February 25, 2009 Edition
Volume VII
Inside this edition of Signature Update
- Some Sage Advice
- An Interesting Set of Statistics
- Flirting with a Bottom?
- Rage Against the Machine
- Oil and Automobiles – Consumption Leads the Way
Some Sage Advice
“Some people say they want to wait for a clearer view of the future. But when the future is again clear, the present bargains will have vanished. In fact, does anyone think that today’s prices will prevail once full confidence has been restored?”
That comment was made 76 years ago by Dean Witter in May of 1932 — only a few weeks before the end of the worst bear market in history.
Have courage! We have been here before — and we’ve survived and prospered.
An Interesting Set of Statistics
Between 1871 (after the post Civil War reconstruction period) and 1900, the US economy was mired in recession 48% of the time.
From 1900 to 1950 recessionary periods amounted to 37% of the fifty-year time frame.
And from 1950 to 2009, we’ve experienced recession only 13% of the time.
Not only have the frequency of recessions decreased substantially, but the duration of recessionary periods since 1950 are less than half of what they had been in the prior 100 years (data source www.nber.org/cycles.html).
Flirting with a Bottom?
As the DOW Jones Industrial Average began a steady decline following the January Presidential Inauguration, many feared we would retest the November 2008 lows before hopefully rebounding back above the 9,000 point level. On February 10th, the DOW closed at less than 8,000 and then hovered for several days within a few hundred points of the November 20th low of just over 7,500 points. ‘Testing’ or ‘retesting’ a bottom means a market pull back towards a previously established lower level and then recovering to higher levels without piercing, or breaking through, the lower level. The longer a market hovers near a low, the greater the likelihood that the bottom will not hold and lower levels will be experienced.
And that’s exactly what happened as the markets fell below their six-month lows late last week, and then slid further on Monday to levels not seen since 1997. It was a dismal day for the markets and accurately reflected the frustration investors and traders have felt as the economy has floundered this last year. Tuesday’s rebound of over 236 points was a welcome relief but may not mean the worst is behind us, as the DOW is still below 7,400 points.
Many thanks to Federal Reserve Chairman Bernanke for affirming his solid support of the banking sector during his remarks to Congress. Amid concerns over the possible ‘nationalization’ of major domestic banks, Bernanke not only made clear the Federal Reserve’s position but also discussed the nature of the equity investments the Treasury has been making in our banks. He described these equity investments as convertible preferred stock that would only convert to common shares (the basic form of ownership in a publicly held corporation) in the event that the capital structure of the bank required additional equity capitalization to meet regulatory requirements. In other words, ‘nationalization’ would only occur if a bank were in such a position as to require federal capital intervention in order to remain solvent. Just as banking stocks suffered based on concerns over ‘nationalization’, these same stocks rebounded following Bernanke’s remarks.
The content of Bernanke’s remarks was sufficient to bolster the entire financial services sector. He made it clear that the Federal Reserve’s primary goal at this stage of economic recession is to bring stability to domestic banks and that the economy will only recover after banks have stabilized. He admitted his optimism for a late 2009 recovery, assuming banks are able to resume normal lending and investing operations. He also made it clear that there are still many risks in front of us and expressed his fears over what may occur if the Federal Reserve and Treasury’s efforts are thwarted.
Congressional representatives questioned Bernanke on the shape of a recession/recovery pattern, commonly expressed in terms of ‘V’, ‘U’, and ‘W’; but the chairman avoided a direct answer and suggested that attempts at forecasting this particular economic period’s makeup had been unsuccessful at best.
All of this is consistent with our view of what’s taking place in the economy. Last week’s issue of Signature Update discussed early signs of recovery and Bernanke supported that view based on the presumption that the banking sector receives crucial support. Further, the negative sentiment in the markets is a common indicator of an economic low point, though recovery may take many months; and in the midst of many ‘doom and gloom’ prognosticators, we remain confident in and optimistic for our economy’s eventual recovery.
