Wharton B School: Executive Pay is Broken

Wharton finance professor Alex Edmans and a group of colleagues propose linking an executive’s compensation to the performance of the firm over a longer horizon.  The model resembles the idea outlined in previous posts of this blog: Regulate executive pay in the financial sector by linking it to the long term performance of key employment and average pay indicators of the U.S. economy as a whole.  This way bankers will be motivated to lend, invest and borrow so that somehow employment and average pay for everyone are increasing over time.

You can read the full blog post from the Knwoledge Wharton blog here

How To Regulate Executive Compensation

The main driver of this economic catastrophe was the behavior of some executives in the banking and financial industry. For this situation to be fixed, we need to alter the behavior of bankers and financiers. Here’s one way of doing it:

1. You regulate the compensation of all +$100,000 earners in any financial institution of certain size. Each institution will be obligated to report electronically and anonymously the pay out for all its +$100,000 earners. This can be done very easily, as they are already doing so, so it is just data mining.

2. You declare that there are no bonuses for anyone in the financial industry from Q3 2009 to Q3 2010.

3. As of Q3 2010, bonuses in the financial industry will be paid only if Quarter On Quarter – QOQ and over the comparable quarter last year (YOY) two indexes grew:

Employment Rate

Inflation-Adjusted Median Wage

It is not that important “how” you measure employment rate and inflation-adjusted median wage, because almost all acceptable methods correlate when it comes to measuring if the index went up or down – they differ only in  absolute numbers. See in the chart below, and the following presentation that shows how wealth creation is distorted and needs to be fixed – by the private sector:   

This is a relatively simple way to alter executives’ compensation in the financial industry, and still continue to promote Capitalism.  Why?

1. Because this way every Banker and Financier will be focusing on POPULAR WEALTH CREATION rather than the wealth creation for the few. Popular wealth creation is different than the DISTRIBUTION of wealth because in popular wealth creation everybody gets more (some get much more, some get “little” more) whereby in distribution of wealth you take from someone and give to someone else.

2. Because this way you take the burden of fixing inequalities from the Government (that  CAN’T fix many things in a timely manner) to the private sector and into the hands of the most financially creative people.

3. Because this way in a recession wealth accumulation amongst the rich is leveled down without forcing wealth distribution (taxes, etc) , and you motivate the financial industry to fix the problems as soon as possible.

4. Because it does not create an regulation monster that consumes resources (the Government agency is auto-triggered-based).

This has to be employed in the western world as a whole, otherwise bankers will migrate from one country to another.

(In the same way, regulate executives’ bonus compensation in the Energy industry and tie it to carbon footprint index – you’ll fix global warming much faster.)

There are plenty of loop holes in this proposal, but granted that the current system isn’t working at all.

AIG SHOULD PAY $0 BONUS THIS YEAR

The NY Times published yesterday part of a letter sent by A.I.G’s CEO to the Treasury Secretary Timothy F. Geithner, defending $165 million in bonuses he wants to pay TODAY to executives in the same business unit that brought the company to the brink of collapse last year.

Just to make sure you all understand: The CEO of AIG wants to pay $165 million in bonuses to those who are responsible to the current financial catastrophe. These people made a fortune in the past 8 years from irresponsible underwriting and investing that was driven by short-term greed – and made a fortune. AIG wants to take your tax dollars and  further inflate their wallets.

Edward M. Liddy, the government-appointed chairman of A.I.G.,  wrote to Mr. Geithner that at least some bonuses were needed to keep the most skilled executives:

“We cannot attract and retain the best and the brightest talent to lead and staff the A.I.G. businesses — which are now being operated principally on behalf of American taxpayers — if employees believe their compensation is subject to continued and arbitrary adjustment by the U.S. Treasury

Mr. Libby is lying. This is the only option, as he is not stupid. He is  lying because he knows very well that there is no way that any of these executive will leave if they don’t get their bonus. The reason? Nobody else is hiring!!

Go ahead, test it – and see how long it takes for your redundant executives to find a new job that pays the same. Non of your competitors is hiring, non of the other financial institutions, so just stop the BS.

Mr. Libby is also promoting the continuation of the financial meltdown. These people have directly caused this situation – They should get a 50% pay cut to discipline them and show them that what they did was wrong.  Giving them bonuses is simple outrageous, as it promotes the same actions that caused this mess.

