By James Kwak
I finally bit the bullet and read “In Defense of the CEO,” Ray Fisman and Tim Sullivan’s article on the cover of the “Review” section of Saturday’s WSJ. The inside continuation page is headlined “When CEOs Are Worth a Fortune.” In fact, I read it twice. But nowhere could I find any evidence or even an argument that any CEOs are worth a fortune—just a lot of implying, assuming, and asserting that they are.
By James Kwak
The indefatigable Lucian Bebchuk has written another empirical paper (Dealbook summary), this time with Alma Cohen and Charles Wang, on the impact of golden parachutes (agreements that pay off CEOs generously in case of acquisition by another company) on shareholder value.
Looking just at the question of whether a company is acquired and for how much, they find out that golden parachutes work about how you would expect. Companies whose CEOs have golden parachutes are more likely to get acquisition offers and are more likely to be acquired, presumably because their CEOs are les likely to contest takeovers. On the other hand, these companies tend to sell for lower acquisition premiums, again because their CEOs are more likely to be happy to be bought out.
“So far, so good,” Bebchuk writes. But the problem is that when you take a longer view, golden parachutes appear to be bad for shareholder value. Companies that adopt golden parachutes have lower risk-adjusted stock returns than their peers—despite the fact that they are more likely to be acquired. Some other factor is outweighing the positive effect (for the stock price) of more frequent takeovers.
Bebchuk proposes one explanation: Golden parachutes make being acquired relatively painless to CEOs. Therefore, they are less afraid of being acquired; and, therefore, they are less concerned about maximizing shareholder value in the first place.
Here’s another possibility: Companies are more likely to grant golden parachutes to their CEOs if they have: (a) CEOs who care more about maximizing their personal wealth than about their companies; (b) boards who are more concerned about doing favors for the CEO than about doing what’s right for the company; or (c) both. Those are not the kinds of companies you want to be investing in, since they’re likely to screw up all sorts of other things in addition to their executive compensation policies.
By James Kwak
From today’s WSJ:
“At J.P. Morgan, the biggest U.S. bank by assets, directors are considering lower 2012 bonuses for Chief Executive James Dimon and other top executives in the wake of a multibillion-dollar trading disaster, said people close to the discussions. But they also are grappling with the question of how to do that without drastically reducing the executives’ take-home pay.”
Huh? Isn’t reducing their take-home pay the point?
By James Kwak
Once upon a time, the story goes, corporate America was fat and happy. Top executives worked in palatial office suites bedecked with flowers, flew everywhere in private jets, and ate every meal at the Four Seasons or Le Bernardin.
Then there was the shareholder value revolution. Michael Jensen and the rest of the Chicago School efficient-market legions showed that shareholder value was the only thing that mattered and stock prices were the only measure of shareholder value. Activist investors demanded an end to executive perks and ushered in the era of pay for performance, in which executives are paid in stock options, so they only make (a lot of) money if shareholders make money. Congress event went along by capping the tax-deductible amount of executives’ base pay, which helped along the shift to stock-based compensation.
By James Kwak
That picture is average total annual compensation for top-five named executive officers at U.S. public companies from 2008 to 2010. (It’s from a blog post by Carol Bowie of MSCI, which used to be called Morgan Stanley Capital International.) Over those two years, total annual compensation increased by 37% for all companies and by 54% for companies in the S&P 500. Basically, while bonuses and severance packages have fallen or grown slowly, that effect has been swamped by much bigger stock and option packages. Which is evidence that if you try to rein in some of the more egregious aspects of executive compensation, the executives, their friends on the compensation committee, and their hired guns at the compensation consulting firms will figure out ways to keep the party going.
It’s possible that 2008 was a low year for executive compensation because of the financial crisis and recession, so this is just rapid growth from a low base. But check this out:
A December 2011 survey by pay consultant Towers Watson of 265 mid-size and large organizations found 61 percent expect their annual bonus pools for 2011 “to be as large or larger than those for 2010,” while 58 percent of respondents expect to fund their annual incentive plans “at or above target levels based on their companies’ year-to-date performance.” Moreover, 48 percent of those surveyed expect long-term incentive plans that are tied to explicit performance conditions “to be funded at or above target levels based on year-to-date performance.”
Critically, 61 percent of respondent in the Towers survey said they believe their total shareholder return will decline or remain flat.
