It’s all Lemonade when it comes to Executive Pay

I’ve had to read executive pay studies for some time since Corporate Finance is one of my fields. This is one of those areas where every time they think they come up with a good explanation and plan, we see a complete failure in the reallemons world. This is because it fits under theories of probability where human behavior is poorly quantified. Executive compensation falls under the Moral Hazard area and of course the Lemon’s problem. Believe me, I’ve worked as a corporate consultant and a corporate flunky long enough to know the high level of lemons in the CEO market. It’s one of my main motivators for going back to the halls of academia. I can only slap my forehead so many times before I get a permanent indentation.

One of the first studies on asymmetric information (the lemons problem) is from George Ackerloff (1970).   His example comes from the market for with used cars.  It centers around determining the reason the seller want to sell of the car. One reason is that it might be a lemon. This is considered a situation with asymmetric information. This means the buyer and the seller have different information.  The seller knows if  the car is a cream puff or a lemon, but the buyer has no idea. He only knows the probabilities or the the odds that the car is a lemon.   So, if he’s rational (and remember the assumption is that he is rational), the buyer will demand a deep discount.

So here’s the news today for investors, board of directors, CEOS, and taxpayers who bail out too big too fail and badly managed companies.  Bloomberg reports that the Obama administration is seeking SEC power over executive pay.

The Obama administration will seek new powers for the Securities and Exchange Commission to force firms to let shareholders vote on executive pay and make directors who set compensation more independent, an administration official said.

Today’s proposal, subject to congressional approval, would cover all public companies. President Barack Obama has long supported giving shareholders nonbinding votes on bonuses, salaries and severance packages. The administration also will name a “special master” to monitor compensation plans for firms receiving exceptional assistance in the financial rescue.

The changes are aimed at reducing systemic risks and quelling a political uproar over bonuses paid to executives whose companies were bailed out by the government. Treasury Secretary Timothy Geithner has repeatedly blamed pay standards tied to short-term profits for contributing to the worst financial crisis since the 1930s.

“It clearly is going to force companies to be more transparent with their disclosure” on compensation, said Irv Becker, national practice leader for Philadelphia-based Hay Group’s executive compensation practice. If the measure is implemented, it likely will take several years before shareholders begin to confront management, he predicted.

“It’ll kind of be novel the first year, maybe the first two, and then likely be a little bit more serious in future years,” said Becker, a former head of compensation and benefits at Goldman Sachs Group Inc.

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The Bailout: More Oversight or More Overlook?

More bailout news today as the Fed pledges $540 billion to shore up mutual funds.  The New York Times outlined the proposed plan to help provide short term debt that many money market mutual funds use to finance their investments.  When the Treasury refused to bail out Lehman brothers, shares of its Reserve Fund fell below $1.  This caused problems in many money market mutual funds as the investors realized their money may not be safe.

Since then, many funds have experienced redemption requests.  This has caused fund managers to move to safer and more liquid sources to shore up their funds.  Many fund managers no longer look to commercial paper and have switched strictly to Treasuries and other investments considered highly safe.  This has squeezed lending to companies looking for bridge loans and working capital sources.  The details have not been finalized, but the Fed is hoping to negoitiate the deal and is looking to JP Morgan Chase to carry out many of the required actions.  This basically expands the lines of businees that taxpayers are now shoring up for financial companies.

While the Fed and Treasury have been forthcoming with plans and money, it is still uncertain when we will actually see them get around to solving the problems instead of doing triage.  We are experiencing more and more situations where taxpayer money is being used to supplement private investments and loans to corporations (including the very financial corporations responsible for this mess).  What we are not seeing is the increased oversight that must go along with the flow of funds into the financial sector.  It is really time for Congress to act now before more money flows to these players who will not be held to account.

Corporate Governance is one of those things that should not be overlooked.  The Treasury’s bailout seems to have more to do with a short term shore up of markets, than rooting out the bad players and ensuring these funds are not abused.  It appears that some of the corporate governance and executive compensation rules originally part of the bail out plan have been watered down.  Many in congress and the Treasury itself stated earlier that any of these financial institutions benefiting from government funds must adapt stricter corporate governance rules and executive compensation limits.  Corporate Governance is a broad set of that basically protect shareholders from executive malfeasance.

The first concern with corporate governance discussed in the bailout was that executive pay should not encourage unnecessary and excessive risk.  In other words, the pay should not INCENT the managers to go after short term profits that endanager the safety of the firm.  Market Report states a very important point here.

The Treasury’s interim final rule requires that the compensation committee of a company’s board of directors review executive pay to make sure it doesn’t encourage management to take too many risks.

The committee has to meet at least once a year with the bank’s chief risk officer to check the relationship between the institution’s risk management and executive pay and incentives, according to the rule.
But the Treasury isn’t replacing any of the directors on the boards of the banks it’s investing in, or adding new directors to represent taxpayer interests. That means there’s no way for the Treasury to check if executive compensation is encouraging too much risk-taking.
If none of the original players have been held accountable and are still in place, how exactly does this change anything?  Remember the old adage, if nothing changes, nothing changes?  Just as before, the
oversight and enforcement will be left to the same folks.  Most of these folks (the board of directors) were in charage of all these big banks and brokerage firms when they were incurring the risky things that led to this melt down.  Most boards were clueless back then. They took the advice of the executives that put their organizations at risk.  So, how are they supposed to suddenly develop knowledge now and do the right thing?  Plus, these folks are supposed to protect the shareholder.  Will they treat the public money with similar weight?
There are a few other rules that were stuck in the bail out terms. One such rule is that banks will not be allowed to deduct executive compensation above $500,000 against taxes.  However, there is nothing saying that they won’t just skip the deduction and pay the executives what they want to any way. Since many executives can go other places, the banks may just pony up the money to retain them.
Also, the original bailout banned golden parachutes.  Now, however,  the Treasury’s interim final rules defined golden parachutes as payments equal to or exceeding three times an executive’s annual salary and bonus.  That means as long as these packages fall under these guidelines, the golden parachutes can remain.
So in conclusion, I’d like to quote from the letter of that 37 year old hedge fund manager that retired with ALL that money betting against the folks that led us down the path to this financial crisis.  Now, not on Mr. Lahde’s plea for legalizing marijuana, but the other one.  The one that says Congress just keeps looking the other way.

On the issue of the U.S. Government, I would like to make a modest proposal. First, I point out the obvious flaws, whereby legislation was repeatedly brought forth to Congress over the past eight years, which would have reigned in the predatory lending practices of now mostly defunct institutions. These institutions regularly filled the coffers of both parties in return for voting down all of this legislation designed to protect the common citizen. This is an outrage, yet no one seems to know or care about it. Since Thomas Jefferson and Adam Smith passed, I would argue that there has been a dearth of worthy philosophers in this country, at least ones focused on improving government.

In short, Congress needs to get with it and start protecting the taxpayer’s money with much more tenacity than the protected investor’s money.  Write them and tell them to strengthen the oversight of the bailout plan.