New feature: Financial Quote of the Day

I am sure I won't do one every day, but seems like something fun to do for a while, so here goes:

"It is wonderful how preposterously the affairs of the world are managed. We assemble parliaments and councils to have the benefit of collected wisdom, but we necessarily have, at the same time, the inconvenience of their collected passions, prejudices, and private interests: for regulating commerce as assembly of great men is the greatest fool on earth."

* Benjamin Franklin as quoted in Dean LeBaron's Book of Investment Quotations, page 119.

U.S. Plans to Curb Executive Pay for Bailout Recipients - NYTimes.com

U.S. Plans to Curb Executive Pay for Bailout Recipients - NYTimes.com:

"The Obama administration is expected to impose a cap of $500,000 for top executives at companies that receive large amounts of bailout money, according to people familiar with the plan.

Executives would also be prohibited from receiving any bonuses above their base pay, except for normal stock dividends. "

Well, this will definitely make Federal Bailout money less desirous.

The WSJ gives us another history lesson

I love history. I love seeing the similarities across the ages and then seeing them (Need a "for instance"? I am currently ristening to American Creations right now on the US constitutional convention of 1787. In it James Madison (who was 5 ft 4 and seemingly taller than his statue at JMU) argued that the way to solve problems with sectional thought in voting which would lead to excessive political swings was to make the republic larger. This is much the same argument many (including myself) have used to say that more hedge funds (not fewer) may (if there is sufficient diversity of opinions and strategies) reduce market volatility.)

Which is a very long-winded way of saying, the WSJ seems to be doing the same thing this week. After looking at what prolonged the Great Depression they turn their attention to looking back at past financial crises to see what we can learn:

Opinion: Expect a Prolonged Slump - WSJ.com by Carmen Reinhart and Kenneth Rogoff:

"...when one compares the U.S. crisis to serious financial crises in developed countries (e.g., Spain 1977, Norway 1987, Finland 1991, Sweden 1991, and Japan 1992), or even to banking crises in major emerging-market economies, the parallels are nothing short of stunning...

...Financial crises, even very deep ones, do not last forever....negative growth episodes typically subside in just under two years. If one accepts the NBER's judgment that the recession began in December 2007, then the U.S. economy should stop contracting toward the end of 2009. Of course, if one dates the start of the real recession from September 2008....

In the typical severe financial crisis, the real (inflation-adjusted) price of housing tends to decline 36%, with the duration of peak to trough lasting five to six years. Given that U.S. housing prices peaked at the end of 2005, this means that the bottom won't come before the end of 2010, with real housing prices falling perhaps another 8%-10% from current levels....

Perhaps the most stunning message from crisis history is the simply staggering rise in government debt most countries experience. Central government debt tends to rise over 85% in real terms during the first three years after a banking crisis. This would mean another $8 trillion or $9 trillion in the case of the U.S.

Interestingly, the main reason why debt explodes is not the much ballyhooed cost of bailing out the financial system, painful as that may be. Instead, the real culprit is the inevitable collapse of tax revenues that comes as countries sink into deep and prolonged recession. Aggressive countercyclical fiscal policies also play a role..."

They go on to briefly discuss differences this time around, but (to me at least) the similarities dominate.

NOTE: Past history rarely repeats itself exactly, but there are enough similarities to learn a great deal from it.

Sweden’s Fix for Banks - Nationalize Them - NYTimes.com

In class last Thursday the idea of temporarily nationalizing banks came up. I promised to show how it could work using Sweden's experience from the 1990s. Then I proceeded to forget to post it. So in a better-late- than-never moment, here is an article from the NY Times.

Sweden’s Fix for Banks - Nationalize Them - NYTimes.com:

"With Sweden’s banks effectively bankrupt in the early 1990s, a center-right government pulled off a rapid recovery that led to taxpayers making money in the long run.

Former government officials in Sweden, many of whom come from the market-oriented end of the political spectrum, say the only way to solve the crisis in the United States is for the government to be prepared to temporarily take full ownership of the banks.

Sweden placed its banks with troubled assets into a so-called bad bank, where they could be held and then sold over time when market and economic conditions improved. In the meantime, it used taxpayer money to provide enough capital to allow banks to resume normal lending."

