SSRN-Executive Pay, Talent and Firm Size by Jaeyoung Sung, Peter Swan

Sung and Swan examine the pay, performance, and size relation using panel data and find that firm size matters but maybe not as much as previous authors had suggested.

SSRN-Executive Pay, Talent and Firm Size by Jaeyoung Sung, Peter Swan:


The authors model a pay relationship and find support for their model. Without getting into the gory details of the modeling, consider two firms (one large, one small) and two managers (one talented, one less so) whose abilities are unknown but can be learned via observation. How much the firms would pay (their reservation price) and how much the managers would accept (their reservation price) are examined.

"...panel data for 1992-2006 exclusive of time factors, which strikingly suggest that the average talent level of small firm CEOs is only slightly lower than that of large firm CEOs, but the talent variability of small firm CEOs is far greater than that of large firms."

A few look-ins.

"...each firm would like to hire an agent who would produce an expected profit to the firm at least as great as the other agent would. However, each firm’s decision can also affect/be affected by the other firm’s decision."

and in examining the pay and performance relation the authors report:

"CEOs employed by firms with positive performance capture over 67% their
exceptional talent in the form of higher pay. By contrast, for negative performers the
relationship is insignificant indicating the absence of penalty for poor performance.
This would indicate that incentive contracts treat negative performance as having a
component of bad luck with less severe penalties in place which is more conducive to
risk-taking."

They also report (and I find myself thinking of professional sports teams here) that large firms can afford to hire some lower level talent and essentially overpay.

"...when a large firm hires a low-ability manager, the expected pay for the low ability manager can be higher than that for a high-ability manager who is hired by a small firm, if the large firm’s productivity and the firm size are sufficiently higher and larger than those of the small firm"

Moreover the authors examine the informational effect of having worked at one firm and then switching. (Intuitively, consider that a manager with low skills will be 'found out' by larger firms. Thus switching firms at least potentially signals lower abilities). To protect themselves, the smaller firms would want to make a more incentive laden contract. To wit:

"..that a manager who previously worked for a large firm will be given a contract with a higher sensitivity than a manager who previously worked for a small firm. We find significant statistical support for this hypothesis."

Interesting stuff. If I were a general manager of a professional sports team, I would definitely want to read this one.


Cite: Sung, Jaeyoung and Swan, Peter L.,Executive Pay, Talent and Firm Size(August 23, 2008).
Available at SSRN: http://ssrn.com/abstract=1250742

Study Examines The Psychology Behind Students Who Don't Cheat

Study Examines The Psychology Behind Students Who Don't Cheat:

"People who don’t cheat “have a more positive view of others,” said Sara Staats, co-author of the research and professor of psychology at Ohio State University’s Newark campus.

“They don’t see as much difference between themselves and others.”

In contrast, those who scored lower on courage, empathy and honesty – and who are more likely to report that they have cheated -- see other students as cheating much more often than they do, rationalizing their own behavior, Staats said"

Interesting from a classroom perspective, but also there has to be a some similar relationship with respect to on cheating on taxes, or not disclosing real information, or lying to regulators/auditors etc.

Some interesting stats stemming from Mortgage Meltdown

The topic that dominated last year's classes is still at the center of attention as classes begin here this Monday. The names have changed (last August we were talking about Bear), but the basic underlying story is the same. Moreover, the size of the problem is better known now.

Burdened by Mortgages, Lehman’s Options Narrow - NYTimes.com:

"In the last 12 months, Freddie’s stock price has dropped 95 percent. During that period, Lehman has fallen 76 percent. The Standard & Poor’s financial index has lost 42 percent...Merrill Lynch is down 68 percent and Citigroup is down 64 percent"

While the article focuses on Lehman who has problems due to its smaller size and concentration of mortgages, some of the more interesting stats are industry-wide numbers. Some short look-ins:

"According to data Standard & Poor’s...more than 41 percent of the subprime mortgages made in 2006 are delinquent....Mortgages to people with credit one rung higher than subprime, called Alt-A, are also being hammered. Standard & Poor’s estimates that more than 21 percent of such mortgages made in 2006 are delinquent."

