Rewarding Rewarding Illusory Alpha: Governance and the Crisis P Patrick Bolton i k B l Columbia University ECGI Annual Lecture , Luxembourg May 7 2010
Outline 1. Main Causes of the Crisis 2. Compensation and Risk-taking p g – Compensation before and during the crisis – – Short-term compensation and risk taking Short-term compensation and risk-taking – Leverage, compensation and risk-taking 3 3. Proposal for reforming executive compensation P l f f i ti ti at highly levered (financial) institutions 4. Conclusion: Governance and Financial Regulation ECGI Annual Lecture , Luxembourg May 7 2010
Causes of the Crisis ECGI Annual Lecture , Luxembourg May 7 2010
Causes of the Crisis • Real Estate Bubble • Excess Leverage Excess Leverage • Fragility of originate-distribute banking model • “L i “Laissez-faire” (efficient markets) ideology & f i ” ( ffi i k ) id l & regulatory forbearance • Excess risk-taking incentives in banking • Governance and risk-management failures in g the financial industry ECGI Annual Lecture , Luxembourg May 7 2010
Incentives and Risk Taking ECGI Annual Lecture , Luxembourg May 7 2010
Incentives and Risk Taking Modern agency theory of executive pay, Holmstrom and Tirole (1993) : Holmstrom and Tirole (1993) : Stock-based compensation aligns CEO and p g shareholders’ long-term objectives : – Stock price an unbiased estimate of fundamentals Stock price an unbiased estimate of fundamentals – Induces managers to focus on long-run value – Performance measure that cannot be manipulated easily ECGI Annual Lecture , Luxembourg May 7 2010
Incentives and Risk Taking Caveats: • No leverage • • N St No Stock-options k pti ns • No endogenous choice of risk or volatility of g y earnings • • Complete markets Complete markets Risk-neutral investors Risk ne tral investors • No speculative bubbles p ECGI Annual Lecture , Luxembourg May 7 2010
Incentives and Risk Taking Bolton, Scheinkman and Xiong (2006) : • • Differences of opinion + short sales constraints => Differences of opinion + short-sales constraints => speculative bubbles • Endogenous choice of volatility Endogenous choice of volatility • Short-termist incentives : play into the bubble & feed the speculative option value with volatility p p y Bolton, Scheinkman and Xiong (2004) : Earnings manipulation that destroys long run fundamental Earnings manipulation that destroys long-run fundamental value to drive up short-term stock performance (see also Peng and Roell, 2008a,b,c) ( g ) ECGI Annual Lecture , Luxembourg May 7 2010
Enron and Corporate Scandals of 2002 A Analysis by Financial Times of the 25 largest l i b Fin nci l Times f th 25 l r t bankruptcies in 2001 – 2002: • 52 executives and directors walked away with pay > $10M , 31 > $25M , 16 > $50M , 8 > pa > $10M 31 > $25M 16 > $50M 8 > $100M • • Ken La (CEO Enron) $247M Ken Lay (CEO, Enron), $247M , • Gary Winnick (CEO, global crossing), $512M . ECGI Annual Lecture , Luxembourg May 7 2010
Rewarding beta & CEO compensation in Practice Practice • • CEOs are awarded at-the-money options CEOs are awarded at-the-money options • No indexing of performance relative to a market b benchmark h k • No correction for beta => • Stellar stock performance may simply be a reflection of a high “beta loading” reflection of a high beta loading • This is particularly problematic if CEO can vest his stock-options before the boom is over k i b f h b i ECGI Annual Lecture , Luxembourg May 7 2010
Compensation and the Crisis: What do we know? ECGI Annual Lecture , Luxembourg May 7 2010
Compensation in Banks: What do we know? Chart 1: Highest Ranked Executive Salary in Commercial Banks 700 600 500 ands of Dollars 400 Thousa 300 300 200 100 0 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 58 70 71 74 88 86 83 75 70 75 77 82 78 72 72 37 Fiscal Year & Number of Banks Mean Salary Median Salary Source: Standard & Poor's Executive Compensation ECGI Annual Lecture , Luxembourg May 7 2010
Compensation in Banks: What do we know? Chart 2: Highest Ranked Executive Option Grant Value in Commercial Banks 2500 2000 1500 usandsof Dollars 1000 Thou 500 0 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 57 68 70 72 79 81 82 72 69 72 73 80 77 71 72 37 Fiscal Year & Number of Banks l & b f k Mean Option Grant Median Option Grant Source: Standard & Poor's Executive Compensation ECGI Annual Lecture , Luxembourg May 7 2010