If you paid taxes in the last year you own roughly 80% of AIG. The person who runs AIG’s investment community division is Teri Watson. Since you are now part of this investment community you should email them and demand not to pay these bonuses – the email is teri.watson@aig.com

Gordon Brown: Bankers’ Compensation is Broken

And here we are again: Gordon Brown, the U.K. prime minister, said today he was “angry that hard-working people are being squeezed because of banking mistakes” and called for an “urgent clean up and clear out” of the banking system, adding that “We must agree international principles to end that short-term bonus culture and instead reward long-term sustainable results.”

We have wrote about this for months now. The feast has to stop. The path to healing involves a lot of pain, and many bankers just don’t feel that pain yet. We said that salaries should be cut by 50% to all executives in the banking and financial sectors who got federal funding, while stopping bonus pay altogether.

People have caused this mess, and people will fix it. They need to feel the pain, work twice as hard with half of what they had, as this is key to guarantee that the economy will get back on its feet as soon as possible.

The full story from Bloomberg is here.

Harvard Business: Exec Comp is Broken

It’s was tempting to say out loud that “Great minds think alike” when reading David Chamption’s post on Harvard Business Review’s blog. We wrote here few times now that executive compensation’s best practices in the financial sector must be revised. Tax payers are forced to own these companies and hence overpay executives for poor performance. Chamption is hinting that  compensation for executives in the financial industry should not be much different than compensation for other federal bureaucrats (we wrote about this before). He also suggests to implement indexed pay systems , which is not a bad idea. Here’s the full quote:

When stock prices were rising and job markets were booming, no-one was too fussed to see CEOs and top bankers rake in their mammoth bonuses. It was the tolerable price we paid for a healthy capitalist system. These people took smart bets and fairly earned the rewards. Fair play to them.

With the Dow off 40%, unemployment at its highest in a decade and rising, and a bankrupted financial system, we’ve turned on the fat cats. Now, they’re responsible. No more than $500,000 for the CEO, we’re saying, at least as long as the taxpayer owns the shares. Fair play to us.

It shouldn’t take a financial rocket scientist to tell you that this kind of cap isn’t the smartest way to clean up the mess. Let’s imagine we’ve fast-forwarded to 2011, the financial crisis is over, and Bank of America is turning in record profits, after carefully cleaning its loan books all by itself and managing growth well, and the government is poised to sell its holdings to an eager public.

Suppose also that JP Morgan has gone down the tubes, having failed to manage its loan portfolio, and is asking for more cash (my apologies to CEO Jamie Dimon for this liberty).

According to the new wisdom we’d pay the CEOs of both establishments $500,000 a year. Yet, as shareholders in Bank of America we should be falling over ourselves to reward the team that delivered such results. (Of course, once the banks are out of trouble, the pay caps go away, but that rewards the performance after the turnaround, not the performance that delivered it).

But as shareholders of JP Morgan, we’d have to be asking ourselves what did those bozos do with the money?

Actually, there is a smarter way to pay top executives. Former Kellogg Professor Al Rappaport wrote an article about it, back in March of 1999.

Rappaport argued that the proper way to reward CEOs was through granting them options whose strike prices were tied to an index of peer group of companies. If the company outperformed competitors, the manager got rewarded. If the company didn’t outperform or did worse, there was no reward. More to the point, if the company did better than competitors even in a falling market (i.e., its share price fell by less than the peer group index) the manager would get a payout, maybe even a hefty one, so it would be perfect for the scenario I just pictured as it would provide incentive for performing in hard times, when you arguably need it most.

Rappaport isn’t the only proponent of indexed pay. Over here in Europe, Herman Stern, CEO of Zurich-based financial consultants Obermatt, has been talking about the same topic. Intuitively, it’s hard to argue with the approach, and it’s likely that more and more people will advocate that companies adopt it.

Simple, right?

But if it’s such a good idea, why didn’t companies adopt it years ago? The short answer is that turkeys don’t vote for Thanksgiving. Executives won’t voluntarily switch to compensation schemes that make it harder to pick up the big bucks. Of course, in a recession and in the wake of a financial crisis it might be easier to get over that problem.

But the short answer isn’t good enough anyway. Unfortunately there’s a more serious obstacle to indexed pay. When the economy heats up again, the war for talent will warm up with it. One of the easy ways for companies to compete in that war is by offering easy dollars. In that case, companies that stick to virtuous indexing may end up losing the best executives. If the Yankees offer a pitcher guaranteed money and the Red Sox offer that same pitcher money for each win over the average pitcher’s wins, where will that pitcher sign?

Would you bet against companies falling back into bad habits of excessive pay if they can afford to?