As discussed last week, a key to this is making it temporary AND making sure there is a real downside (loss of jobs, no bonus, or loss of equity) for those who are taking the risks.

What caused the Depression? Opinion: Policies Prolonged Depression - WSJ.com

Here is hoping that we learned our lesson since the 1930s.

The WSJ ran a good op/ed piece by Harold L. Cole and Lee Ohanian describing how government policies helped create the Great Depression. As we ponder what the role of government should be in helping the economy to recover from the current recession, politicans could do much worse than to read this!

Opinion: Policies Prolonged Depression - WSJ.com:

"Why wasn't the Depression followed by a vigorous recovery...? It should have been. The economic fundamentals that drive all expansions were very favorable during the New Deal. Productivity grew very rapidly after 1933, the price level was stable, real interest rates were low, and liquidity was plentiful. We have calculated on the basis of just productivity growth that employment and investment should have been back to normal levels by 1936....

So what stopped a blockbuster recovery from ever starting? The New Deal. Some New Deal policies certainly benefited the economy by establishing a basic social safety net through Social Security and unemployment benefits, and by stabilizing the financial system through deposit insurance and the Securities Exchange Commission. But others violated the most basic economic principles ... choked off powerful recovery forces.....The most damaging policies were those at the heart of the recovery plan, including The National Industrial Recovery Act (NIRA)....covered over 500 industries.... created a code of "fair competition" which spelled out what producers could and could not do, and which were designed to eliminate "excessive competition" that FDR believed to be the source of the Depression.

These codes distorted the economy by artificially raising wages and prices, restricting output, and reducing productive capacity by placing quotas on industry investment in new plants and equipment....Our research indicates that New Deal labor and industrial policies prolonged the Depression by seven years."

And it should be noted that this was not a knee jerk reaction to the current recession; Cole and Ohanian published their famous work which is the basis for for the current WSJ piece in the Journal of Political Economy in 2004.

Not coincidentally I am finishing up The Forgotten Man by Amity Shlaes who largely comes to the same conclusion and paints a picture of FDR as a really bad economist to say the least.

The Future of Securities Regulation by Luigi Zingales

Luigi Zingales has been in the news a bunch lately. He has testified to Congress, been on NPR, in Forbes, in The Economist, and the Wall Street Journal to name just a few (and these have all been since September!!!)

Which is to say when Luigi Zingales speaks (or writes) on the Future of Securities Regulation it makes sense to take note.

(On the paper that follows he only allows two paragraphs quotes so the review will be short, but by all means read the whole thing.)

SSRN-The Future of Securities Regulation by Luigi Zingales:

"....I propose a series of reforms that center around corporate governance, while shifting the focus from the protection of unsophisticated investors in the purchasing of new securities issues to the investment in mutual funds, pension funds, and other forms of asset management....three main areas of intervention.

1. First, a reform of corporate governance aimed at empowering institutional investors to nominate their own directors to the board....a new Glass-Steagall Act, which...will separate mutual fund management from investment and commercial banking...
2. The second goal should be the protection of unsophisticated individuals with regard to their investments. The minimum this protection entails is enhanced disclosure....
3. The third goal should be that of reducing the regulatory gap between public markets and private markets. The recent trend of migration...suggests that this differential is excessive. This migration should be stopped not only by deregulating the public market, but also by introducing some disclosure standards in the private one."

(note the numbers (1,2,3) were added to help the reader and are not in the actual paper).

Good stuff! I highly recommended reading it all!

An I^3 Paper!(Interesting, Important, and Informative)


BTW: even if you are not interested in regulation, the figures at the back of the paper are excellent and could/should be included in many classes from Investments to Macroeconomics, Money and Banking, Financial Institutions, and even Corporate Finance.

Cite: Zingales, Luigi ,The Future of Securities Regulation(January 29, 2009). Chicago Booth School of Business Research Paper No. 08-27; FEEM Working Paper No. 7.2009. Available at SSRN: http://ssrn.com/abstract=1319648

The Copyright I guess is to Zingales himself, but I could not find it on the paper but he asked the copyright be mentioned. I would say it is his, but I will check and edit this when I know.

