Posted by Marc Hodak on June 3, 2009 under Executive compensation | 
Recent research finds a significant correlation between something called prepaid variable forward contracts and negative relative returns to shareholders.
In layman’s terms, the executives are selling their firms short (after a fashion), and their stockholders are suffering afterward.
Now, executives can’t actually sell their firm’s shares short. That has been illegal since the Erie Railroad scandal in the late 1800s. But executives are allowed to sell their company’s shares that they own, and they are allowed to sell those shares in forward contracts, i.e., an agreement to sell them in the future. Why would an executive do this?
Supporters of the contracts say they help executives with concentrated exposure to company stock diversify while retaining voting rights for the shares until the contract ends.
The problem is that shareholders don’t want their managers to diversify. They like having the pilot in the front of the plane without a parachute. Read more of this article »
Posted by Marc Hodak on June 2, 2009 under History, Irrationality |
On a recent trip to D.C., I got some change from a vending machine, and thought, “Damn, someone managed to get a fake coin into the change box.” It looked like a casino token. I was pissed. When I looked more closely, I got confused. It’s markings said United States of America and indicated a value of $1. I shrugged and put it in my pocket. Shortly afterward, I saw a sign on the wall that read:
I read that one line twice: “They Save the Nation Money.”
Once upon a time, the currencies of choice were gold or silver. These precious metals had many properties that made them especially useful as currency– they were scarce, portable, and divisible into any useful denomination of coin. People using such coins in exchange could be reasonably certain that the next person in the chain of commerce would accept it at an equivalent value for which they received it. The only problem was that these metals had to be weighed for each transaction.
Monarchs exploited the opportunity to create greater trust in commerce by minting uniform denominations with the seal of the sovereign stamped on the coin. The stamp assured its value. To enhance the credibility of that stamp and protect the value of the coin, the sovereign threatened penalties to anyone representing a debased version of the coin as the real thing.
Eliminating the need for scales in every transaction was a huge advance in commerce, equivalent to the replacement of cash and checks with credit cards. The monarch capitalized on the value of his stamp by selling officially minted coins to banks for slightly more than they were nominally worth in bullion, which banks were willing to pay because the demand for the coins was high. This profit was called seigniorage.
Alas, monarchs didn’t enforce anti-counterfeiting laws against themselves. When they began to debase their coins, their currency suffered from inflation, and their people began reverting to other trusted coins, or to bullion and scales. To enforce their debasement, governments began forcing their people to use the debased currency via legal tender laws. The history of how seigniorage transformed from a game of narrow spreads into a large-scale, legal counterfeiting operation is long and sordid, but it has finally, apparently come to this:
The U.S. government now advertises that the coins it wishes the public to circulate have minimal intrinsic value.
I understand that the government is promoting this as a savings versus paper bills, which cost less per dollar to produce, but must be replaced more frequently, making their overall cost higher than the equivalent currency in coin. Still, I’m astounded that minimizing the intrinsic value of what is in circulation is being sold as a public benefit. I’m not yet sure how it’s being bought, but I can see a whole bunch of otherwise thoughtful people nodding, “That makes sense.”
Posted by Marc Hodak on May 28, 2009 under Executive compensation |
Finally, a sensible editorial on banking compensation. Alan Blinder waves away the misdirection associated with “how much” bankers have been paid to identify the critical element of “how” they’ve been paid. The answer, as my loyal readers know, is the infamous trader’s option and the trader’s supervisor’s option.
Darwinian selection ensures us that these folks are generally smart young people with more than the usual appetite for both money and risk-taking. Unfortunately, their compensation schemes exacerbate these natural tendencies by offering them the following sort of go-for-broke incentives when they place financial bets: Heads, you become richer than Croesus; tails, you get no bonus, receive instead about four times the national average salary, and may (or may not) have to look for a new job. These bright young people are no dummies. Faced with such skewed incentives, they place lots of big bets. If tails come up, OPM will absorb almost all of the losses anyway.
Blinder suggests what I would consider timid, but sensible reform directed at exactly the right place–the board of directors.
