Cashing in Before the Music Stopped

Posted by Lucian Bebchuk, Alma Cohen, and Holger Spamann, Harvard Law School on Monday December 7, 2009 at 10:07 am
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Editor’s Note: This post is based on an op-ed article from the print edition of today’s Financial Times by Lucian Bebchuk, Alma Cohen, and Holger Spamann. The op-ed article is based on their study, “The Wages of Failure: Executive pay at Bear Stearns and Lehman 2000-2008,” which is available here. Although Lucian Bebchuk is a consultant to the US Treasury’s office of the special master for TARP executive compensation, the views expressed in the post should not be attributed to that office.

According to the standard narrative, the meltdown of Bear Stearns and Lehman Brothers largely wiped out the wealth of their top executives. Many – in the media, academia and the financial sector – have used this account to dismiss the view that pay structures caused excessive risk-taking and that reforming such structures is important. That standard narrative, however, turns out to be incorrect.

It is true that the top executives at both banks suffered significant losses on shares they held when their companies collapsed. But our analysis, using data from Securities and Exchange Commission filings, shows the banks’ top five executives had cashed out such large amounts since the beginning of this decade that, even after the losses, their net pay-offs during this period were substantially positive.

In 2000-07, the top five executives at Bear and Lehman pocketed cash bonuses exceeding $300m and $150m respectively (adjusted to 2009 dollars). Although the financial results on which bonus payments were based were sharply reversed in 2008, pay arrangements allowed executives to keep past bonuses.

Furthermore, executives regularly took large amounts of money off the table by unloading shares and options. Overall, in 2000-08 the top-five teams at Bear and Lehman cashed out close to $2bn in this way: about $1.1bn at Bear and $850m at Lehman. Indeed, the teams sold more shares during the years preceding the firms’ collapse than they held when the music stopped in 2008.

Altogether, equity sales and bonuses over that period provided the top five at the two banks with cash of about $1.4bn and $1bn respectively (an average of almost $250m each). These cash proceeds considerably exceed the value of the executives’ holdings at the beginning of 2000 (which we estimate to be in the order of a respective $800m and $600m).

Of course, the executives would have made much more had the banks not blown up. By contrast to shareholders who stuck with the banks, however, the executives’ total pay-offs during the period were decidedly in the black.

Our analysis undermines the claims that executives’ losses on shares during the collapses establish that they did not have incentives to take excessive risks. The fact that the executives did not sell all the shares they could prior to the meltdown does indicate that they did not anticipate collapse in the near future. But repeatedly cashing in large amounts of performance-based compensation based on short-term results did provide perverse incentives – incentives to improve short-term results even at the cost of an excessive rise in the risk of large losses at some (uncertain) point in the future.

To be sure, executives’ risk-taking might have been driven by a failure to recognise risks or by excessive optimism, and thus would have taken place even in the absence of these incentives. But given the structure of executive pay, the possibility that risk-taking was influenced by these incentives should be taken seriously.

The need to reform pay structures is not, as many have claimed, simply a politically convenient sideshow. Even if the type of incentives given to executives of Bear and Lehman – and others with similar pay structures – were not the cause of risk-taking in the past, they could be in future. Financial institutions, and the regulators overseeing them, should give the necessary priority to redesigning bonuses and equity-based compensation to avoid rewarding executives for short-term results that are subsequently reversed.

The stories of Lehman and Bear will undoubtedly remain in the annals of financial disaster for decades to come. To understand what has happened, and what lessons should be drawn, it is important to get the facts right. In contrast to what has been thus far largely assumed, the executives were richly rewarded for, not financially devastated by, their leadership of their banks during this decade.