So the question we should be asking ourselves is not how we should be paying bosses – we’ve lots of good ideas about that-but rather how can we make fair pay schemes stick.

It’s a question I put to Stern, and I hope he – or someone – can answer it. Maybe you can. How would you make indexed pay systems stick?

Our thought process, outrageous as it may be for some people,  leads to somewhat of the same conclusion as of some of the good people at HBS.

19.7 Billion in Losses? We’ll Double Your Pay

February 10th, 2009: UBS, the world’s biggest banker to the rich, as a disastrous expansion into investment banking, reported a bigger-than-expected 8.1 billion Swiss franc ($7 billion) net loss in the fourth quarter and an annual loss of 19.7 billion francs, the biggest ever by a Swiss company and above predictions for 18.7 billion francs.

March 2nd, 2009:  UBS, the world’s biggest banker to the rich, reported to increase salaries for senior bankers to about 300,000 pounds ($429,400) from about 120,000 pounds ($171,800).

If this was a small business, say, the Pizza place around your block, nobody would have gotten a raise if the business was losing money while the Pizza industry was collapsing. Nobody.

There is no place in the western world where one could not live in prosperity for $171,800 / year. Hence, there is no reason to double the pay of anyone until the bank is profitable again.

There is also no risk of people leaving in case salaries are not raised. That is because nobody is hiring.

Once again, this shows that something is broken. Banks get tax payers dollars and use them to double up salaries.

After all, if you kept your job, it seems like it’s a good time to be a banker. Somebody strong is watching out for you, making sure you keep your high standard of living though you lost billions of dollars of our money by making bad investment decisions. Good for you.

Vikram Pundit: Please Transform Into Entreprenurial Mode

If Citigroup goes belly up, we are all into a really bad 2009.

So here’s what you, Vikram Pundit, CEO of City, need to do. It is what all Start-Up CEOs are doing these days, and you should do it too:

1. Your salary is already at $1. Great.
2. Cut the salary of anyone who reports directly to you by 50%, and no bonuses as well. Exclude your secretary.
3. Cut the salary of anyone who reports directly to those who report directly to you by 40%, and no bonuses as well. Exclude their secretaries.
4. Continue on until everyone’s salary is cut by at least 20% , and no bonuses. Do not touch the salary of any of the secretaries and adminitration people (including cleaning).
5. Personally call your top 10 vendors in terms of cost and renegociate – lower them all by 40%. Start with lawyers, then PR/Marketing, etc.
6. Have every other executive who retains services from vendors to do the same.
7. Have someone cut all travel expenses by 50% – start by banning employees to travel to 5 star hotels.
8. Sell all non-core business. fast.

Any employee who doesn’t like this plan can go search for other job. He or she won’t find one.

You have our money now, even if we chose to bank to with others, curtesy of the U.S. Governmnet. So act responsibly.

Thank you,

The Worried Tax Payer.

Madoff vs. Your Mutual Fund: Madoff Wins

Cuban, as always, gets it right when it comes to “buy and hold” invesment strategies. This time, he suggest that investing in a mutual fund that tracks Dow or Nasdaq was a big mistake,  even in comparison to investing with Madoff.

Here is the quate from Cuban’s blog:

Lets go back in time 10 years and look at 2 typical  investors, Jack and Jill. Both are in the same tax bracket, have worked hard and saved a lot of money, $250,000 . Its their life savings. Everyone says they should put their money in the market, where it will grow and fund their retirement. So they did.

Which begs the question, who suffered more stress along the way ? The market investor who has had to endure 10 years of ups and downs and ups and way down in the market, or the Madoff Ponzi investor who lived happily and stress free for 9 plus years and must now face the uncertainty of their SIPC and other claims to get their money back ?

One thought they got the break of a lifetime and through a friend was able to invest with the one and only Bernie Madoff. The other put half their money, $125k, in a mutual fund that matched the performance of the Dow Jones, and half in a mutual fund that matched the performance of the Nasdaq.

Neither touched the money other than to cover the fees and any taxes, which for the sake of this example we will say were the same for both.

Who has more money today ? The person who invested “wisely” or the person who invested with a crooked Ponzi Scheme ?

The mutual fund investor bought their Dow Jones Fund when the market was 9550 in Feb of 1999. That  $125k investment has shrunk to about $95k. They bought the Nasdaq Fund when the index  was at 2342.  Today that $125k  would be worth about $ 77k.  Their $250k nest egg of February 1999 is now worth $172,000 . Thats bad , but not as bad as Madoff’s sucker, right ?

