of allowing the traders to set their own bonus, and has (for the traders) the additional advantage of allowing both sides of each trade to report a profit, and so put money into all pockets involved.

Now with the help of AIG the whole world is suddenly able, if not to understand the system, at least to see that it was obscene. In today's world of trillion dollar bailouts, $165 million is chump change, but it seems to have been enough to get people to pay attention to something that Warren and Charlie have been complaining about for years. For investors and managers a recession is a wonderful learning experience. Clearly it would be nice if the same level of wisdom could be imparted without pain, but sadly it appears that there is something about the human condition that prevents this.

The capitalist donkey has just been clobbered by the a 2x4 so now that he is paying attention it is time for investors and directors to demand that their company's compensation structure aligns the interest of the managers and traders with those of the shareholders. And even though we can have no hope that this wisdom will be universally accepted we can personally benefit by making the understanding a company's compensation structure a top priority in our investment analysis.

The Politicians of the World will have a lot of fun with this, but it does not seem to me that this is a problem that can be solved by regulation. It is much too complex; each company's compensation must reflect the unique nature of its industry and its markets. While it may not be possible to write a laws that will bring about rational compensation, it is something that the market can do now that the 2x4 has been applied. Investors can see the damage caused by irrational compensation systems, and adjust their behavior accordingly. Capital markets must direct investments to companies that are able to compensate employees in a way that removes any conflict of interest between the employees and the shareholders. While this may seem hopelessly idealistic' Berkshire has for many years been trying to set an example. Fifty years from now it may be accepted that Buffett's greatest contribution to management philosophy was his work on employee compensation.

Markets will reward investors and investment managers that direct money to financial companies that establish Buffett like compensation systems. Irrational pay structures eventually yield ugly behavior. The correction of this problem will yield a stronger and more competitive financial industry an industry were America can create competitive high paying jobs. This is an Industry that important for the long term growth of the country's economy. So thank you AIG, it's been an expensive lesson but hopefully not one we will soon forget.

There is of course the danger that regulators and legislators will want to pass silly laws with lots unintended consequences, but after many years of complaining about silly regulation, I have settled on the view is that the only thing more certain that the Beltway's ability to pass silly rules is that the targeted industries will eventually find some way around those rules. For example witness the ability of the highly regulated banking system to invent a totally unregulated shadow banking system that now controls more assets than the regulated banks.