‘Rage against the Machine’
Okay, so I think that’s the name of modern punk rock group, and no… I wouldn’t recognize even one of their attempts at lyrical expression, but I can’t find a better term to represent the sentiment of most responsible homeowners across the country as they respond to some of the ‘mortgage bailout’ proposals working their way through the executive and legislative branches of government. Massachusetts Representative Barney Frank accosted the heads of the nation’s major banks a few weeks ago as he asserted that these leaders simply cannot be capitalists as the markets thrive and then become socialists during protracted declines - referring to accepting federal resources during difficult periods while seeking unencumbered autonomy and profitability during more prosperous times. However, Frank and his associates are pleased to defend a federal ‘mortgage bailout’ in which troubled homeowners may accept a reduction in the principal balance of their mortgage in the face of declining real estate values, but would not be required to return anything to the taxpayer in the event that the home is sold in the future for more than its value at the time a principal reduction had been made.
There may be more than a little hypocrisy in this position, and these elected representatives are successfully rallying their less fortunate constituents at the cost of the taxpayer. Virtually everyone with whom I have discussed these proposals, including certain self-described ‘liberals’, are hard put to understand what our elected officials are thinking. To date, the federal bailout proposals for banking and business have included incentives for the tax payer in the event that these corporations prosper as a byproduct of receiving federal funds. Isn’t it only reasonable to expect homeowners who may directly benefit from government resources to be held to the same standard? Some suggest that we all will benefit from reduced foreclosures and the attending stabilization of the housing market, but the same case can be made for the overall economic benefits of a more stable banking and business climate. Both positions have merit, of course, but that doesn’t mean that we should ignore prudence and accountability.
It has become dangerously convenient for us to look to the federal government during this time of crisis; and while I would argue that the enormity of the problems we face have required the equally enormous resources of the Federal Reserve and Treasury, we simply can’t succumb to the same lack of accountability and irresponsibility for which we have expressed open disdain when observed in corporate boardrooms.
Oil and Automobiles – Consumption Leads the Way
Recent US Department of Energy reports represent oil inventory declines in January of over 200,000 barrels versus an expected increase of nearly 2 million barrels. Consumer demand increased by 2.6% representing the highest consumer fuel demand in over twelve months. This rise was consistent with higher retail sales figures for January and reflects an overall increase in spending in the face of increasing levels of unemployment.
This data follows Consumer Price Index (CPI) and Producer Price Index (PPI) increases for the first time in several months of .4% and .8% respectively. These increases, though neither significant nor representative of a certain trend, offer welcome relief to deflationary concerns brought on by a weak domestic and global economy.
Of note is one of the worst Consumer Confidence Index (CCI) reports in recent memory. With 1985 representing a baseline index of 100, and a January CCI of 37.4, the most recent index level of 25 is troublesome. It stands juxtaposed to other consumer indicators but most often reaches its lowest levels 2-3 months before an economic recovery.
As US automakers, particularly GM and Chrysler, continue to flirt with financial disaster, there are indications that domestic automobile demand may surge even before the economy shifts into recovery mode. Consumer and industrial automobile demand fell to unsustainably low levels in the late fall and winter months and will ultimately give rise to a surge in demand as fleets age and consumers are forced to evaluate the cost efficiencies of repair versus replacement.
Wednesday, February 25, 2009
Tuesday, February 17, 2009
Early Recovery Patterns Emerge
Most investors understand that the stock markets typically lead the economy by some six to nine months, and that the market gains or losses of today may either foretell emerging economic trends months in advance, or represent very short-term reactions to current events. This helps explain the market declines in the 2nd and 3rd quarters of 2008. Even though GDP was still increasing and corporate profits were reasonable, a pattern was emerging that spelled trouble for the 4th quarter and beyond. Sometimes the pattern can be seen in data and graphs, and other times it can only be discerned through observation or discussion. We understand the markets and the economy to be replete with meaningful nuances that are often misunderstood or overlooked – in hindsight they are all too clear.
As Treasury Secretary Geithner unveiled plans for the distribution of the second round of TARP funds earlier this week, the markets responded with a one-day decline of almost 400 points on the DOW. Within a few days, it was obvious that it wasn’t so much what Geithner said about the Treasury’s plans as it was his plan’s lack of detail, leaving open the same type of discretion in distributing TARP’s enormous federal resources that bloodied former Treasury Secretary Paulson in his final months in office. Additionally, the US stock markets had rallied the prior week on the administration’s leaked comments regarding possible revisions to the ‘mark-to-market’ rule. Geithner not only didn’t offer any substance to back up earlier comments but was mute on the subject in what was his most important public address since being confirmed by the Senate.