Maybe not. Because the Madoff investor had less than $500k invested, there is a good chance that they could be protected by the SIPC, who is already sending out claim forms. So when its all said and done, the Madoff investor could not only get all their $250k back, but they are also elgible for a share of any funds recovered. While that number may be miniscule, it could mean that SIPC elgible and paid Madoff investors actually made money over the 10 year period, while those that put their money in the market got hit very hard.

The sad thing is, that the same comparison could be made for many blue chip stocks that are down 50, 60, even 90pct or more.

This adds to the general notion that the people who are least hurt from this economic downturn are those who helped creating it. Between guarantees, liquidity support, and capitalization, the government has provided between $7 trillion to $9 trillion of help to the financial system.  A big chunk of it went to continue on pay salaries and bonuses to those who literally caused this, making them even richer. So it is not surprising that, at the end of the day, people who invested with Madooff are better off than those who invested in “safe” mutual funds.

The Danger of Virtual Goods to Your Retirement

The global market for virtual goods was estimated to exceed 2.1 billion dollars in 2007.  Virtual goods are what they sound: virtual clothes, virtual homes, virtual cars. I am hesitant to say how much of it was paid by U.S. consumers, but let’s assume that it was more than 80%.  It means that more than 1.5 billion dollars was spent on goods that have zero value, because they are, well, virtual.

You, the “baby boomers,” brought yourselves to a state of collapse. You made things so bad that only the most ignorant would say you could stay the course.  By bringing your lifestyle to an abrupt halt, you had to take notice.

So take notice of virtual goods. Why? Because your pension fund is probably investing in that through Venture Capital investments. And why it is important? Because this is one of the very few industries the U.S. can out compete its global competitors and balance its debt, making your personal financial future much brighter.

For that to happen, there needs to be an equivalent of the Chinese unfair trading rules protecting their industries and ensuring that their tangible goods are cheaper than of the U.S.

It may sound odd, but if one can ban U.S. consumers from consuming virtual goods , and yet allow the “export” of these same virtual products that U.S. companies “make”, then you just found a growing industry worth billions that balance the trade deficit.  The U.S. has unfair advantage here because of the creativity of its entrepreneurs, and your retirement can be much more secured. Think of it as another form of natural gas that can only be made in the U.S. and export outside.

Unfortunately, this suggested course of action will not happen. What is likely to happen is that U.S. consumers will continue to consume virtual goods, leaving less money for tangible goods and services. This will have net negative effect on the economy as a whole, and further danger your retirement.

So, make sure to ask your pension fund manager if she can push the Venture Capitalist to direct their companies to exclusively export their virtual goods.  It will benefit us all.

Boomers’ Main Risk is Not Taking One

News Flash: Boomers fail to face the truth that they face substantial gaps between their future desires and reality.

Oh, it’s not really news, they know it but not doing anything about it.

The growing healthcare costs, tagged with the current decline in housing and nest egg value, are forcing new ways of coping.  Boomers are essentially left with two main options:
1.    NOT retiring and continue on working till the very last days of their lives.  In every developing country that is the norm, so maybe there isn’t any harm in Americans working till death.
2.    TAKE MORE RISK. Risk and Return Are Correlated – The Higher The Risk The Higher Return, so you might be able to grow your nest egg back.

There is no option 3. Vangurds’ customers in the age of 50 – 64 don’t have enough time to compensate for the average 40% nest egg decline they had in 2008.  If they stick to their current strategy, they gamble that we will have a bull market for most of 2009 – 2024  time period.
Everyone, from Paulson to every financial planner out there, are back at the drawing boards figuring out how to substantially revise their plans. This is exactly what boomers should do. As of today, it includes Bakers as well.
You know you are doing something right if:
1.    You spend 3x – 10x more time on planning and learning. If you spent 2 hours a month on your retirement portfolio planning, make it 10 hours from now on. Read more, as your advisor also had 40% decline in his / hers portfolio, so they don’t know more than you.
2.     Somehow, you create a “pool” of advisors that have different ideas.
3.    Decide: work till death or take more risk. You have to decide, and then act on it. Otherwise, you are facing a crisis in a few years.

Realistically, only 20% or so of boomers will revise their plans and act upon them. The rest are subject to unchangeable behavioral patterns such as lack of discipline, delaying actions in uneasy or complex matters, and planning short term.
However, since there are 77 million people within this category, there is a big prize for those will be able to get the 80% to act.