Of course the mortgage problems have led to other problems for Wall Street firms. For instance fewer new issues are being sold which reduces fee income to the banks.

"According to Goldman Sachs research, debt underwriting...has fallen off a cliff....asset- backed issues have fallen 80 percent...and mortgage-backed offerings are off 87 percent."

Hedging jet fuel prices at airlines

Airline hedging has been a topic of discussion on the FinanceProfessorblog since its inception. With volatile energy prices, it is now a hot topic within the airlines as well. Here is a look at the discussion from FlightGlobal.

Hedge your bets:

"A large part of deciding whether or not to hedge comes down to the way in which ­airlines view hedging. Those that see it as an insurance policy which enables them to ­foresee exactly what they will be paying for fuel, therefore avoiding any nasty shocks, are the most likely to implement long-term fuel hedging strategies.

'Airlines should look at hedging as a ­strategic device that keeps them on an even keel and avoids extremes,' says Leo Drollas, deputy executive director and chief ­economist at the London-based Centre for Global Energy Studies. But he adds that there is a tendency for airlines to hedge tactically rather than ­strategically, meaning they are 'either too heavily hedged or too light on hedging, so they lurch from one situation to another'."

The article also gives some real world examples. For instance from Lufthansa (who I recently flew to Barcelona)

"One airline that follows a strategic approach to fuel hedging and has done so since 1990 is Lufthansa. "Our hedging programme is designed to shield the airline from the adverse impact of the market," says Lufthansa vice-president corporate fuel management Helmut Fredrich. "Our strategy is that we are not ­speculating if there is a low [fuel] price environment. The aim is to mitigate the effects of changing oil prices to give Lufthansa time to adjust to different levels. We start 24 months out, building up our hedges by 5% a month so that after 18 months up to 85-90% of demand is hedged." This means 90% of Lufthansa's fuel is hedged for the coming six months, while 54% is so far hedged for 2009."

Good stuff. Well worth the read (it is fast).

SEC short selling rule made little impact: studies | Deals | Regulatory News | Reuters

Do you remember in July when regulators imposed short sale restrictions on 19 financial stocks due to fears of the stocks collapsing and thus leading to a market-wide panic? Well the constraints were recently lifted and now Arturo Bris finds that the regulations did little good and even hurt efficiency.

SEC short selling rule made little impact: studies | Deals | Regulatory News | Reuters: "study from Arturo Bris, a finance professor at IMD business school in Lausanne, Switzerland, found that, even controlling for short selling, market efficiency had deteriorated more for the 19 stocks affected by the rule than for other comparable U.S. financial stocks."

Bris finds, among other things, that while the 19 stocks fell more than their matches, they did not have significantly worse accounting performances, they did not have significantly different short selling activity prior to the rule, and that liquidity and informational efficiency both fell seemingly as a result of the regulations.

From the article:

"from the pre‐EO period to the post‐EO period, relative quoted spreads for G19 stocks have increased from 18 percent to 48 percent, but they have increased only from 11 percent to 29 percent for comparable US financial stocks."

and

"...significant volatility increases: open‐to‐close and close‐to‐close volatility increase 158 percent and 188 respectively. Trade price range increases 4.37 percent in the post‐EO period."

Interesting.

The WSJ also reports on this story here.

Damodaran Online: Home Page for Aswath Damodaran

Damodaran Online: Aswath Damodaran Ok so I am biased. I have watched him spreak several times at conference and we are using his VAluation text in Fin 410. That said, his website definitely gets top billing! Take a while and look it over. You will be amazed at what you learn.

Study Tallies Corporations Not Paying Income Tax - NYTimes.com

While it might be more of an accounting piece, it is still sort of interesting for corporate finance classes. And definitely draws into question using stated (as opposed to effective) tax rates for computing cost of capital etc.