The emergent pattern that devastated the markets in the 2nd half of 2008 was all about the credit markets. Even the most seasoned investors and market analysts were unable to see the import of the trend until it was too late as such a scenario had never before been observed. The Washington ‘blame game’ began only after the government’s own culpability in the credit market demise became obvious--some suggest in an effort to mask Democratic leadership’s role in the root causes of the now burst housing bubble.
In a February 11th interview with CNBC’s Mark Haines and Maria Bartiromo, Christina Romer, the current head of the President’s Council of Economic Advisors, affirmed that the recent ‘carnage’ in the markets not only took most everyone by surprise but occurred in a short, eighty-five day period from August 28th to November 20th, 2008. The trading range of the DOW Industrials shifted from approximately 10,800 – 13,000 downward to 7,450 – 9,000 in response to a virtual melt down of the credit markets. The velocity of the US currency - that is, the currency’s movement through banking and the economy - came to a standstill and very nearly brought our economy to its knees.
As the Bush administration and Federal Reserve sought to move the legislative branch to action in an attempt to affect solutions to the mounting crisis, President Bush, Treasury Secretary Paulson, Federal Reserve Chairman Bernanke and others took the stage to warn us of the impending threat to our economy. Their efforts were rewarded with massive consumer and corporate pull backs in spending, record volatility in the stock markets, and decreases in business and consumer confidence levels--in addition to the passage of the TARP legislation. The administration’s efforts to create solutions to the mounting problems also worsened the nation’s economic outlook. Unemployment began to surge, sales faltered, and GDP first softened and then marked real declines. Even now, it’s difficult to tell how much of what we have experienced these past months is cause or effect.
What is certain is that the Treasury and Federal Reserve’s efforts to bring liquidity back into the credit markets, though inadequate to completely solve the economy’s worsening problems, averted a 1930’s style collapse. Banks slowly began to lend, first to each other, then to low risk corporate borrowers, and finally to consumers. Congressional Budget Office estimates were released mid-week suggesting that bank consumer lending, though low, is at a pace reflective of the recession in which we find ourselves. This data was released only after the heads of the country’s major financial institutions gathered before congress this last week for what amounted to a ‘trip to the wood pile’. Though some measure of public humiliation may have been warranted, the venom with which certain congressional leaders attacked these executives was only exceeded by the ignorance of the attackers. Clearly, the newly seated House of Representatives wanted Wall Street executives to understand that they were being punished. What these congressional representatives ignored is the resultant punishment the electorate received as their vitriolic rants and blatant pandering sent markets lower.
In the midst of all of this, the markets are doing what they have done for decades-- finding ways to accurately reflect the long-term future value of equity participation in corporation ownership. Slowly and with little outward confirmation, they’re beginning to reflect the emergence of an early pattern of economic recovery that may develop later in 2009.
Pending real estate sales increased by 6.5% in January and retail sales surged by over 1%. These important improvements were accompanied by more subtle, but still meaningful, improvements in the Institute of Supply Management’s Non-Manufacturing Index and the Baltic Dry Shipping Index. Though one month gains in anything can’t be taken as a pattern, these particular gains are meaningful in that they support other early signs of real economic recovery that may become more apparent in the 2nd half of the year. If the patterns continue, the markets will likely rally in the spring or summer of 2009. Though this may seem optimistic in light of the current difficulties, it would also be a natural reaction to investor sentiment, as we have become all too accustomed to near constant market negativity and are ready to embrace positive signs--which sentiment is often the very fuel for double-digit equity market rebounds. Likewise, consumers most often provide the fuel for economic recovery; and as savings rates have increased in recent months, we may soon reach a point at which the desire to spend surpasses the desire to save. Retail sales would then experience a sustained upward trend.
Others signs of early recovery are not as intuitively recognized. Gold, which had decreased sharply in the 2nd half of 2008, has rebounded in recent months to close at over $940 per ounce – a common precursor to equity market improvement. Oil and gasoline inventory surplus acceleration has slowed and oil’s steep decline in value has leveled off, suggesting that demand is once again increasing, albeit cautiously. Unemployment has continued to increase, now at 7.6%, and will likely exceed 9% before the end of the year; but unemployment is a backward looking indicator and typically reaches it worst levels six months after a recovery has begun.