  1. Academic community should be a judge in this case of executive compensation without any envy or jealousy. Academic community should not promote a limitation of executive compensation and anti- capitalism just because CEO, CFO, COO (not University professors) are making a lot of money. In my view, shareholders should pay them that much just because they work very hard without 3 months vacation to maximize shareholder’s market value. The problem for me is not how big are their compensation packages as long as they reach the company target goal. We should only set this alarm if they collect more money than they made. It is why I call for academic community to stand for justice to both internal (incl CEO, CFO,..) and external shareholders. If their salaries was tied to a pre-set formula, it will be clear to any average investor when to complain about their salaries. For instance, if the policy is that in case of non profit, CEO, CFO, COO will collect no bonus and when the company loses more than 20 %, CEO, CFO, COO will receive more illiquid base salary, I believe that their salaries will be more logical to the investing public and less lottery or tip to every one.
    That said, Prof Bebchuck will be seen as a good judge when he will add executive compensation and company profit analysis to his alarm-study
    Arthur Mboue, MBA, JD

    Comment by Arthur Mboue — December 7, 2009 @ 6:46 pm

  2. A well researched and written piece. However, in noting that “incentives do matter” it seems that the authors remain trapped within the model that requires public company leadership teams to extract vast sums from the companies they manage. The only new thing here is the timing of the cash-out and linking that to long term success rather than short term.

    The authors would make a greater contribution if they examined the question of “how much is enough” in total compensation with a starting assumption that corporate agents and leadership teams are vastly overpaid, anyhow. That is a board failure. Where is the evidence that good results can not be achieved by paying the leadership teams half as much – or less? A squeeze on total compensation could well make risk management incentives a secondary issue.

    The real problem is that boards remain unwilling to get the best value in executive leadership. It is far easier to shower share owner money on leadership teams than it is to drive that cost down.

    Comment by JGP — December 8, 2009 @ 12:21 am

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  5. Executive compensation and the financial crash …

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  9. The results do not imply that the crisis was caused by distorted incentives. As Fahrenbrach and Stulz (2009) show, the chief executives lost vast amounts of money in the crisis. When the crisis approached, they did not knowingly take excessive risks owing to distorted incentives. They did not foresee the crisis. This was a case of trial and error.

    Comment by Roland Vaubel — December 18, 2009 @ 5:40 am

  10. I find one thing fascinating about the risk-taking that led to the crisis: Why is it that none of the partnerships got as heavily exposed to riskier subprime securitization or otherwise highly leveraged mortgages as did the publicly traded firms?

    Perhaps the risk taking was moderated by the rules of joint and several liabilty — its not just the partnership that would have seen its assets exhausted if they failed as spectacularly as Lehman or Bear Stearns did — but the partners personal assets would be on the line as well — homes, cars, boats, etc.

    For some reason, that kept the partnerships from being as reckless as the publicly traded firm. I do not think that was a coincidence.

    I detailed this here:
    http://www.amazon.com/exec/obidos/ASIN/0470520388/thebigpictu09-20

    Comment by Barry Ritholtz — January 11, 2010 @ 1:18 pm

  11. Ahh, found the excerpt I was looking for — page 136:

    “This had an enormous impact upon the ways investment banks approached business generation and risk management. Like many public companies, they became increasingly short-term focused. “Making the quarter,” in Street parlance, meant pulling out all the stops to hit your quarterly profit figures, by any means necessary. Incentives became misaligned with shareholders’ interests, as risky short-term performance was rewarded with huge bonuses. Not surprisingly, this worked to the detriment of long-term sustainability.

    But short-termism was only part of the equation. Of greater concern was how these firms’ internal risk management changed. Unlike in public corporations, partners are personally liable for the acts of any of the members of the partnership. If any one of a firm’s partners or employees loses a trillion dollars, every last partner is on the hook for that money.

    As you would imagine, this creates enormous incentives to make sure that risk is managed very, very carefully. Nothing focuses the mind like the real possibility that any partner could bankrupt all the rest. It’s no
    coincidence that partnerships like Lazard Freres and Kohlberg Kravis Roberts did not suffer the same kind of risk management failures as Bear Stearns and Lehman Brothers, among others. (Lazard went public in 2005, but too late in the credit cycle for it to get into much trouble.)

    Comment by Barry Ritholtz — January 11, 2010 @ 1:23 pm

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  19. [...] years with investment bankers to entirely forget their reality. And I have data to back me up: In a study late last year, three Harvard Law School researchers examined public documents to assess whether one “standard [...]

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