Pay Collars Won't Hold Back Wall Street's Big Dogs

Of all the decrees that come spewing continually out of Washington, there is only one that works every time: the law of unintended consequences.

This past week, the Obama administration slapped a $500,000 cap on cash compensation for senior financial executives whose firms receive future federal aid. That put an official U.S. stamp on the outrage of the investing public.

In 2008, Wall Street lost more than $35 billion and triggered trillions more in losses around the world -- but rewarded itself with $18.4 billion in cash bonuses. That defies the common-sense judgment that it is good results, not bad, that should be rewarded; most dog owners know better than to give Fang a biscuit after he takes a chunk out of somebody's finger.

So Wall Street got its just deserts. Unfortunately, while this move rightfully punishes yesterday's fools, it may inadvertently create tomorrow's culprits. The Treasury Department stated that the pay cap is meant to "ensure that the compensation of top executives in the financial community is closely aligned not only with the interests of shareholders ... but with the taxpayers providing assistance to those companies."

If only it were so simple. "The search for ways to get around this," says one expert on Wall Street compensation, "started within minutes of the announcement."

For starters, the limits seem to apply only to "senior executives" -- the chief executive, chief financial officer and the like -- and not to many of the people who can earn the really big bucks on Wall Street, like traders, hedge-fund managers and the mad scientists who cooked up all those derivatives that almost destroyed the world financial system. Leaving the compensation of these hot shots intact, while reducing the pay of the people who are supposed to boss them around, isn't going to make the investing world any safer.

Outsourcing is another way to get around a pay cap. In 2003 and 2004, managers at Harvard University's giant endowment came under withering fire from the ivory tower for earning upward of $35 million apiece. They soon left to start their own firms, which were promptly hired by the endowment and got paid a percentage of assets under management rather than a cash salary and bonus. That new form of payment stopped the criticism cold -- even though it isn't likely the managers earned any less. Nor did it reduce risk-taking: One spinoff from Harvard Management Co., Jeff Larson's Sowood Capital, blew up in 2007, dealing Harvard a $350 million loss.

Wall Street firms could easily follow in Harvard's wake, spinning off a trading or underwriting operation as a new company and retaining an ownership stake in exchange for a share of the profits and losses. The top dogs at the new firm would no longer face limits on their compensation, but the shareholders' capital at the original firm -- including taxpayer dollars -- might be at even greater risk than before.

Finally, the new rules from the Treasury Department permit Wall Street's "senior executives" to get incentive pay in the form of preferred stock that can't be cashed in until the taxpayers get their money back. But there s no rule yet against cashing all of it in at that point -- what compensation experts call cliff-vesting.

Thus, managers may be tempted to take greater risks in hopes of speeding up their preferred-stock payoff. If the risks go bad, Uncle Sam will eat the losses. "It's the classic trader's option," says George Wilbanks, a managing director at executive recruiter Russell Reynolds Associates: "Heads I win, tails you lose." He adds, "That's my biggest fear: that people are going to swing for the fences to get to the cliff-vest faster."

Psychologist Elke Weber of Columbia University has a different take. She doesn't feel that managers will become reckless now to speed up their preferred-stock payoff. But that risk could rise rapidly as firms come closer to getting Uncle Sam off their backs.

The whole financial fiasco is one big unintended consequence. Securitization was supposed to spread risk to folks willing to bear it but instead ended up concentrating it in the hands of people who didn't understand it.

Wall Street imploded largely because the inmates -- the star traders and quant geniuses -- took over the asylum. Paying the wardens less won't put the inmates back in their cells.

Write to Jason Zweig at intelligentinvestor@wsj.com