To be fair, there are still troubling signs in our economy, and they can’t be ignored. Housing and banking, the ‘Jack and Jill’ of our economic difficulties, have yet to bottom and must do so before long-term recovery can be evidenced. Additionally, the current anti-corporate sentiment pervasive in the House and Senate is alarming and seems to be exceeded only by our elected official’s lack of understanding of business and economics, as well as a recognition that shareholders, inclusive of over 50% of registered voters, are damaged far more than executives as share values decrease and dividends are cut.
Signature Update is offered by Richard Haskell, Managing Director of Signature Wealth Management
As Treasury Secretary Geithner unveiled plans for the distribution of the second round of TARP funds earlier this week, the markets responded with a one-day decline of almost 400 points on the DOW. Within a few days, it was obvious that it wasn’t so much what Geithner said about the Treasury’s plans as it was his plan’s lack of detail, leaving open the same type of discretion in distributing TARP’s enormous federal resources that bloodied former Treasury Secretary Paulson in his final months in office. Additionally, the US stock markets had rallied the prior week on the administration’s leaked comments regarding possible revisions to the ‘mark-to-market’ rule. Geithner not only didn’t offer any substance to back up earlier comments but was mute on the subject in what was his most important public address since being confirmed by the Senate.
The emergent pattern that devastated the markets in the 2nd half of 2008 was all about the credit markets. Even the most seasoned investors and market analysts were unable to see the import of the trend until it was too late as such a scenario had never before been observed. The Washington ‘blame game’ began only after the government’s own culpability in the credit market demise became obvious--some suggest in an effort to mask Democratic leadership’s role in the root causes of the now burst housing bubble.
In a February 11th interview with CNBC’s Mark Haines and Maria Bartiromo, Christina Romer, the current head of the President’s Council of Economic Advisors, affirmed that the recent ‘carnage’ in the markets not only took most everyone by surprise but occurred in a short, eighty-five day period from August 28th to November 20th, 2008. The trading range of the DOW Industrials shifted from approximately 10,800 – 13,000 downward to 7,450 – 9,000 in response to a virtual melt down of the credit markets. The velocity of the US currency - that is, the currency’s movement through banking and the economy - came to a standstill and very nearly brought our economy to its knees.
As the Bush administration and Federal Reserve sought to move the legislative branch to action in an attempt to affect solutions to the mounting crisis, President Bush, Treasury Secretary Paulson, Federal Reserve Chairman Bernanke and others took the stage to warn us of the impending threat to our economy. Their efforts were rewarded with massive consumer and corporate pull backs in spending, record volatility in the stock markets, and decreases in business and consumer confidence levels--in addition to the passage of the TARP legislation. The administration’s efforts to create solutions to the mounting problems also worsened the nation’s economic outlook. Unemployment began to surge, sales faltered, and GDP first softened and then marked real declines. Even now, it’s difficult to tell how much of what we have experienced these past months is cause or effect.
What is certain is that the Treasury and Federal Reserve’s efforts to bring liquidity back into the credit markets, though inadequate to completely solve the economy’s worsening problems, averted a 1930’s style collapse. Banks slowly began to lend, first to each other, then to low risk corporate borrowers, and finally to consumers. Congressional Budget Office estimates were released mid-week suggesting that bank consumer lending, though low, is at a pace reflective of the recession in which we find ourselves. This data was released only after the heads of the country’s major financial institutions gathered before congress this last week for what amounted to a ‘trip to the wood pile’. Though some measure of public humiliation may have been warranted, the venom with which certain congressional leaders attacked these executives was only exceeded by the ignorance of the attackers. Clearly, the newly seated House of Representatives wanted Wall Street executives to understand that they were being punished. What these congressional representatives ignored is the resultant punishment the electorate received as their vitriolic rants and blatant pandering sent markets lower.
In the midst of all of this, the markets are doing what they have done for decades-- finding ways to accurately reflect the long-term future value of equity participation in corporation ownership. Slowly and with little outward confirmation, they’re beginning to reflect the emergence of an early pattern of economic recovery that may develop later in 2009.