The thing we have working against us is incredible, but understandable conservatism on the part of shell-shocked boards that truly can’t distinguish bold, good mechanisms from bold, schlock mechanisms. I know where they’re coming from. I feel the same way about macroeconomists as I try to get a handle on what’s going on. The thing we have working in our favor is that, the top executives at even public companies actually have a lot of skin in the game, and it’s not just upside. Dick Fuld and Jimmy Cayne didn’t actually want to end up the way they did. If they had any idea of the risks they were actually enabling, they would have looked for a better way. Their surviving competitors are not dummies.
Extra credit for the compensation mavens reading this if they can identify the irony in the title, which was actually coined nearly 20 years ago.
Posted by Marc Hodak on May 27, 2009 under Executive compensation, Reporting on pay |
The new head of UBS is apparently faced with the same problems that were faced by the old head of UBS. One of the biggies is: how do you remain competitive (and solvent) as a bank without being competitive as an employer? Answer: you can’t. Another problem, then: how do you remain competitive as an employer without upsetting the public?
As in the U.S., the Swiss bank gave up its right to pay high bonuses when it got into trouble and accepted a bailout from their government, which basically capped the bonuses. The Swiss people, kindly and educated as they are, still suffer from the mob’s envy of the highly paid. UBS had a choice between being competitive or making the public happy, and they chose survival.
The “exceptional” salary increases “were necessary to safeguard our profitable business areas and to secure their success,” Gruebel said. “Following significant cuts in variable compensation, we had fallen well behind the market in certain areas, and that is unsustainable in the long run.”
Hmm. Companies being compelled to dramatically raise salaries when they were constrained from paying bonuses…who could have predicted that?
By the way, have you noticed that whenever Bloomberg (the same can be said for the WSJ) have multiple stories about a subject, they always start with the part about executive compensation?
Title reference here.
Posted by Marc Hodak on May 26, 2009 under Economics, History |
The world is far too complicated for me to figure out beyond my little niche in corporate governance. So, I’m always looking for high quality material to inform me on the larger issues. Gold, Money, and the U.S. Constitution by Eugene Holloway is such material.
It’s easy to bemoan the actions of private or political officials out of context, or to argue polemical abstractions. By weaving the history into the law, Holloway provides a richer understanding of why things evolved the way they have, and a sense (warning, really) of where things are likely to go from here. An excellent read.
Note: I have linked to the last of four parts, but additional links to the prior three parts are right on that page.
Posted by Marc Hodak on under Revealed preference, Stupid laws |
New York State, in an obvious attempt to see just how much it can piss off its taxpayers, has sent an extraordinary notice to all its citizens. It warns them that not only will their tax rates be raised in 2009, but they will have to recalculate their 2008 taxes now based on the new 2009 tax rates in order to comply with the new law. I know you think you just misread that last statement, so read it again, and rest assured that it is correct.
Here’s how it works. Most income taxes need to be paid each quarter on an estimated basis; the state doesn’t want to wait until the end of the tax year to collect its loot. The typical rule for estimated taxes is the lower of either (a) 90% of your actual tax bill that you’ll eventually have to pay or (b) 100% of your last year’s actual tax bill. For most filers whose incomes are flat or growing, the easiest thing to do is to look at your tax bill for last year and just pay that in equal installments over the current tax year. Simple enough.
This year, New York is saying that if you wish to use the second option to pay estimated taxes, i.e., 100% of last year’s taxes paid, you need to recalculate the amount you would have owed last year based on this year’s higher tax rates.
That’s right, the lovely time you recently spent calculating your New York taxes, you need to go through that again now using the new tax rates so that the state can squeeze that last $100 from you without having to wait until next April. We really are talking about chickensh*t sums, here. For the 60% of people who hire accountants to do their taxes, the vast majority of them would ending paying more for this recalculation than they would owe in additional estimated payments.
Why would the state do such a crazy thing? Because the state’s politicians are desperate for those incremental dollars, and they truly don’t care if what it costs you to pay them the lawful amount.
