Posted by Marc Hodak on March 2, 2009 under Executive compensation, Invisible trade-offs, Unintended consequences | 
Nassim Nicholas Taleb has written a good description of what is now widely understood to be one of the key perverse incentives that fueled the recent credit bubble–i.e., the trader’s option:
Take two bankers. The first is conservative. He produces one annual dollar of sound returns, with no risk of blow-up. The second looks no less conservative, but makes $2 by making complicated transactions that make a steady income, but are bound to blow up on occasion, losing everything made and more. So while the first banker might end up out of business, under competitive strains, the second is going to do a lot better for himself. Why? Because banking is not about true risks but perceived volatility of returns: you earn a stream of steady bonuses for seven or eight years, then when the losses take place, you are not asked to disburse anything.
Like like many others cognizant of the moral hazards of the trader’s option, Taleb throws up his hands and recommends hiving off the risky portions of banking from the “utility” parts of banking, and heavily regulating the compensation of the latter. So easily said, isn’t it?
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Posted by Marc Hodak on February 26, 2009 under Irrationality |
For me, the most surreal aspect of the press’s credulous reporting on the unconstrained orgy of spending they insisted on calling the “stimulus package” was their reporting of “jobs impact.” The scare quotes and accompanying skepticism arise from the definition of “jobs impact” as “jobs created or saved,” an unverifiable notion specifically designed to eliminate any accountability for the numbers being offered.
Nevertheless, those numbers were dutifully published. In the Houston Business Journal, The Tennesean, New Mexico news station KRQE, etc., everyone reported the local number of “jobs created or saved” by the spending bill. CBS regurgitated these spoon-fed numbers:
California…will see a “jobs impact” of 396,000. Texas (with 269,000 jobs predicted), New York (with 215,000 jobs predicted) and Florida (with 206,000 jobs predicted) also fare well.
Less populous states see far less impact: Alaska, North Dakota, Vermont and Wyoming are each only predicted to see a “jobs impact” of 8,000.
Hmm, 8,000 each for the smaller states. What a coincidence.
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Posted by Marc Hodak on under Scandal |
The Wall Street Journal continues its descent into tabloid territory. Below a poorly cropped picture of Paul Greenwood mashed up against that of strutting horse was the following caption:
Money manager Paul Greenwood, left, [as if anyone would mistake the horse for a Greenwood] after his arrest Wednesday. Authorities claim he and associate Stephen Walsh spent lavishly on horses, houses, and collectible teddy bears. Right, Mr. Greenwood’s horse farm [because we’re still having trouble differentiating Greenwood from the horse] boasts show ponies that can fetch more than $100,000, according to his web site.
Nota bene: the authorities weren’t quoted as claiming that the money used to buy this stuff was robbed from customers. No, they’re being quoted as saying it was spent lavishly. Last time I checked, spending lavishly was not a crime, which brings up an interesting question about scandal reporting: why are authorities being quoted on how the money was spent versus how it was acquired?
To appreciate the answer, one must understand the stages of scandal prosecutions. Every scandal has a target of outrage. That target is tried first in the court of public opinion before being tried in a court of law (if they actually get there). In the court of public opinion, it’s much easier to convict someone for being rich than for being a fraud. The Wall Street Journal is basically pronouncing a verdict without a trial, using pronouncements of “authorities” as its cover to say what it wanted to say.
It is also helping the government prepare for a prosecution. Fortunately, a court of law has slightly higher standards than the court of public opinion. “Too rich to be innocent” is not quite a high enough hurdle. The first Tyco prosecution was almost entirely based on lurid tales of $6,000 shower curtains or umbrella stands, a $2 million birthday party, and various mistresses. I was there, and the incompetent prosecutors resembled chimps banging on pots with their disjointed presentation of loudly irrelevant facts. They ended up confusing the jury, and failed. It took a second, much more streamlined prosecution focused on what the defendants actually did to their shareholders, to get convictions.
But the real trial will come later. First, the public trial and the verdict.
Posted by Marc Hodak on February 25, 2009 under Scandal |
No over-priced pansy auto CEO could be this good.
Posted by Marc Hodak on February 23, 2009 under Politics |
I was taught to think in terms of return on capital relative to cost of capital. Totally outdated way of thinking. In financial terms, the return on capital invested in GM or Chrysler is still less than zero. In fact, it will likely be negative 50 percent. That’s the best case scenario.
The correct way of thinking about this is in terms of return on political investment.