Compensation in Banks: What do we know? p Chart 3: Highest Ranked Executive Bonus in Commercial Banks 1200 1000 800 800 usand s of Dollars 600 Thou 400 200 0 0 0 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 58 70 71 74 88 86 83 75 70 75 77 82 78 72 72 37 Fiscal Year & Number of Banks Source: Standard & Poor's Executive Compensation Mean Bonus Median Bonus ECGI Annual Lecture , Luxembourg May 7 2010
Stock option grants are characterized by short vesting Chart 4: Option Vesting of all Options Granted- Commercial Banks (1996-2007) 30% 30% 25% 20% 15% 10% 25.8% 19.9% 18.2% 18.2% 5% 10.5% 5.7% 1.7% 0% 0 1 2 3 4 5 More than 5 years Vesting Schedule Source: Thomson Reuters Insiders ECGI Annual Lecture , Luxembourg May 7 2010
Large portion of options exercised shortly after they vest they vest Chart 5: Time Until Exercise - Commercial Bank Vested in the Money Options (7,254 Transactions) 40 35 34.1 30 ransactions 25 T ercent of T 20 20 15.5 15 P 11.0 9.2 10 7.8 7 8 5.5 6.1 4.5 4.1 5 2.0 0.3 0 0 0 1 1 2 2 3 3 4 4 5 5 6 6 7 7 8 8 9 9 10 10 Years after Vesting Source: Thomson Reuters Insiders ECGI Annual Lecture , Luxembourg May 7 2010
Compensation and the Crisis : What do we know? 1 1. Fahlenbrach and Stulz (2009) Fahlenbrach and Stulz (2009) 2. Bebchuk, Cohen and Spamann (2009) 3 3. Chen, Hong and Scheinkman (2009) Chen Hong and Scheinkman (2009) ECGI Annual Lecture , Luxembourg May 7 2010
Compensation and the Crisis: What do we know? 1 1. Fahlenbrach and Stulz (2009): Fahlenbrach and Stulz (2009): • Look at up to 95 BHCs and IBs in 2006 • Regress buy-and-hold returns from July 1, 2007 to December, 31, 2008 on five measures of CEO , , incentives : – Cash bonus/salary Cash bonus/salary – $-ownership & $-equity risk sensitivity – % %-ownership & %-equity risk sensitivity hi % i i k i i i ECGI Annual Lecture , Luxembourg May 7 2010
Fahlenbrach and Stulz (2009) • • Investigate insider trading of bank CEOs in 2007 Investigate insider trading of bank CEOs in 2007- 2008 • Estimate $-loss of CEOs on their stock holdings • • On average CEOs lost $28 7M on shares not sold On average, CEOs lost $28.7M on shares not sold • Median loss $5.1M • ¾ of CEOs did not sell any shares ECGI Annual Lecture , Luxembourg May 7 2010
Fahlenbrach and Stulz (2009) Cross-sectional regressions of buy-and-hold returns Cross-sectional regressions of buy-and-hold returns from July 2007 to December 2008 ECGI Annual Lecture , Luxembourg May 7 2010
Fahlenbrach and Stulz (2009) Cross-sectional regressions of buy-and-hold returns from July 2007 to December 2008 ECGI Annual Lecture , Luxembourg May 7 2010
Fahlenbrach and Stulz (2009) CEO insider trading ECGI Annual Lecture , Luxembourg May 7 2010
Fahlenbrach and Stulz (2009) MAIN CONCLUSIONS: MAIN CONCLUSIONS: • No evidence that CEO incentive misalignment caused worse performance • • Banks where CEOs had better incentives Banks where CEOs had better incentives performed significantly worse than other banks • Possible explanation: CEOs with better incentives took greater risks ECGI Annual Lecture , Luxembourg May 7 2010
Bebchuk, Cohen and Spamann (2009) • • Looks at executive compensation at Bear Stearns Looks at executive compensation at Bear Stearns and Lehman Brothers from 2000 to 2008 • Top executive teams at Bear Stearns and Lehman Brothers obtained between $1.4 billion and $1 billion respectively from cash bonuses and equity sales. ECGI Annual Lecture , Luxembourg May 7 2010
Bebchuk, Cohen and Spamann (2009) TOTAL CASH FLOWS FROM BONUSES AND EQUITY SALES 2000-2008 ECGI Annual Lecture , Luxembourg May 7 2010
Bebchuk, Cohen and Spamann (2009) ESTIMATED VALUE OF INITIAL HOLDINGS ECGI Annual Lecture , Luxembourg May 7 2010
Bebchuk, Cohen and Spamann (2009) MAIN CONCLUSIONS: MAIN CONCLUSIONS: • Performance-based compensation at Bear Stearns and Lehman did not result in an alignment of executives’ interests with long-term shareholder value • • The opportunity to cash out large amounts of The opportunity to cash out large amounts of shares and options tilted executives incentives towards short term stock prices towards short-term stock prices ECGI Annual Lecture , Luxembourg May 7 2010
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