Saturday, December 29, 2007

Risk vs. Reward

One of the chief premises of self-regulating markets is that the brand carries immense value. So an owner of a brand will work hard to not compromise the hard-earned reputation.

As Paul Krugman, a respected economist from Princeton and one of the best columnists for the New York Times writes, "In a 1963 essay for Ms. Rand’s newsletter, Mr. Greenspan dismissed as a “collectivist” myth the idea that businessmen, left to their own devices, “would attempt to sell unsafe food and drugs, fraudulent securities, and shoddy buildings.” On the contrary, he declared, “it is in the self-interest of every businessman to have a reputation for honest dealings and a quality product.”"

Of course these days most big companies in the US are publically held, and run not by owners, but by hired executives. These executives are paid a lot of money, and majority of their compensation is tied to the short term performance of the company, usually as measured by its stock price.

An average executive stays on the job for 8.2 years. A typical vesting period of a stock package is between 4 and 6 years. Most stock option packages require the options to be exercised (sold) within 10-12 years from the date on which they were granted.

Most of executive contracts also have provisions for a "golden parachute" - if executive's employment is terminated for any reason, he or she is entitled to large severance bonus, sometimes measured in tens of millions of dollars. "Golden parachute" contracts usually do not require the executive to meet any performance standards - he or she gets paid even when fired for gross incompetence.

So what does all this mean for an executive as a rational player?

Most importantly, there is a clear incentive to UNDERPRICE risk.

Suppose you have a risky scheme that, if successful, will bump your company's earnings significantly, even if temporary. If unsuccessful, it could cause a major setback for earnings, that could potentially knock the company off its feet for years.

In other words, there is a choice between potentially unlimited upside, and a golden parachute as a downside.

Let's do some modeling - throw a bunch of random numbers at the problem. The numbers are fictitious, but the orders of magnitude are about right - I've been reading them in the newspapers for years.

Let's say we have a CEO that has a $5M golden parachute built into his contract, and a package of options based on a $10M investment (e. g. he gets the result of appreciation of the stock that is worth that much, if the stock does appreciate).

Let's say we have a strategy of organic growth, where the company does whatever it was doing for a while, and enjoys the historical growth rate of a 10% per year, for the next 5 years.

An alternative is a major product line restructuring. Let's say that if the project is successful, the stock may appreciate by an order of magnitude (10 times) over the period of 5 years. However, if it fails, the stock price falls by 60%. Let's say the probability of success is very low, let's say 10%.

The expected pay off for the risky alternative is 9*0.1 + (-0.6)*0.9 = 0.36. The expected pay-off for the organic growth strategy is (1 + 0.10)^5 - 1 = 0.61. The risky strategy is a clear loser.

Let's see how the same calculation looks from the perspective of our CEO. In both cases our hero rules the company for 5 years, then heads for the greener pastures.

Organic growth: ((1 + 0.10)^5 - 1) * 10M(stock options) + 5M(golden parachute) = $11M.
The Risky Project: 9 * 10M * 0.1(stock options) + 5M(golden parachute) = $14M.

Hmmm... Risky strategy is a clear winner! The difference between the owners and the employees here is that the owners are negatively impacted by the losing part of the bet, whereas the employees benefit from winning, but do not suffer from losing.

This statement applies mostly to the top of the hierarchy, of course - if the company goes down, it will downsize the grunts, which would very much feel the negative effect - by not being able to pay their mortgages. The top, however, will have the benefit of a very big pay-off either way, enough to pay for the private jet's fuel for quite some time.

"Wait a minute!" - you'll say. What about the CEO's reputation? After the failure he has inflicted on his company he will not be hired anywhere else? Turns out that this is not true. More about it tomorrow.

As a side note, ANY stock-option based compensation package by definition has limited downside (you get nothing if the stock goes below the exercise price), and unlimited upside. For a rational corporate player, this should encourage taking risks.

I think overall risk in the US economy is very much underpriced, because there is no incentive at the top to price if fairly. Let's look at an insurance businesses as our second example.

Insurance industry earns money by collecting the premiums, paying the claims, and keeping the difference. For a normal year the amount of claims is fairly stable and predictable. This allows actuarials to set the price of your home insurance very precisely. However, there are events that happen very infrequently (major hurricanes or earthquakes) that could potentially have enormous effect on the claims, and sizable effect on the cost of your premium.

However, NOT taking these events into account makes perfect sense from the perspective of a CEO - the likelihood that a major once in a hundred years event will hit on his watch is low, and the potential upside of not including it in premiums is high - it allows the company to undercut competitors, get more customers, and increase the stock price.

While not accounting for a probable event may be malicious and potentially criminal, there are plenty of legal way of going a long way towards the same goal, while still deriving sizable benefits. It is because the probability of an improbable event is extremely hard to estimate.

For example, geologists think that a devastating earthquake should hit the Pacific Northwest some time in a future, but it could be any time in the next 1000-10000 years. Well, an insurance company could figure in a conservative probability of .1%, or a liberal probability of 0.01%. In either case, nobody could possibly claim a foul play, but financial incentives dictate the liberal estimate, regardless of the truth.

By the way, this premium will have to pay for a total loss of the house. A typical house in Seattle area is worth around 600000. If, say, 400000 of this is the cost of the building (assuming that the plot is not destroyed by the earthquake, which is actually NOT a given, either, because the geological evidence shows swaths of land underwater after the previous such event), .1% is $4000 a year, and .01% is $400. It's a big difference.

Judging from my own insurance premium (which does have an earthquake rider), they are not figuring in even the liberal estimate.

Now, what would other insurance companies be forced to do to compete? Lower their own premiums, of course! Which would in turn require underpricing the risk by the entire industry.

If you keep this propensity to undeprice risk and its overall effect on the entire industries, what happened during the .COM and the subprime mortgage crises becomes perfectly clear. In both cases execs at the bodies charged with evaluating the riskiness of the investments had short term horizons, and massive financial incentive s for allowing very questionable investments to go through. And the competitiveness of the industry ensured that once a few companies chose to disregard the risk, the rest were required to follow.

So where does this all lead us? My conclusion is that the principle of self-regulation is suspect, especially when taken as a religion by the crazy Ayn Rand followers. Hopefully, they will be wiped out by the next election, but the picture they paint is simple, easy to understand, can be packed in a 30-second TV commercial... and false. Which makes it very easy to sell to the American electorate which has notoriously short attention span.

We are yet to see how the mortgage crisis will ultimately turn (I will blog my own predictions at some point). The question is - who is going to be next? My hope is that it's not going to be the airlines, where the price competition is extreme, the ridership is high, and the fleet is wearing out.


vtv said...

It seems to me that golden parachute is less probable for an organic growth than it is for a risky project case. Could it be so?

Sergey Solyanik said...

You mean - getting fired and receiving the money under the GP contract? Yes, of course!

vtv said...

I mean that firing itself is less likely for an organic growth. No firing means no GP.

If so, then formula for an organic growth may bring even less income for a CEO:
"Organic growth: ((1 + 0.10)^5 - 1) * 10M(stock options) = $6M."

Or GP works anyway?

Sergey Solyanik said...

GP gets paid when the exec leaves - on his or her own volition or otherwise... But in my calculations I assumes that the CEO stays on a job for longer time in the case of organic growth, so no GP money is paid in that case.