SSRN-The January Effect - A New Piece for an Old Puzzle by Jason Fink, Kristin Fink, Jonathan Godbey

You probably have all heard of the January effect. It is the historical fact that stocks have done better in January than in other months. That much all researchers agree on.

Why? That is a very good question. Some seems to be taxes, some size, but now Fink, Fink, and Godbey find that the age of the firm also matters. Specifically young firms out perform old firms in January even after controlling for size and other factors.

SSRN-The January Effect - A New Piece for an Old Puzzle by Jason Fink, Kristin Fink, Jonathan Godbey:

"For decades the finance profession has noticed the tendency of equity prices, most noticeably for small stocks, to rise in value in the month of January. The small stock January effect appears to have been significant over the last thirty five years. However, we demonstrate that even after controlling for both the size of the firm and systematic factors, young firms experience significant and abnormally positive January returns. This age effect has several possible sources, including firm level information uncertainty in January or increased investor demand related to young firms."

Now I can say this about the paper since the authors are friends of mine and if you can't pick on friends who can you pick on? Uh, Good timing.

How so? Well the paper came out in October. I waited with the intent of using in in January as soon as the market turned up. So what happens? I will let CNN tell you:

From CNNMoney.com:

" It was the worst January ever for the Dow industrials and S&P 500, according to Stock Trader's Almanac data.

The Dow lost 8.8% and the S&P 500 lost 8.6% in the month.

The Nasdaq's loss of 6.4% was eclipsed by last January's loss of 9.9%. That 2008 loss was the worst in the tech average's history, going back to its inception in 1971."

Oh well. Maybe next year. OR (and this is stated entirely without proof since as far as I know there is not a "new firm" index), given the average age of firms in the NASDAQ is less than that of the DOW and S&P 500, maybe it supports the paper even more.

Behavorial Accounting? Executive Overconfidence and the Slippery Slope to Fraud by Catherine Schrand, Sarah Zechman

SSRN-Executive Overconfidence and the Slippery Slope to Fraud by Catherine Schrand, Sarah Zechman: Interesting paper.


First from the abstract:

"...executive overconfidence increases the likelihood that a firm commits financial reporting fraud. A manager that faces an earnings shortfall is more likely to manage earnings to overcome it if he believes the shortfall is temporary and, hence, the earnings management will be a one-off event that likely will go undetected....Overconfident managers with unrealistic beliefs about future performance are more likely to find themselves in this situation.....Our analysis that uses firm-level proxies for overconfidence suggests that there are two types of frauds: Those associated with moderate levels of overconfidence, perpetrated by executives who ex post fall down the slippery slope, and those perpetrated by executives with extreme overconfidence that commit fraud for opportunistic reasons ex ante. Analysis of individual executives supports the notion that there are two types of overconfident executives that engage in fraud. Those with opportunistic motives are more likely to....earn more total and have a higher percent of variable cash compensation, and are less likely to have accounting experience. Finally, we document that a matched sample of non-fraud firms do not have stronger governance mechanisms that prevent fraud. This result mitigates [lessens] the possibility that it is weak governance rather than executive overconfidence that is a significant determinant of fraud.

Many interesting things to consider here!

• The logic that over confident managers are more likely to commit fraud makes perfect intuitive sense and while some might have some reservations with the attempt to determine what industries attract overconfident managers (for instance seemingly these industries have higher variances and thus at times are overvalued and fraud could be partially explained by this (see Jensen 2005,2008)), the notion definitely makes sense.

• It was interesting (and not very surprising) to see that those who had more to gain (more variable pay) or more to lose (founding families) were more likely to commit fraud, but disappointing to see that common governance measures did not reduce the fraud risk. Not sure what to make of that.

Good stuff!


Cite:
Schrand, Catherine M. and Zechman, Sarah L. C.,Executive Overconfidence and the Slippery Slope to Fraud(December 30, 2008). AAA 2009 Financial Accounting and Reporting Section (FARS) Paper; Chicago Booth School of Business Research Paper No. 08-25. Available at SSRN.

The Bailout Game | Home

The Bailout Game | Home-- Ok, forget academic finance, this is good and funny! You can decide whether to bail out the various players or let them fail. Takes a second to load but is really well done!

Thanks to Charlie (a former student) for sending this along to me.