Study Tallies Corporations Not Paying Income Tax - NYTimes.com: "Two out of every three United States corporations paid no federal income taxes from 1998 through 2005, according to a report released Tuesday by the Government Accountability Office, the investigative arm of Congress."

In the article (which is not the best), transfer prices are brought up. And since that is always a topic in class, the following is worth noting:

"...the G.A.O. said that it did not have enough data to address the role of what some policy experts say is a crucial factor in profits sent overseas.

That factor, known as transfer pricing, involves corporations’ charging their overseas subsidiaries lower prices for goods and services, a common move that lowers a corporation’s tax bill. A number of corporations are in transfer-pricing disputes with the Internal Revenue Service."

While this is interesting, I would much rather see how much they paid. For instance the article said that larger firms were more apt to pay taxes, but does not say if that is 1% or 34% etc. But in spite of the problems it is still worth reading and shows that the money paid to accountants and tax lawyers is not for nothing.

SSRN-Do Behavioral Biases Adversely Affect the Macro-Economy? by George Korniotis, Alok Kumar

Talk about ambitious! Korniotis and Kumar apparently have found a link between behavioral finance and economic difference across different US States.

SSRN-Do Behavioral Biases Adversely Affect the Macro-Economy? by George Korniotis, Alok Kumar: "

This study investigates whether the adverse effects of investors' behavioral biases extend beyond the domain of financial markets to the broad macro-economy. Our results demonstrate that risk sharing (RS) levels are higher in U.S. states in which investors have higher cognitive abilities and exhibit weaker behavioral biases"

A few look-ins:

"examine whether the systematic effects of behavioral biases extend beyond the domain of financial markets to the aggregate macro economy. Specifically, we investigate whether behavioral frictions adversely affect the level of interstate risk sharing (i.e., state-level income smoothing) that can be achieved using financial markets. To our knowledge, this is the first paper that examines whether systematic behavioral biases can in‡fluence broader macro-economic indicators such as state-level risk sharing"

Looking at cognitive abilities:

"Because direct measures of cognitive abilities of stock market participants are not available, we use the demographic characteristics of the brokerage investors (e.g., income, education, age, social networks, etc.) to define a cognitive ability or “smartness” proxy for each investor and use these imputed cognitive ability measures to obtain aggregated state-level measures of cognitive abilities."

The findings? That behavioral finance does seem to impact economic measures.

"The average RS in states with less sophisticated investors (= 0.131) is less than half of the average RS in states with greater investor sophistication (= 0.324). Collectively, our evidence indicates that the aggregate behavioral biases of individual investors infl‡uence the level of risk sharing across the U.S. states."

Which partially explains the finding that state's risk sharing is quite different from state to state.

"For example, states such as Iowa, South Dakota and Kentucky achieve very low (less than 10%) levels of risk sharing using financial assets. In contrast, states such as Delaware, New Mexico and Oregon attain risk sharing levels of about 50%.""

Interesting! Which is at least consistent with the view that behavioral finance does influence the economy. Surely not the last word on this one.

Citation: Korniotis, George M. and Kumar, Alok,Do Behavioral Biases Adversely Affect the Macro-Economy? (August 12, 2008).
Available at SSRN: http://ssrn.com/abstract=1219304

FMA annual Conference

FMA Conference
Just a reminder the FMA conference is October 8-11 this year. It is in Grapevine Texas. See you there!

Back to blogging

Vacation is winding down so I will get back to blogging. It has been a great summer with trips to relief trips to Missouri (helping after tornadoes) and Iowa (gutting homes after flooding), as well as a vacation to Barcelona.

But I am back and let the blogging begin again!

The capital role of finance in history - Money Matters - livemint.com

Finance and history have been linked for centuries. Here is an interesting look at some long run trends and later in the article what the history says may happen if the US loses its preeminent position.