In a recent interview with Bloomberg (Simon’s commentary here), President Obama compared bank CEOs to athletes–a analogy favored by Goldman director Bill George, among others. However, Obama got the analogy right:
“The president, speaking in an interview, said in response to a question that while $17 million is ‘an extraordinary amount of money’ for Main Street, ‘there are some baseball players who are making more than that and don’t get to the World Series either, so I’m shocked by that as well.’”
That is, Obama is saying that some bankers are overpaid, just like some athletes are overpaid. Maybe he read my earlier post?
Wall Street critics often say that compensation should be in long-term restricted stock so that managers and employees do not have the incentive to take excessive risk, make big money in good years, deposit the cash in their bank account, and then escape to their private islands when their bets blow up the next year. Wall Street defenders like to point to Dick Fuld, who supposedly lost $1 billion by holding on to Lehman Brothers stock that eventually became worthless. You don’t get more of a long-term incentive than that, the argument goes.
Lucian Bebchuk, Alma Cohen, and Holger Spamann have exploded this myth in a Financial Times op-ed and a new paper. They look at the CEOs and the other top-five executives of Bear Stearns and Lehman Brothers. (All numbers are adjusted to January 2009 dollars.) From 2000 through 2008, these ten people received $491 million in cash bonuses (Table 1) and sold $1,966 million in stock (Table 2); on average, each person took out $246 million in cash. (Both Lehman and Bear had rules that prevented top executives from cashing out equity bonuses for five years from the award date–see p. 16 n. 33.)
Everybody knows by now that Bank of America is buying back the $45 billion of preferred stock that the government currently owns. While the reason why they are doing this is obvious, I’m going to pretend it isn’t for a few paragraphs.
Buying back stock costs money — real cash money. Why would a company ever do such a thing? The textbook answer is that a company should do it if it doesn’t have investment opportunities that yield more than its cost of capital. The cash in its bank account, in some sense, belongs to its shareholders, who expect a certain return. If the bank can’t earn that return with the cash, it should return it to the shareholders. In this case, though, the interest rate on the preferred shares is only 5%, which is far lower than usual cost of equity. In fact, Bank of America just issued $19 billion of new stock in order to help buy back the government’s preferred stock. The cost of that new equity (in corporate finance terms) is certainly higher than 5%. In other words, Bank of America just threw money away.
Benjamin Friedman, in the Financial Times (hat tip Yves Smith), questions the high cost (read: compensation) of our financial sector. But he does not simply say that huge bonuses for bankers are unfair. Instead, he says that the costs of financial services need to be balanced against their benefits.
The discussion of the costs associated with our financial system has mostly focused on the paper value of its recent mistakes and what taxpayers have had to put up to supply first aid. The estimated $4,000bn of losses in US mortgage-related securities are just the surface of the story. Beneath those losses are real economic costs due to wasted resources: mortgage mis-pricing led the US to build far too many houses. Similar pricing errors in the telecoms bubble a decade ago led to millions of miles of unused fibre-optic cable being laid.
The misused resources and the output foregone due to the recession are still part of the calculation of how (in)efficient our financial system is. What has somehow escaped attention is the cost of running the system.
In particular, Friedman wonders at the relationship between the value provided by financial services and the opportunity cost involved: “Perversely, the largest individual returns seem to flow to those whose job is to ensure that microscopically small deviations from observable regularities in asset price relationships persist for only one millisecond instead of three. These talented and energetic young citizens could surely be doing something more useful.”
This reminds me of something Felix Salmon wrote about a while back: If profits and compensation in the financial sector go up and keep going up, that’s a priori evidence of inefficiency, not efficiency. Those higher profits mean that customers are paying more for their financial services over time, not less, which means that financial services are imposing a larger and larger tax on the economy. Now, it is possible that they are also increasing in value fast enough to cover the tax, but that is something to be proven.
By James Kwak
I was surprised at the number of commenters on yesterday’s post who thought that executive compensation is a red herring or a political talking point or “populist pablum.” I agree that some of the outrage over compensation by TARP recipients is a bit overblown. But I also think that the incentives created by current compensation structures were a serious contributor to the financial crisis – which was, after all, largely about banks taking one-sided risks because of asymmetric payouts (lots of upside, limited downside) – and that fixing those incentives is an important task for regulatory reform.
So, I decided to call on some reinforcements. Lucian Bebchuk, a leading researcher of executive compensation (book; importat paper discussed here), and Holger Spamann have a new paper called “Regulating Bankers’ Pay” that discusses precisely this issue. They conclude not only that regulation of banks’ executive compensation would be a good thing, but that it may actually be better than the traditional regulation of banks’ activities.