Spotlight on Bonuses

It seems like everyone's attention has turned to pay and bonuses at Financial Institutions, so I will at least temporarily join the crowd.

To set the stage, this is just a sampling of the 3,745 news items (according to Google) today alone that dealt with Wall Street bonuses

From What Red Ink? Wall Street Paid Fat Bonuses-NY Times.

"Despite crippling losses, multibillion-dollar bailouts and the passing of some of the most prominent names in the business, employees at financial companies in New York, the now-diminished world capital of capital, collected an estimated $18.4 billion in bonuses for the year.

That was the sixth-largest haul on record, according to a report released Wednesday by the New York State comptroller."

From CBS News:



Obama Pressures Wall Street Over Bonuses - NYTimes.com:

"President Obama branded Wall Street bankers “shameful” on Thursday for giving themselves nearly $20 billion in bonuses as the economy was deteriorating and the government was spending billions to bail out some of the nation’s most prominent financial institutions...."there will be time for them to get bonuses....Now’s not that time.”

I agree with most of the articles and the President but not for the fairness reasons (although as a signal to customers and employees accepting any bonus seems a horrible move) but rather because what a bonus is intended to do.

Bonuses are meant as rewards used to create the proper incentives. Bonuses that are paid regardless of performance do not do that. And yes I realize that bonuses are way down, but given their performance, they still seem too high.

If you take a second and examine compensation, there are two key things to consider: the level of pay (how much you pay people) and the form of pay (Salary, Bonus, market-based pay etc.). Each is important, but the form much more so.

Level of pay is what attracts and keeps employees (and yes even managers). In the words of Keven Murphy when I took his class, it is what "gets them in the door and what keeps them. Form of pay (and re-evaluations of the level of pay) is what creates incentives and helps to motivate people to do what we want them to do.

Don't think so? Consider this example directly from my class. Suppose you are hired as CEO of a firm and paid a straight salary of $2 million a year. You are told that the pay will never change so long as your firm does not go out of business and you can not be fired. How would you behave? Consider the many agency costs that may arise. Risk taking would likely be scaled way back, debts reduced, dividends and capital expenditures lowered since your main goal is to keep the firm in business so you get your $2 million annuity.

Bonuses and market-based pay are, at least in theory, designed to motivate the employee to do what is in the firm's (and more specifically the shareholders') best interest. For instance, stock options that increase in value with increasing volatility, are a means of making managers less risk averse. Bonuses are similar but more often based on non market factors (either accounting-based or performance based).

Which gets us back to the question of paying Wall Street executives bonuses. If the form of pay is to serve as a proper motivator (that is to motivate them to do what we want), something has to be at risk (Again go back to the example, if I say you get a $2 million bonus no matter how well you do, does it motivate you or is it just another word for salary?).

By any standard, most financial institutions have had a horrible year. To reward managers (which is essentially saying "Good job") is wrong. Indeed, a strong case may be made that the reason why bonuses have been so high over the past few years is not that the firms were doing so well, but that they appeared to be doing so well and the outcome of many of the investments had not yet been determined. Thus some ex-post settlement (IF I remember correctly it was Jensen and Meckling in 1976 who suggested this) whereby the executives give back past bonuses (and not just this year's) is really what should happen.

Now of course it is not going to. There is a movement afoot to get some of this year's bonuses back at firms who got government bailouts but even this faces very long odds.

While it may be a disappointment (in the spirit of no matter how many times Charlie Brown goes to kick the football, I always hope that Lucy will come around this time and do the right thing and let him kick and I am disappointed when Lucy pulls it away), it really should not be a surprise to anyone that managers will largely get their bonuses even if the bonuses are smaller than in the past (remember they probably should not have gotten the past ones at all if the true value of their investments were known then).

As Garvey and Mibourn (2003) showed managers tend to get rewarded when things go right (good luck?) and yet are not penalized when things go wrong (bad luck?). I somehow doubt that this time around will be any different Charlie Brown will still end up on his back and managers will still look out for themselves and not shareholders.

Financial Rounds: Biases in Implied Volatilities

I will TRY to get to this later, but it is so important (yeah I am biased--I like implied volatilities) that I did not want to take any chances of getting busy and not getting to it AND besides it is a good opportunity to suggest new readers take a look at Financial Rounds. It is one of my favorites and written by another FinanceProfessor (who goes by the Unknown professor).