Pending real estate sales increased by 6.5% in January and retail sales surged by over 1%. These important improvements were accompanied by more subtle, but still meaningful, improvements in the Institute of Supply Management’s Non-Manufacturing Index and the Baltic Dry Shipping Index. Though one month gains in anything can’t be taken as a pattern, these particular gains are meaningful in that they support other early signs of real economic recovery that may become more apparent in the 2nd half of the year. If the patterns continue, the markets will likely rally in the spring or summer of 2009. Though this may seem optimistic in light of the current difficulties, it would also be a natural reaction to investor sentiment, as we have become all too accustomed to near constant market negativity and are ready to embrace positive signs--which sentiment is often the very fuel for double-digit equity market rebounds. Likewise, consumers most often provide the fuel for economic recovery; and as savings rates have increased in recent months, we may soon reach a point at which the desire to spend surpasses the desire to save. Retail sales would then experience a sustained upward trend.
Others signs of early recovery are not as intuitively recognized. Gold, which had decreased sharply in the 2nd half of 2008, has rebounded in recent months to close at over $940 per ounce – a common precursor to equity market improvement. Oil and gasoline inventory surplus acceleration has slowed and oil’s steep decline in value has leveled off, suggesting that demand is once again increasing, albeit cautiously. Unemployment has continued to increase, now at 7.6%, and will likely exceed 9% before the end of the year; but unemployment is a backward looking indicator and typically reaches it worst levels six months after a recovery has begun.
To be fair, there are still troubling signs in our economy, and they can’t be ignored. Housing and banking, the ‘Jack and Jill’ of our economic difficulties, have yet to bottom and must do so before long-term recovery can be evidenced. Additionally, the current anti-corporate sentiment pervasive in the House and Senate is alarming and seems to be exceeded only by our elected official’s lack of understanding of business and economics, as well as a recognition that shareholders, inclusive of over 50% of registered voters, are damaged far more than executives as share values decrease and dividends are cut.
Signature Update is offered by Richard Haskell, Managing Director of Signature Wealth Management
Friday, February 6, 2009
Executive Compensation Limits - a move in the wrong direction?
Executive Compensation Limits – a move in the wrong direction?
An efficient economy, at virtually any level, depends on a variety of factors to maximize utility and optimize growth potential, and one of the most important of these factors is competition. It is widely recognized that healthy competition breeds lower prices, higher output, and generally is good for American business. However, there’s currently an effort underway to artificially limit one of the most important competitive forces in our country, incorrectly supposing that it will help restore health to our economy, profits to our corporations, and value to shareholders. That force is executive leadership and their compensation packages.
While there are clearly examples of outlandish bonuses accepted by certain executives who have returned terrible performance for their shareholders, these are the exception rather than the rule. By and large, CEO’s and their management teams, in the face of relentless pressure, have worked tirelessly in an effort to maximize shareholder value, and they’ve done so based on compensation agreements which offer monetary rewards as certain goals are met or exceeded. These individuals work for the same reason the rest of us do – to satisfy needs and wants, to feel a sense of accomplishment, and to further various personal agendas. If an employer limits our ability to do these things, then we often become less effective or seek employment elsewhere. If the limits are placed only on one corporation or employer, then the corporation becomes less competitive; if the limits are placed across an industry, then the industry ultimately fades into mediocrity; if they are placed on an entire nation, then that economy repeats the demise of other, centrally-planned governments no longer relevant in today’s economy.
There’s been much made in the media this last year over the compensation offered to executives in many of our major, publically-held corporations. Members of the House and Senate, shareholder advocacy groups, and others have expressed their disapproval at salaries and bonuses paid to CEO’s across the country as those CEO’s corporations have amassed unfathomable losses and experienced devastating declines in shareholder value. In the wake of all of this, media representatives and elected officials, many of whom have annual incomes expressed in terms of millions of dollars per year, have helped stir up sufficient public outrage that there are now credible efforts afoot to limit executive compensation in hopes of restoring fiscal strength to corporate America.
Though many have called for federal intervention in limiting executive compensation for all publically held corporations, the Obama administration has deftly sought limitations only for executives who’s corporations are in receipt of federal ‘bail out’ funds of one form or another. Obama’s economic team appears to understand a few important principals too often overlooked by many: first, we only have a right to influence behaviors in which we are vested; and second, when we limit rewards, we limit motivations to perform.