They certainly want you to think they do. Yesterday was Executive Compensation Day in Washington. The Treasury Department appointed Kenneth Feinberg to oversee executive pay at seven companies that have received extensive government aid – AIG, Citigroup, Bank of America, and the car companies and their finance companies. The administration, which always seemed uneasy with the popular outrage over bonuses earlier this year, seems willing to throw the seven sinners to the wolves, while letting the bulk of the financial sector off the hook. Feinberg will only provide advice to other TARP beneficiaries, and banks that pay back TARP money will not even have to deal with that.
This, of course, solves precisely nothing. The problem with “executive compensation” – no, make that just “compensation” – in the financial sector was its structure. Huge end-of-year bonuses tied to short-term metrics, with no corresponding downside risk, motivated people to take on excessive risk in hopes of maximizing those bonuses. And the companies we need to worry about most are not the ones that are most beaten-down today, but the ones that are (relatively) the strongest and will be taking the biggest bets.
In my opinion, one of the biggest contributors to the crisis we know so well was compensation schemes that gave individuals at financial institutions – from junior traders all the way up to CEOs – the incentive to take massive bets. Put people in a situation where the individually rational thing to do is take lots of risk, and they will take lots of risk – especially if they are generally ambitious, money-loving, and predisposed to think that if the market is giving it to them, they must deserve it.
Alan Blinder does a good job explaining the problem in simple terms in the first half of his WSJ op-ed. However, I’m not optimistic about his solution:
It is tempting to conclude that the U.S. (and other) governments should regulate compensation practices to eliminate, or at least greatly reduce, go-for-broke incentives. But the prospects for success in this domain are slim. (I was in the Clinton administration in 1993 when we tried — and failed miserably.) The executives, lawyers and accountants who design compensation systems are imaginative, skilled and definitely not disinterested. Congress and government bureaucrats won’t beat them at this game.
Rather, fixing compensation should be the responsibility of corporate boards of directors and, in particular, of their compensation committees. . . . The unhappy (but common) combination of coziness and drowsiness in corporate boardrooms must end. As one concrete manifestation, boards should abolish go-for-broke incentives and change compensation practices to align the interests of shareholders and employees better. For example, top executives could be paid mainly in restricted stock that vests at a later date, and traders could have their winnings deposited into an account from which subsequent losses would be deducted.
Why am I not optimistic? Disney.
Data from Equilar (methodology), published by The New York Times:
I know this is simplistic, but I just couldn’t resist.
- Stock total return is a poor way to measure CEO performance – yet it’s the one that CEOs and boards commonly point to to justify compensation.
- A CEO may have been granted a large stock award in 2008 as a reward for “good performance” in 2007. This could explain the combination of high compensation and poor 2008 performance. However, just think about what that means for a second.
- Most of the large compensation awards are largely restricted stock or stock options. These were valued as of the data of the grant, so if the company’s stock price later fell, the CEO is unlikely to realize the calculated value of the award. But imagine if the stock price had gone up instead: the CEO and the board would be insisting that the award should be valued as of the grant date, not the later exercise date (when it would be worth much more).
Also, I excluded a company called Mosaic, because it’s total return was 257%, so it packed all the other companies into one side of the chart. Mosaic’s CEO earned $6 million.
$165 million, of course, is less than one-tenth of one percent of the total amount of bailout money given to AIG in one form or another. Yet it may turn out to be the $165 million that broke the camel’s back.
The AIG bonus saga neatly encapsulates many of the problems that we have identified with the financial system and with the bailout to date.
. . . since the Geithner-Summers team seems to be looking for them.
Why not say that all bank compensation above a baseline amount – say, $150,000 in annual salary – has to be paid in toxic assets off the bank’s balance sheet? Instead of getting a check for $10,000, the employee would get $10,000 in toxic assets, at their current book value. A federal regulator can decide which assets to pay compensation in; if they were all fairly valued, then it wouldn’t matter which ones the regulator chose. That would get the assets off the bank’s balance sheet, and into the hands of the people responsible for putting them there – at the value that they insist they are worth. Of course, the average employee does not get to set the balance sheet value of the assets, and may not have been involved in creating or buying those particular assets. But think about the incentives: talented people will flow to the companies that are valuing their assets the most realistically (since inflated valuations translate directly into lower compensation), which will give companies the incentive to be realistic in their valuations. (Banks could inflate their nominal compensation amounts to compensate for their overvalued assets, but then they would have to take larger losses on their income statements.)
We can dream, can’t we?