The capital role of finance in history - Money Matters - livemint.com:

"Almost a hundred years ago in 1910, Austria-born economist Rudolf Hilferding wrote a book called Finance Capital....In his book, Hilferding described the emergence of a new type of capitalism dominated by the banks. He believed that the power of the old manufacturing interests had waned, pushed aside by a whole new breed of powerful bankers who controlled the pursestrings of the economy....“Through this relationship,” he argued, “capital assumes the form of finance capital, its supreme and most abstract expression.”"

Not too big to fail?

Bloomberg.com: Worldwide:

"`We need to create a resolution process that ensures the financial system can withstand the failure of a large complex financial firm,'' Paulson said in the speech excerpts distributed by the Treasury to reporters traveling with him in London.

The Treasury chief noted while there is a resolution mechanism for commercial banks, there is no such process for securities firms. Federal Deposit Insurance Corp. Chairman Sheila Bair has also urged that an agency be given power to take over and liquidate investment banks in an orderly manner. The FDIC has that power over lenders whose deposits it insures."

Let me confess that teaching Financial Institutions and Markets is not my favorite (although much better than its counterpart Money and Banking). That said, there are times that I wish I were still doing it. This is one of those times since the class room discussion over this would be very interesting. FTR I agree. I think large firms should be allowed to fail and if the current system is such that the cost of failure is too high, lowering it (either by allowing a more orderly liquidation or other means) is a worthy endeavor.

Grasso now and then. A look back to 2003.

Bloomberg.com: U.S.:

"Richard Grasso, the former New York Stock Exchange chairman who became a poster child for Wall Street excess, won a court ruling that allows him to keep his entire $190 million pay package.

A state appeals court in Manhattan today dismissed the remaining claims against him for excessive pay, and Attorney General Andrew Cuomo announced he won't appeal further"

And so it is over. At least we can hope it is. In writing this I went back to my the old (now defunct) Financeprofessor Newsletter (September 25, 2003) to see the story as it was originally written back in 2003 when it broke. Here it is in its entirety:

How much is too much? A look at the controversy surrounding Grasso’s
pay Short view: it is not just the pay!
***********************************************************

What started as a fairly minor story about a large pay plan really took
on a life of its own as the uproar over the pay package for the NYSE’s
Dick Grasso is arguably the biggest corporate and institutions story in
several months. Grasso originally was set to receive a $186+ million
pay package. The payment almost immediately drew criticism from all
corners. As the criticism grew, Grasso gave back about $48 million of
the pay, but this did not appease his critics who now included board
members, NYSE employees, and shareholder groups including California
State Pension plan, North Carolina’s State Pension fund, and the NY
State Pension plan. On top of this criticism were numerous newspaper
editorials calling for Grasso’s resignation.

On Wednesday Grasso called a special board meeting. During this phone
meeting and in the face of mounting criticism, (in the press, from the
SEC, and from various stakeholder groups mount), Grasso tendered his
resignation to the board. Somewhat to Grasso’s chagrin, the resignation
was accepted by the board of directors.

Grasso had worked for the NYSE since 1969 (he began at $82 a week!) and
had been president since 1995. Looking back at Grasso’s reign one finds
that he oversaw the NYSE during some of its most fast changing times.
While the NYSE did lose market share on his watch, things were much
better than many had feared for the NYSE. Facing competition from both
new and existing markets, Grasso helped differentiate the exchange as a
place that strived to protect investors while also offering the best
possible execution of trades. However, Grasso is probably most known
for his rallying of his “troops” following the events of September 11,
2001.