Financial Rounds: Biases in Implied Volatilities

"In their paper "Implied and Realized Volatility in the Cross-Section of Equity Options" Manuel Ammann, David Skovmand and Michael Verhofen examine whether implied volatilites differ systematically from realized vlatilities, and whether those differences are related to firm risk (beta) size (market cap),growth opportunities (market/book), and momentum. Here's the abstract:

Using a complete sample of US equity options, we analyze patterns of implied volatility in the cross-section of equity options with respect to stock characteristics. We find that high-beta stocks, small stocks, stocks with a low-market-to-book ratio, and non-momentum stocks trade at higher implied volatilities after controlling for historical volatility. We find evidence that implied volatility overestimates realized volatility for low-beta stocks, small caps, low-market-to-book stocks, and stocks with no momentum and vice versa. However, we cannot reject the null hypothesis that implied volatility is an unbiased predictor of realized volatility in the cross section."

Google Trends: unemployment

With thousands of jobs being lost daily, thought it might be interesting to look at the number of searches for unemployment being done on Google. Not surprisingly the searches are way up (about 3 times as high as a few years ago).

Google Trends: unemployment: "Scale is based on the average traffic of unemployment from United States"

Commentary: How to rescue the bank bailout - CNN.com

Joseph Stiglitz has a thoughtful piece on CNN.com. While I disagree with what appears to be a call for the nationalization of more banks, I do agree that rewarding upside without some real downside risk will only yield more risky behavior which will hurt the economy and lead to future blow-ups. My solution I guess would be to both allow temporary nationalizations (but with a hard fast exit date of no more than five years where the bank is either sold or closed) but also bite the bullet and let some banks fail now. Sure it is painful. Sure some will lose jobs, but what is the alternative?

Some look-ins that might help explain why there is no simple quick fix:

Commentary: How to rescue the bank bailout - CNN.com:

"For a while, there was hope that simply lowering interest rates enough, flooding the economy with money, would suffice; but three quarters of a century ago, Keynes explained why, in a downturn such as this, monetary policy is likely to be ineffective. It is like pushing on a string."

Then:

"...came the idea of equity injection, without strings, so that as we poured money into the banks, they poured out money, to their executives in the form of bonuses, to their shareholders in the form of dividends.

Some of what they had left over they used to buy other banks -- to pursue strategic goals for which they could not have found private finance. The last thing in their mind was to restart lending."

And his version of "Debt makes good times great, bad times horrible" and realization the problem is REALLY big:

"Leverage, or borrowing, gives big returns when things are going well, but when things turn sour, it is a recipe for disaster. It was not unusual for investment banks to 'leverage' themselves by borrowing amounts equal to 25 or 30 times their equity.

At 'just' 25 to 1 leverage, a 4 percent fall in the price of assets wipes out a bank's net worth -- and we have seen far more precipitous falls in asset prices. Putting another $20 billion in a bank with $2 trillion of assets will be wiped out with just a 1 percent fall in asset prices.... So they have come up with another strategy: We'll 'insure' the banks, i.e., take the downside risk off of them.

The problem is similar to that confronting the original 'cash for trash' initiative: How do we determine the right price for the insurance?"

Why aren't banks lending?

"But even were we to do all this -- with uncertain risks to our future national debt -- there is still no assurance of a resumption of lending....risks are high in a recession. Having been burned once, many bankers are staying away from the fire...Many a bank may decide that the better strategy is a conservative one: Hoard one's cash, wait until things settle down, hope that you are among the few surviving banks and then start lending. Of course, if all the banks reason so, the recession will be longer and deeper than it otherwise would be."

DAVOS 2009 - DealBook Blog - NYTimes.com

Davos always creates good news items, interviews, and even class discussions. Keep on eye on the NY Times blog from the festivities.

DAVOS 2009 - DealBook Blog - NYTimes.com:

"A team of reporters and editors from The New York Times and The International Herald Tribune will be in Davos, Switzerland, reporting on World Economic Forum Annual Meeting 2009 from Jan. 28 to Feb. 1. The conference brings together world leaders from politics, business, religion, media and philanthropy. We will be providing updates throughout the day with news and analysis."