Jan. 26 (Bloomberg) -- As President Barack Obama moves to re-regulate the financial system, he shouldn’t forget the most glaring abuse of all: the executive larceny otherwise known as compensation.

Last week’s shotgun firing of John Thain provided a reminder of Wall Street’s singular lack of proportion. When he was hired as chief executive officer of Merrill Lynch & Co. in 2007, Thain collected a signing bonus in cash and stock worth $43 million, in addition to lucrative stock options.

A year later, Thain was hungry for more. Even though Merrill was hemorrhaging money and even though its eventual acquirer, Bank of America Corp., was seeking a second dose of government aid, Thain accelerated billions of dollars of bonus payments for his troops. Reportedly, he considered, before changing his mind, seeking $10 million for himself.

At least Thain managed to preserve some value for Merrill’s shareholders. His predecessor, Stan O’Neal, all but destroyed the firm, and still collected an exit package worth $161 million.

Such payouts always seemed obscene. Now, with the banking system in ruins, their true cost is exposed. Poorly designed incentives stimulated ill-considered risks. It isn’t too much to say that executive over-pay was the original sin that fostered the culture of corporate bubbles.

Not just today’s credit meltdown, but all of the stock market booms and busts of the past 20 years -- from junk bonds to high tech to Enron Corp. to, finally, the subprime mortgage fiasco. It is time for it to stop. In any other country, people who bankrupted companies, much less triggered national depressions, would be lucky to escape the big house, let alone be rewarded with eight-figure paychecks.

Pay Soars

The short story of executive pay over the past few decades goes like this. Stocks did poorly in the 1970s. Academics such as Harvard University’s Michael Jensen noticed that CEOs owned relatively little stock; they urged boards to give them more.

Pay levels skyrocketed, foremost on Wall Street, but also throughout America. Where once the CEO stood to take home 20 or 30 times as much as the employee on the bottom, by the late 1990s the ratio had soared to 300, even 400 times. It was said that pay couldn’t possibly be excessive, for it was set in the market -- and the market, good heavens, was never wrong.

True, boards lavishly rewarded success. They also rewarded failure. They doled out stock options and if the stock collapsed, they larded out more options at the lower share price. Set the bar low enough, and any CEO, no matter how incompetent, will sooner or later tumble across it.

Paid to Stay

One of my favorite examples was Edward Whitacre, the former CEO of SBC Communications Inc., now AT&T Inc. Over a long stretch, Whitacre got annual, multimillion-dollar “retention” bonuses. He and others like him got millions for merely not leaving and then, with no sense of irony, they got lavish parachutes should they be forced out -- all in addition to the unconscionable swag they got for doing their job.

Their defenders argued that this generation of CEOs was more able, more motivated, more focused on shareholder worth. What they really were was entitled.

A Robert Rubin could put in a mediocre decade at Citigroup Inc. and receive $115 million for it. Rubin had a vague advisory role and, as he has lately emphasized, no responsibility. Then whence the $115 million? What is remarkable about Rubin is that his story is anything but rare.

We want executives who are both hungry for success and wary of failure. In America, hunger and wariness were dulled by seven- and eight-figure paychecks. Excessive pay created a surreal universe, pampered and insulated from the world inhabited by most Americans, not least the executives’ own shareholders. Pay was excessive for executives who failed; it was also inflated for those who succeeded.

Tumbling Dice

Recognizing their entitled state, CEOs concluded they might as well shoot for the moon. If their gambles paid off, they made hundreds of millions. If they didn’t, by the time the bubble burst a CEO would have salted away $50 million or more.

What academics missed was that the executives didn’t have skin -- their own money -- in the game. Their options cost them nothing. And the horizon over which their pay was calibrated was far too short. Over the last 15 years, executives were rewarded repeatedly for “performance” over brief intervals even though their stock performance, over the entire period, was negative.

Think of baseball players with poor batting averages given princely sums for the few times they manage to reach base.

Street Confusion

My friends on Wall Street complain of being scapegoated; of a populist retribution. Many are good people and many are very talented and bright. But they confuse talent with entitlement.

Walter Wriston, Citibank chief from 1967 to 1984, was as good as any banker today. He transformed Citi and was the dominant banker of his era. He never made more than $1 million a year.

The fix is simple. Congress should require that any compensation to an executive exceeding a set threshold -- $5 million strikes me as right -- would require approval by the shareholders. The rule should apply to every form of pay, including the present value of stock options and exit packages.

In theory, boards already represent the shareholders. But directors have failed to do the job. Nurtured by management, they have been co-opted by the system and are unable to perceive its excesses. Therefore, shareholders need the power to set limits on pay directly.

Protecting Capitalism

Such a proposal would be attacked as anti-capitalist; it is anything but. Capitalism honors capital. It protects and enables those who invest. Managers with skewed incentives, and especially those rewarded for failure, are a pox on capital.

It also would be attacked as anti-wealth. That is also wrong. Under the capitalist system, there is a time-honored method of amassing wealth. It is called buying stock. Owners of stock don’t get retention bonuses or golden parachutes. Their rewards can be great, but they are claimed only in proportion to the sum invested, and only as a result of business success. Executives should try it.

(Roger Lowenstein, author of “When Genius Failed,” is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the author of this column: Roger Lowenstein at elrogl@hotmail.com

Last Updated: January 26, 2009 00:00 EST