However, there were some puzzling actions (such as remaining on boards
of firms on NYSE while in the role of regulator and president of the
exchange) and failing to adequately improve the corporate governance on
the NYSE. This was problematic as how could the NYSE call for improved
governance for the firms that list on the exchange if the exchange
itself did not have its house in order. Additionally, few would argue
that Grasso’s pay was not at least quite generous. In his first full
year as president, he was paid an estimated 50% more than his
predecessor. Moreover this pay grew quickly to over $30 million by 2001
(or at least it appears that way, it is hard to say as the NYSE is
famous for its secrecy and this pay does not include any bonuses or the
like). Ironically (and maybe coincidentally) Grasso’s predecessor was
William Donaldson. Yes the same William Donaldson who is now the head
of the SEC and has publicly spoken out against the pay plan. (It should
be noted that Donaldson’s pay package while presumably lower in value,
was at least as secretive as Grasso’s).
http://www.thestreet.com/pf/markets/matthewgoldstein/10111429.html

No doubt one of the first changes that we will see is improved
transparency. At a time when investors and regulators are demanding
more disclosure and transparency, the NYSE is a bastion for information
asymmetries and a lack of transparency. This can be demonstrated by
showing what happened once the Grasso story broke. First no one knew
how the pay was set or why it was so high. Then, like sharks with blood
in the water, reporters were quick to find more examples of “excess” and
apparent conflicts of interest that occurred on Grasso’s watch.

For instance the NY Times reported that this plan was “six times as
generous as those at major financial services companies.” And MSNBC
uncovered that charities who were associated with board NYSE board
members received significant donations from the NYSE. These payments
may not be problematic, but without disclosure, it seems like they are
hiding something which is not a good thing.
http://www.nytimes.com/2003/09/18/business/18PLAC.html
http://www.msnbc.com/news/968992.asp

However, in the end, Grasso may still have a last laugh. If he can
prove that he was dismissed without good cause (an unlikely event), then
his forced resignation could trigger an additional $57 million payment
for dismissal “without cause.”
http://www.usatoday.com/money/markets/us/2003-09-24-grasso-severance_x.htm


So who will be the next president? Not many people are stepping up in
line. For now John Reed, the former chairman of Citigroup, is serving
as interim president. His pay? $1.00
http://www.marketwatch.com/news/yhoo/story.asp?source=blq/yhoo&siteid=yhoo&dist=yhoo&guid=%7B68FDB434%2D5BBE%2D4B97%2D812C%2D9CED074E5B4C%7D

http://www.forbes.com/2003/09/22/cx_da_0922topnews.html
http://www.nytimes.com/2003/09/19/business/19CHIE.html
http://www.nytimes.com/2003/09/19/business/19BOAR.html
http://www.nytimes.com/2003/09/19/business/19NORR.html
http://www.washingtonpost.com/wp-dyn/articles/A35519-2003Sep19.html
http://news.bbc.co.uk/1/hi/business/3122508.stm

If indeed this type of pay plan is a problem and an indicator of more
serious governance problems at the exchange, then reforms are needed or
the next president will be the same. (As Fool.com points out this is a
nice definition of fungibility). While the exact shape of the reforms
for the NYSE are unknown, it is easily within the realm of possibility
that the NYSE may be forced to give up its role as a regulator.
Additional changes may be to limit conflicts of interest by not having
NYSE board member from firms who trade on the NYSE. In the short term,
the next in line of fire will almost assuredly be the board of Directors
who approved the pay plan. Stay tuned.
http://www.nytimes.com/2003/09/18/business/18PLAC.html
http://news.bbc.co.uk/1/hi/business/3122508.stm
http://www.businessweek.com/bwdaily/dnflash/sep2003/nf20030918_9486_db035.htm

http://www.fool.com/news/commentary/2003/commentary030923dg.htm

Many of the large pension funds that pushed for Grasso’s resignation are
now pushing for more lasting reforms. CALSTRS (Calpers’ sister fund)
took the lead but shortly many others joined in pushing for a breakup of
market function and regulation functions.
http://biz.yahoo.com/rf/030923/financial_calstrs_nyse_1.html
http://sanjose.bizjournals.com/sanjose/stories/2003/09/22/daily22.html
http://news.ft.com/servlet/ContentServer%3Fpagename%3DFT.com/StoryFT/FullStory%26c%3DStoryFT%26cid%3D1059480057505

http://www.philly.com/mld/inquirer/business/personal_finance/6819978.htm

Longer term the NYSE is also facing many operational decisions. Not
least of which is how it is going to continue to compete with the
multitude of electronic trading platforms. As many have pointed out
specialists do provide important services, but this service is most
valuable in market downturns, and whether investors will pay for this or
not is still up for debate.