Most debates on tax policy center on the elasticity of supply, i.e., the degree to which an increase in taxes will reduce the willingness of the person being taxed to continue engaging in the taxed behavior. For example, if raising the sales tax causes people to buy less such that the actual tax raised is minimal, and businesses will otherwise suffer from the reduced sales, most policy makers would say that’s not an efficient tax. In New York State, we now have proof positive that if a business has to pay someone doing no productive work $10,000 in order to get the state an extra $8,000, the politicians feel they are ahead. Such abuse of New York State taxpayers is why we are seeing more of this.
Posted by Marc Hodak on May 25, 2009 under Executive compensation, Unintended consequences |
Damn those finance geeks. The government imposed restrictions on their bonuses, and they turned around and increased their salaries. Who could have predicted that?
It’s as if Wall Street has this mysterious knowledge about the ability of value to be transformed into different kinds of financial claims, and that these claims that can be traded across time…and stuff. Where does this mysterious knowledge come from?
Posted by Marc Hodak on May 23, 2009 under Executive compensation, Politics, Reporting on pay |
Congress cooking up new legislation (artist's depiction)
According to this story in Bloomberg:
Treasury Secretary Timothy Geithner called for an overhaul of compensation practices at financial companies and said the Obama administration’s plan to help realign pay with performance will be rolled out by mid-June.
“I don’t think we can go back to the way it was,” Geithner said in an interview on Bloomberg Television’s “Political Capital with Al Hunt,” to be aired tonight and over the weekend. “We’re going to need to see very, very substantial change.”
Geithner is not too clear what he means by “the way it was” in compensation practices that begs for “very, very substantial change,” so let me clarify.
1) Let’s say you work in a bank that has seven divisions. One particularly leveraged division, not the one you work in, totally screws up pushing the whole bank into a loss. Your division made money. In fact, it made enough to keep the whole bank from going under. In Geithner’s view, echoing the view of the rest of the government and the media, you should get no bonus.
2) Let’s say you work for a company that the government has more or less taken over. You have a contract with the company for your services, a contract the government in essence approved, dictating compensation to be paid later (bonus, retention payment, deferred comp, whatever). The media hates you and embarrasses the politicians. In Geithner’s view, you should get none of the promised payment.
In other words, given the mob’s inability to distinguish behavior and results within institutions, once those institutions become unpopular, the mob’s sensibilities of what other people should be paid should be made the law of the land. The mob is similarly blind to the difference among firms in an unpopular industry, as if there were no difference between Goldman and Lehman, or between JP Morgan Chase and Citi, in their need or willingness to take bailout money.
The hypocrisy doesn’t stop there:
[Geithner] said that Wall Street’s pay practices encouraged taking on short-term risk, and helped precipitate the financial crisis. What’s needed is a set of broad standards that federal regulators can use to make sure that doesn’t happen again, he said.
If we exchange “Wall Street’s pay practices” with “Congressional policies” we get a far more accurate sense about what precipitated the crisis.
Posted by Marc Hodak on May 20, 2009 under Invisible trade-offs, Politics |
One of the best encapsulations I have ever read on the subject. Sample:
Politicians need headlines. And this means they have a deep need to do something (“Sen. Snoot Moves on Widget Crisis!”), even when doing nothing would be the better option. Markets will always deal efficiently with gluts and shortages, but letting the market work doesn’t produce favorable headlines and, indeed, often produces the opposite (“Sen. Snoot Fails to Move on Widget Crisis!”).
Awesome stuff. This article should be required reading in every school purporting to teach introductory social science.
FD: I’ve done my part in introducing the author, John Steele Gordon, into a curriculum; he has guest lectured in my “History of Scandal” course at NYU.
Posted by Marc Hodak on May 19, 2009 under Executive compensation |
Shell Oil’s board has suffered one of the worst rebukes a board can bear–the slap down of their executive pay package in a “say on pay” vote.
I’m not a big fan of “say on pay,” but when a company sets up an incentive plan based on placing in the top three among a set of peers, then the company places fourth, you can’t expect to get away with:
“The difference between Shell and the third-ranking company, France’s Total SA, was marginal and Shell’s ranking didn’t fully reflect its relative performance.”
The Brits, especially, will not countenance a bonus for finishing behind the French. What was the board thinking, really?
