Spero Consulting

Archive for December 5th, 2008

A Vari­ety of Risk & Incen­tive Ideas All in One Post!

There is an arti­cle in The Wall Street Jour­nal today enti­tled, Citadel’s Losses Add to Mr. Griffin’s Pain.

We’re rather indif­fer­ent to Mr. Griffin’s pain as we’re sure that he is to ours, but that’s not why we are writing.

We men­tion the arti­cle because it relates to ear­lier post­ings and pro­vides an idea for exec­u­tive com­pen­sa­tion that we haven’t seen dis­cussed before.

Mar­kets, Crises, Nedges and Sledges. It’s often the case that rel­a­tively the good per­form­ers or safer invest­ments suf­fer unjus­ti­fi­ably along with bad per­form­ers or losers in mar­ket down­turns, crises, and pan­ics. We ital­i­cized “unjustifiably” because we doubt that such a notion applies to mar­ket eco­nom­ics. However, such events can tran­spire for a num­ber of reasons. 

As we men­tioned on Tues­day in Tak­ing the Fun(ds) out of Hedge Funds, bet­ter per­form­ers may suf­fer – if there is such a notion in mar­kets – when poorly incen­tivized investors sell those secu­ri­ties at small gains or small losses rather than rec­og­nize large losses on ter­ri­ble performers.

Also, as Richard Book­staber nicely describes in the excel­lent A Demon of Our Own Design there may be runs on high qual­ity assets if mar­ket par­tic­i­pants know that dis­tressed sell­ers hold those assets. Mr. Book­staber pro­vides a few exam­ples, includ­ing the run on Brazil­ian bonds dur­ing the Asian Cri­sis (in 1997), and Long-​Term Cap­i­tal Management’s (LTCM’s) mas­sive prob­lems due to the fact that it was pub­licly announced that Trav­el­ers was end­ing pro­pri­etary, fixed-​income trad­ing at Salomon Smith Bar­ney in July, 1998.¹

In addi­tion, these mar­ket dynam­ics are why we often refer to hedges as nedges (near hedges) or sledges (some­what like hedges). Pedge or predge for “prob­a­bilis­tic hedge” also cap­tures this notion that things aren’t as secure, locked-​down, and pre­dictable as they might at times seem.

In stressed times, there are few proper – i.e., risk-​free – hedges. Instead, it becomes quite pos­si­ble to lose on both sides of trade. One of the main, exac­er­bat­ing prob­lems is the fact that dur­ing calm times, traders and ana­lysts receive evi­dence that allows them to over­es­ti­mate the valid­ity or pre­dictabil­ity of the inter­ac­tions of the var­i­ous parts. So, for those folks, “hedg­ing” day-​to-​day prof­its and activ­i­ties dur­ing calm times, espe­cially in “cost-​effective” ways, leaves them exposed to the rarer, but far more dam­ag­ing large events.²

High-​water Marks and Exec­u­tive Com­pen­sa­tion. The arti­cle on Citadel briefly men­tions high-​water marks that relate to asset val­ues and com­pen­sa­tion for fund man­agers. That means that if a (hedge) fund gen­er­ates loses, it must recoup those losses before the fund man­ager can earn a per­for­mance bonus – usu­ally 20% of gains.

We’d like to see cor­po­ra­tions imple­ment sim­i­lar, equity-​related com­pen­sa­tion schemes for their senior man­agers and boards.

A quick search of the web turns up oth­ers offer­ing the same rec­om­men­da­tion, but our brief search iden­ti­fied no firms that have incor­po­rated such a sched­ule into their exec­u­tive com­pen­sa­tion plans. 

We could see where it would be dif­fi­cult to show that such a pol­icy is opti­mal in a math­e­mat­i­cal agency model, but that’s due to com­pu­ta­tional con­straints that force such mod­els to be stark. The basic rea­son that such a pol­icy would be sub­op­ti­mal in a math­e­mat­i­cal model is that there would likely be a wide range of pre­lim­i­nary out­comes where it would be dif­fi­cult to moti­vate the per­son to con­tinue to work, and given that, the ini­tial risk pre­mium would have to be large to ensure that the agent would par­tic­i­pate.³

How­ever, in real life, such a pol­icy would seem very com­pelling and would likely be less demo­ti­vat­ing to other employ­ees, and that should be worth some­thing. In fact, maybe even more than the direct effect on man­age­ment, and that’s one of the ben­e­fits that would be dif­fi­cult to for­mally model with­out a sub­stan­tial loss of ele­gance or the elim­i­na­tion of solvability.

Now, per­haps we’re also drawn to the idea because we’ve seen any num­ber of man­age­ments paid for sub­stan­tial improve­ments in share prices that turn out to be noth­ing more than the right-​side of an upward fac­ing parabola. The same man­age­ment team was also in place dur­ing the left-​side decline, too. Of course, we’re will­ing to sar­cas­ti­cally admit that down times can’t be avoided as they’re always due to gen­eral eco­nomic con­di­tions, whereas the upsides are solely due management’s actions and prowess. Yeah, we doubt that you’re buy­ing it, either.

As always, we might update the post as we think about it a bit more.