In an attempt to determine how widespread the large pay plans are, the
SEC (Donaldson) is asking that all of the financial markets disclose
their executive pay. Seeing what each is paid will be interesting.. In
the background are those markets that are already publicly traded and
hence already disclose their executive pay. For instance the Chicago
Merc’s James McNutty’s pay while lower than Grasso’s, is still pretty
high by most standards and above most of his peers when options are
included. Thus, the question arises as to whether more disclosure would
in fact dramatically lower the pay.
http://www.nytimes.com/2003/09/24/business/24PLAC.html
http://www.forbes.com/markets/newswire/2003/09/24/rtr1090379.html

Additional sources used:
http://www.msnbc.com/news/967497.asp
http://www.msnbc.com/news/967365.asp
http://www.msnbc.com/news/967359.asp
http://news.bbc.co.uk/1/hi/business/3114616.stm
http://money.cnn.com/2003/09/17/markets/grasso_meet.reut/
http://news.bbc.co.uk/1/hi/business/3117786.stm
http://www.forbes.com/2003/09/11/cx_da_0911topnews_2.html
http://www.washingtonpost.com/wp-dyn/articles/A62752-2003Sep11.html
http://www.forbes.com/newswire/2003/09/09/rtr1077345.html

What others are saying:
“Each troubling detail of the package: its basis on cash; the lack of
comparability with CEO's of other major financial institutions (let
alone the heads of quasi-regulatory agencies); the apparent dozing on
the job by the NYSE compensation committee; not to mention the size of
it, is so appalling as to be almost comical. The type of mathematical
and moral calculus that structured the compensation package, and
Grasso's twisted logic in explaining it, is more in keeping with the
leadership of the Enron's and WorldCom's of the world, than it should be
with the executive of the world's most prestigious stock exchange”
http://www.tompaine.com/feature2.cfm/ID/8910

Financier Starts Sentence in Prostitution Case - NYTimes.com

It has not been a good year for Jeff Epstein. A billionaire money advisor who owned his own island in the Caribbean as well as a large townhouse in NY, Epstein used to be known for his secrecy, smart friends, dislike of suits and ties, and yoga. That has changed in the past year. In fact, it has changed in a big way! Read on:

Financier Starts Sentence in Prostitution Case - NYTimes.com:

"On Monday morning, he turned himself in and began serving 18 months for soliciting prostitution....It is a stunning downfall for Mr. Epstein...a tabloid monument to an age of hyperwealth. Mr. Epstein owns a Boeing 727 and the largest town house in Manhattan. He has paid for college educations for personal employees and students from Rwanda, and spent millions on a project to develop a thinking and feeling computer and on music intended to alleviate depression.

But Mr. Epstein also paid women, some of them under age, to give him massages that ended with a sexual favor, the authorities say."

In addition to these charges, he was also recently was identified as a major investor in Bear Stearns' (where he used to work) hedge funds that collapsed last year:

From NY Times DealBook:

"The New York Post reported Monday that he was the “Major Investor No. 1″ described in a recently unsealed indictment as one of the three largest investors in two Bear Stearns hedge funds that collapsed. A spokesman for Mr. Epstein confirmed to the Post that he was the investor, who wasn’t identified in the indictment but was said to have had $57 million tied up in the funds shortly before they imploded early last summer.....The indictment said that in April 2007, the investor — whom we now know to be Mr. Epstein — told Mr. Cioffi he was thinking about pulling his money out of the fund. The funds had a bruising February and both funds lost money in March of that year."

So he was at least right on wanting to pull his money out of the fund.

For more on the charges see the Wikipedia entry.