Good commentary on the Chrysler corporate welfare package here.
Posted by Marc Hodak on February 22, 2009 under Collectivist instinct, Politics |
Reuters began an article titled “Europe says all markets must be regulated” with the following lead:
Europe said on Sunday it was time to get tough with tax havens and strictly oversee all financial markets as part of sweeping reforms to avoid future meltdowns.
Let’s translate:
“Europe said“: The heads of several governments, representing the politicized sectors of their respective European countries said…
“it was time to get tough with tax havens“: they see this as yet another opportunity to shut down tax competition…
“and strictly oversee all financial markets“: and expand their political cartel over areas they don’t currently control
“as part of sweeping reforms to avoid future meltdowns“: to increase their already immense regulatory powers, with no real expectation that they will exercise them with any more success or accountability than they have in the past.
This might be a good time to formalize Hodak’s Law: Politicians will assert that there is no problem in society that can’t be solved by giving them more money and more power.
For some reason, the press always credulously reports these power grabs as if they were the only sensible way of discussing or dealing with problems.
Posted by Marc Hodak on February 19, 2009 under Executive compensation, Self-promotion |
That was my proposed title for this article just published in Forbes, but the editors there, well they have their own mind about things.
Anyway, their Bonus issue is up, and the line-up is great. It includes a colleague, client, collaborator, and competitor (quoted in one of the pieces). Enjoy!
Update: Anyone who says that print media offers the ability to offer more nuanced analysis and discussion of issues hasn’t worked in incentive compensation! My article basically says two things: you have to compete, and incentives matter. Most of the comments basically assume the opposite, which is par for the course on this emotional issue.
Posted by Marc Hodak on under Executive compensation |
Whenever a CEO declines a significant chunk of change, as GE CEO Immelt did this past year with regards to his $11.7 million bonus, the reaction is predictable: some react positively, feeling that Immelt is in touch with us regular folks, that feels our pain; others are decidedly more cynical about Immelt’s motives, or about the capitalist system that made such an ‘obscene’ payment possible. The more sophisticated board observer would recognize that Immelt and the board finely executed their respective prerogatives, with the board proposing and the CEO disposing in one of the few areas of goverance where that is the way it’s supposed to be.
My perspective is a little different. I’m left wondering, why did the bonus plan fail so badly?
It failed for two common reasons that bonus plans fail: it was based on the wrong metrics, and the pay-for-performance leverage across those metrics was miscalibrated. Immelt’s $11.7 million came from GE’s long-term incentive plan. This plan was based on performance against four metrics: earnings per share growth; revenue growth; cumulative return on capital; and cumulative cash flow from operating activities.
Taken together, these four metrics are a pretty good basket of indicators. But GE’s plan, as is common, does not take these metrics together–it calculates distinct pay-for-performance schedules for each of them individually, and individually half of these metrics would not be expected to closely relate to shareholder value.
For example, revenues can be bought with extra costs. If a company did this, you would expect to see it in a decline in earnings. In fact, GE just met its maximum revenue growth target, but fell well below it’s minimum earnings target. What do shareholders care about more? If one item on the menu is delicious, but the other is poison, is it an OK meal on average? For bonus plans, the answer is often “yes,” as it was in GE’s case.
So, GE’s long-term plan, suffering from some rather common afflictions, mistakenly created large awards for their managers. Immelt was a mensch for forsaking his portion of the award. The real question is, will he and his board realize what a crappy plan it was that created such an award, and will they bother trying to design something better next time?
Posted by Marc Hodak on February 18, 2009 under Executive compensation, Politics, Unintended consequences |
This is my public service announcement.
Many firms and a few compensation consultants are still trying to figure out what the stimulus plan restriction on executive compensation really mean, and what they should be considering as a result of these rules. Here are the answers.
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Posted by Marc Hodak on February 17, 2009 under Collectivist instinct |
In the zero-sum world that most journalists inhabit, they can hardly write a story about the crunch in public services without tying it to the billions paid in Wall Street bonuses, presumably directly from the public treasury. Witness in Reuters: Elderly New Yorkers angry as crisis hits poorest:
In New York, with city and state tax revenues tumbling, benefits and services to the elderly are being cut, and many older residents are furiously drawing comparisons to the billions of dollars spent to bail out banks — and pay Wall Street bonuses.
Well, why shouldn’t they draw those comparisons? Hasn’t the mainstream press furiously inked it onto the minds of its readers, capitalizing upon and reinforcing their economic illiteracy?
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