Through the Federal Reserve, US Treasury, and FDIC the federal government has now pumped trillions of dollars into the financial system, most notably through major banks, insurers, and auto makers. As this has taken place, we’ve come precariously close to ‘nationalizing’ these institutions. Treasury Secretary Geithner has recently asserted the administration’s commitment to stop short of nationalizing our banking system, which pronouncement sent stock values higher across the financial services industry, and obviously calmed investor concerns. However, the administration has also expressed its intent to limit executive compensation in any organization in which federal funds have been invested, specifically imposing, by legislation, a $500,000 annual salary cap, and a possible moratorium on bonus compensation of any kind.
Since the government has a vested interest in these corporations, by virtue of having invested billions of dollars in them, the administration not only has the right to do this, but in many ways the limitations appear to make sense. But will these limitations ultimately be in the best interest of the economy, our country, and our citizenry? Perhaps not.
When facing extraordinary difficulties, corporations need to draw on extraordinary talent, committed leadership, and devoted loyalists. While it might be comforting to suppose that the leadership and management of US corporations will bring these traits to the table out of sense of nobility, it would also be grossly naïve. Even as legislation to limit compensation is being debated, executives and management teams critical to the operation of certain banks which have been the recipients of federal ‘bail out’ funds have announced their departure for organizations that are not expected to be under such limitations. Some of these individuals may well have helped create the problems these organizations have experienced, but others have been responsible for some of the only currently profitable operating groups in these companies.
It is likely that we are only seeing the leading edge of this phenomenon. At exactly the time in which we need the ‘best and the brightest’ directing the affairs of corporations in which we taxpayers have invested massive sums, our futures if you will, we also appear to be standing by while our elected officials put these investments at risk by unwittingly driving out much of the talent with the ability to restore profitability and growth. In fact, many are encouraging this. For some it is an issue of irresponsibility; sadly, for others it is out of ignorance and envy.
The problem with executive compensation is not that is has been too high; rather, it is that it has been too loose. Extraordinary salaries and bonuses were offered, by contract, without the requirement for clearly defined, measureable benefits for the corporation and its shareholders. In most cases, these packages were approved by corporate directors responsible to represent shareholders, and in these cases it is hard to fault those executives who have accepted what was offered them. In cases where fraud or malfeasance was involved, there are legal remedies for these corporations to extract restitution from the offending parties. In many cases, the wrong lies not with the executives and their managers, but with the boards and directors themselves.
Some misunderstand the nature of many compensation packages as they hear figures that climb into the high seven figure range, supposing that these sums were received in cash. Indeed, in some cases, far too much was provided in cash, but again, this was only allowed by approval of the board of directors. Though salaries are most often paid in cash, most bonuses are a mix of cash and stock or stock options. In cases where stock is granted, there is usually a waiting period imposed before the stock can be exchanged for cash or other value, thus giving the beneficiary of the bonus motivation to help protect or increase shareholder value. Where stock options are granted, these are almost always offered in such a way as to only create value if the share value of the corporation increases over time, and are based on the executive or manager’s ongoing service to the corporation; again, a motivator for executive performance.
When understood in this light, two important factors emerge. First, much of the compensation, that which was based on stock price and performance, has been dramatically impacted with the declines in the stock markets, in many cases completely eliminating the potential value of that part of the compensation package. Second, and perhaps more important, is that it is less important to limit the level of executive compensation than it is to address on what basis it is earned and how it is received. Where liquid, or short-term incentives (cash, perks, etc.), are offered as a reward to encourage performance, then short-term benefits are likely to be the outcome. Where less liquid, or longer-term benefits (stock, stock options, deferred compensation, etc.) are offered, there is greater motivation to build long-term value.
Most would agree that appropriate salaries ought to be provided for a job done, well or otherwise, but bonuses should provide incentive for performance that goes beyond the pale. In the early 1980’s, most Wall Street executives received 50% to 90% of their annual compensation by way of annual bonuses, with anywhere between 10% to 80% of that in the form of stock or stock options. In most cases, stock rewards had to be held for no less than three years before they could be sold, and the stock options only became valuable if the recipient remained with the firm for three to five years, and if the stock price rose above a certain value.
While this same formula remains the norm today, the relationship between salary and bonus, and the ratio of bonuses paid in cash versus stock or stock options, began to shift in the mid 1990’s. It is no coincidence that today’s economic crisis has its roots in this same period.
