The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-08, by Lucian A. Bebchuk, Alma Cohen and Holger Spamann, Harvard Law School
The received wisdom has so far been that the top executives at Bear Stearns and Lehman Brothers suffered with their shareholders as their firms went kaput. The story was that these executives made genuine mistakes and they paid the consequences. If that is true, then incentives do not need to be changed to align them more closely to long-term shareholder value because, after all, both shareholders and executives saw the value of their holdings wiped out. But Bebchuk, Cohen and Spamann say it isn’t enough to consider whether the top executives lost money in the crash—they could have made pots of money before the crash. To see whether they did indeed lose money, they, therefore, considered the compensation paid to the top five executives at each firm over the period 2000-08.
The researchers found that the executives had already pocketed in prior years large amounts of money as cash bonuses. In the aggregate, during 2000-08, the top-five teams of Bear Stearns and Lehman accumulated cash bonus payments exceeding $300 million (around Rs1,400 crore) and $150 million, respectively.
Further, the executives regularly took large amounts of money off the table by unloading shares and options. The researchers point out that, “during 2000-2008 the top-five executive teams at Bear Stearns and Lehman cashed out total amounts of about $1.1 billion and $860 million respectively. Indeed, we find that during the years preceding the firms’ collapse, each of the teams sold more shares than they held when the music stopped in 2008.” The bottom line: In sharp contrast to shareholders who held their shares throughout 2000-08, the executives’ payoffs during the same period were significantly positive.
The moral of the story, say the researchers, is that the executives’ taking large amounts of performance-based compensation based on short-term results did provide them with undesirable incentives—incentives to seek improvements in short-term results even at the cost of an excessive increase of the risk of large losses in the future. In short, the story at both Bear Stearns and Lehman Brothers bears out the case for realigning executive compensation more closely with the interest of long-term shareholders.
Illustration: Jayachandran / Mint
The Potential Impact of The Global Financial Crisis On World Trade, by Warwick J. McKibbin and Andrew Stoeckel. World Bank Policy Research Paper 5134
How long will the effect of the global financial crisis last? McKibbin and Stoeckel have modelled the financial crisis “to disentangle the various direct and indirect effects of the crisis on international trade and how events might unravel”. The authors discuss the shocks to which the global economy has been subject. These include the bursting housing bubble in the US, UK and some other countries; the rise in equity risk premia, particularly after the Lehman Brothers collapse; and a rise in household risk, as households view the future as more risky, which affects their saving and spending decisions. These shocks have led to three policy shocks, which include an easing of monetary policy to near-zero official rates of interest in major developed economies; an easing of fiscal policy across countries and large run-up in government deficits; and a rise in trade and financial protectionism.
The authors point out that while the fiscal stimulus increases the gross domestic product growth initially, the impact of this is small. But the higher government borrowing will ultimately increase real interest rates, which reduces private investment. This has an impact on trade. The researchers point out that “durable good consumption falls because of the rise in real interest rates, while non-durable good consumption rises due to the income increase. The effect is that imports of durable goods fall and non-durables rise. In addition, the higher real interest rate tends to attract foreign capital, which appreciates the real exchange rate and tends to crowd out exports”.
Simply put, while the stimulus measure may have an initial beneficial impact, they will also have unforeseen consequences. According to the model, higher real interest rates persist for up to six years after the stimulus, which “points to some serious potential problems to be faced by policymakers during the recovery period from 2010 onwards”.
And finally, one of the conclusions of this study is that trade protection as well as fiscal stimulus have an adverse impact on global trade. That’s because “the aftermath of the fiscal responses crowd out global demand and slow the recovery”.