Performance-pay Perplexes.(The Talk of the Town)(hedge fund managers; chief executive officers)

The havoc on Wall Street following the collapse of the subprime-mortgage market boils down to a simple truth: for years, lots of very smart people took lots of very foolish risks, betting borrowed billions on dubious mortgage derivatives, and eventually the odds caught up with them. But behind that simple truth is a more surprising one: the financial whizzes made bad decisions in part because that's what they were paid to do.

Not literally, of course. The way that hedge-fund managers and investment-bank C.E.O.s get paid is supposed to make them perform better for the investors they serve. Hedge-fund managers, for instance, typically are paid "2 and 20": they get two per cent of total assets as a management fee, and they keep twenty per cent of their investment gains (above some agreed-upon benchmark). Letting hedge-fund managers keep a chunk of their winnings gives them an incentive to do well for their clients: in theory, they get rich only if their clients do.

In practice, though, things don't always work that way. Fund managers get bonuses at the end of each year, and they keep those performance fees even if the fund eventually goes south. So if a billion-dollar hedge fund rises twenty per cent in its first year and falls twenty per cent in its second, its investors will have lost money, while the fund's manager might earn forty million dollars in performance fees. Hedge funds do have a rule that's meant to deal with this problem: when a fund loses money, it yields no performance bonus until investors get back to even. The catch is that nothing prevents a hedge-fund manager from simply shutting down after a bad year and walking away with the fees he's already accrued. Sometimes this happens out of necessity: the two subprime-focussed funds at Bear Stearns whose closure precipitated this summer's market mayhem had seen their assets annihilated. But sometimes it happens because a manager has no incentive to keep supervising a fund that won't generate a decent performance fee. In either case, the managers keep what they've earned and investors are left holding the bag. In short, a hedge-fund manager can do a lousy job and still become very wealthy.

Because fund managers reap large rewards on the upside without a correspondingly punitive downside, they have a much greater incentive to take big risks than ordinary investors do. Hedge funds generally leverage their bets with large amounts of borrowed cash--one Bear Stearns fund, for instance, borrowed ten times its capital--which makes it possible for them to turn small gains into enormous ones. Of course, leverage can also turn small losses into enormous ones. That helps explain why bad bets by hedge funds have been at the heart of the biggest financial-market meltdowns of the past decade.

A similar tendency to underplay risk is at work in parts of corporate America, thanks to the ubiquity of stock ...