As the administration, House and Senate debate various limitations on executive compensation, they are correct to place the emphasis on salaries being commensurate with the job to be performed, but to limit the opportunity to receive extraordinary rewards for extraordinary accomplishments will only serve to disadvantage those same corporations and industry segments so desperately in need of fresh ideas, innovative solutions, and tireless, ambitious, and motivated executives. Were the administration to place limits on executive compensation across the board, regardless of whether or not an organization has been the recipient of federal funds, not only would it signal a move towards a form of government inconsistent with the interests of our society, but it would serve to limit competition in the US market, our most talented corporate leaders would seek opportunities globally, and our entire economy would suffer greatly.
This is a time period in which virtually everyone agrees that we need to become more competitive, not less. Societies, governments, and corporations are uniquely capable of creating outcomes based on providing incentives for those who perform towards the outcomes desired. Rather than limit opportunity, competition, and rewards, we should focus our energies on determining how we best direct rewards to those who accomplish clearly defined, measurable goals that move us towards a restoration of growth and profitability, and then invite the world to follow and try to keep up.
An efficient economy, at virtually any level, depends on a variety of factors to maximize utility and optimize growth potential, and one of the most important of these factors is competition. It is widely recognized that healthy competition breeds lower prices, higher output, and generally is good for American business. However, there’s currently an effort underway to artificially limit one of the most important competitive forces in our country, incorrectly supposing that it will help restore health to our economy, profits to our corporations, and value to shareholders. That force is executive leadership and their compensation packages.
While there are clearly examples of outlandish bonuses accepted by certain executives who have returned terrible performance for their shareholders, these are the exception rather than the rule. By and large, CEO’s and their management teams, in the face of relentless pressure, have worked tirelessly in an effort to maximize shareholder value, and they’ve done so based on compensation agreements which offer monetary rewards as certain goals are met or exceeded. These individuals work for the same reason the rest of us do – to satisfy needs and wants, to feel a sense of accomplishment, and to further various personal agendas. If an employer limits our ability to do these things, then we often become less effective or seek employment elsewhere. If the limits are placed only on one corporation or employer, then the corporation becomes less competitive; if the limits are placed across an industry, then the industry ultimately fades into mediocrity; if they are placed on an entire nation, then that economy repeats the demise of other, centrally-planned governments no longer relevant in today’s economy.
There’s been much made in the media this last year over the compensation offered to executives in many of our major, publically-held corporations. Members of the House and Senate, shareholder advocacy groups, and others have expressed their disapproval at salaries and bonuses paid to CEO’s across the country as those CEO’s corporations have amassed unfathomable losses and experienced devastating declines in shareholder value. In the wake of all of this, media representatives and elected officials, many of whom have annual incomes expressed in terms of millions of dollars per year, have helped stir up sufficient public outrage that there are now credible efforts afoot to limit executive compensation in hopes of restoring fiscal strength to corporate America.
Though many have called for federal intervention in limiting executive compensation for all publically held corporations, the Obama administration has deftly sought limitations only for executives who’s corporations are in receipt of federal ‘bail out’ funds of one form or another. Obama’s economic team appears to understand a few important principals too often overlooked by many: first, we only have a right to influence behaviors in which we are vested; and second, when we limit rewards, we limit motivations to perform.
Through the Federal Reserve, US Treasury, and FDIC the federal government has now pumped trillions of dollars into the financial system, most notably through major banks, insurers, and auto makers. As this has taken place, we’ve come precariously close to ‘nationalizing’ these institutions. Treasury Secretary Geithner has recently asserted the administration’s commitment to stop short of nationalizing our banking system, which pronouncement sent stock values higher across the financial services industry, and obviously calmed investor concerns. However, the administration has also expressed its intent to limit executive compensation in any organization in which federal funds have been invested, specifically imposing, by legislation, a $500,000 annual salary cap, and a possible moratorium on bonus compensation of any kind.
Since the government has a vested interest in these corporations, by virtue of having invested billions of dollars in them, the administration not only has the right to do this, but in many ways the limitations appear to make sense. But will these limitations ultimately be in the best interest of the economy, our country, and our citizenry? Perhaps not.
When facing extraordinary difficulties, corporations need to draw on extraordinary talent, committed leadership, and devoted loyalists. While it might be comforting to suppose that the leadership and management of US corporations will bring these traits to the table out of sense of nobility, it would also be grossly naïve. Even as legislation to limit compensation is being debated, executives and management teams critical to the operation of certain banks which have been the recipients of federal ‘bail out’ funds have announced their departure for organizations that are not expected to be under such limitations. Some of these individuals may well have helped create the problems these organizations have experienced, but others have been responsible for some of the only currently profitable operating groups in these companies.
It is likely that we are only seeing the leading edge of this phenomenon. At exactly the time in which we need the ‘best and the brightest’ directing the affairs of corporations in which we taxpayers have invested massive sums, our futures if you will, we also appear to be standing by while our elected officials put these investments at risk by unwittingly driving out much of the talent with the ability to restore profitability and growth. In fact, many are encouraging this. For some it is an issue of irresponsibility; sadly, for others it is out of ignorance and envy.
The problem with executive compensation is not that is has been too high; rather, it is that it has been too loose. Extraordinary salaries and bonuses were offered, by contract, without the requirement for clearly defined, measureable benefits for the corporation and its shareholders. In most cases, these packages were approved by corporate directors responsible to represent shareholders, and in these cases it is hard to fault those executives who have accepted what was offered them. In cases where fraud or malfeasance was involved, there are legal remedies for these corporations to extract restitution from the offending parties. In many cases, the wrong lies not with the executives and their managers, but with the boards and directors themselves.
Some misunderstand the nature of many compensation packages as they hear figures that climb into the high seven figure range, supposing that these sums were received in cash. Indeed, in some cases, far too much was provided in cash, but again, this was only allowed by approval of the board of directors. Though salaries are most often paid in cash, most bonuses are a mix of cash and stock or stock options. In cases where stock is granted, there is usually a waiting period imposed before the stock can be exchanged for cash or other value, thus giving the beneficiary of the bonus motivation to help protect or increase shareholder value. Where stock options are granted, these are almost always offered in such a way as to only create value if the share value of the corporation increases over time, and are based on the executive or manager’s ongoing service to the corporation; again, a motivator for executive performance.
When understood in this light, two important factors emerge. First, much of the compensation, that which was based on stock price and performance, has been dramatically impacted with the declines in the stock markets, in many cases completely eliminating the potential value of that part of the compensation package. Second, and perhaps more important, is that it is less important to limit the level of executive compensation than it is to address on what basis it is earned and how it is received. Where liquid, or short-term incentives (cash, perks, etc.), are offered as a reward to encourage performance, then short-term benefits are likely to be the outcome. Where less liquid, or longer-term benefits (stock, stock options, deferred compensation, etc.) are offered, there is greater motivation to build long-term value.
Most would agree that appropriate salaries ought to be provided for a job done, well or otherwise, but bonuses should provide incentive for performance that goes beyond the pale. In the early 1980’s, most Wall Street executives received 50% to 90% of their annual compensation by way of annual bonuses, with anywhere between 10% to 80% of that in the form of stock or stock options. In most cases, stock rewards had to be held for no less than three years before they could be sold, and the stock options only became valuable if the recipient remained with the firm for three to five years, and if the stock price rose above a certain value.
While this same formula remains the norm today, the relationship between salary and bonus, and the ratio of bonuses paid in cash versus stock or stock options, began to shift in the mid 1990’s. It is no coincidence that today’s economic crisis has its roots in this same period.
As the administration, House and Senate debate various limitations on executive compensation, they are correct to place the emphasis on salaries being commensurate with the job to be performed, but to limit the opportunity to receive extraordinary rewards for extraordinary accomplishments will only serve to disadvantage those same corporations and industry segments so desperately in need of fresh ideas, innovative solutions, and tireless, ambitious, and motivated executives. Were the administration to place limits on executive compensation across the board, regardless of whether or not an organization has been the recipient of federal funds, not only would it signal a move towards a form of government inconsistent with the interests of our society, but it would serve to limit competition in the US market, our most talented corporate leaders would seek opportunities globally, and our entire economy would suffer greatly.
This is a time period in which virtually everyone agrees that we need to become more competitive, not less. Societies, governments, and corporations are uniquely capable of creating outcomes based on providing incentives for those who perform towards the outcomes desired. Rather than limit opportunity, competition, and rewards, we should focus our energies on determining how we best direct rewards to those who accomplish clearly defined, measurable goals that move us towards a restoration of growth and profitability, and then invite the world to follow and try to keep up.
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