The Golden Parachute: Why Current CEO Compensation in America is Unjustified

Now that the presidential election has passed and the future Commander in Chief of the United States is known, attention has shifted from the promises of change in the future to fixing the country’s deteriorating economy. One of the biggest issues that have elicited cries of outrage is the topic of CEO compensation in public companies, especially the ones that have been failing during this financial crisis. For example, Richard Fuld, former chief executive of Lehman Brothers Holdings Inc. received $484 million in compensation from 2000 until it filed for bankruptcy in September. Similar payouts have been recorded at other failed institutions like AIG and Countrywide. Considering that those individuals led their companies to failure, the question must be raised as to whether or not these CEOs are deserving of the outrageous pay packages they are given. Is it necessary to pay the top men in Corporate America tens or hundreds of millions of dollars in salary, stock, and other benefits? Additionally, is it fair that their bonus packages are often not directly linked to the performance of their company’s stock? When I started my research for this post, I was of the belief that CEO compensation in America is mostly justified, except for the extreme cases like Lehman Brothers and Countrywide. However, the more I looked into the topic, the more I came to believe the opposite. Except for certain cases where a CEO significantly increases the value of a company’s stock, the current level of pay for CEOs in America is not justified, for the amount of value they add to it is exceeded by their cost of services.

For most employees in the world, the amount of money and other benefits they are given for their work is directly correlated to their performance and the value they add to their employers. Recently in America, it seems that CEOs of large public companies have become exempt from that policy. One of the responsibilities of a CEO is to maximize value for shareholders. The problem has been that, looking at some of the highest earning CEOs in 2007, their pay is an unjustifiably large percentage of the company's earnings (see below, left). For those institutions that do link executive income to performance, they have developed too narrow of a focus on earnings. As Leo Hindery, Jr. observes in BusinessWeek, “from the end of World War II until the mid 1990s, prominent public and private company CEOs almost universally viewed their responsibilities as being equally split among shareholders, employees, customers, and the nation.” However, as time passed and companies became less regulated and their owners more greedy, shareholders became the most important. Hindery also points out that “at that point, because of the prevalence of stock option and restricted stock grants, shareholders included many if not most senior managers at a large number of publicly traded companies.” The problem that arises when the focus of a company turns towards making a profit and not towards accountability and responsibility is that encourages short-term profiteering and long-term irresponsibility, the American Federation of Labor and Congress of Industrial Organizations argues in an article entitled “Why the Mortgage Crisis Matters”. This attitude lead to the use of the complex financial instruments that produced large short-term gains, but in the end, is at the root of the credit crisis our country is suffering from right now.

In addition to being unjustified, bad for the company, and unhealthy for the economy, giving CEOs these huge salaries and stock options with even larger severance packages only grows the gap between the rich and the poor. On average, during 2007, average CEO pay was 344 times that of an average worker in the United States. Hindery points out that in other industrialized nations like Britain, Canada, and Japan, that multiple drops to 22, 20, and 11, respectively. What is it about the average CEO that makes him or her hundreds of times more important to a company than its average employee? Would the average CEO be more useful to a company than an additional 344 employees? Freek Vermeulen discusses how the boards of directors in these companies (the people who determine how much a CEO makes) use a comparison to a company’s “peer group” to justify the number they choose. Unfortunately, the problem with this logic is that the overcompensation of executives is system wide. It is a rare instance when the head of a company is not making at least upper seven digits. In reality, there are only a handful of individuals who are actually worth the kind of money CEOs are being given today. They are the Warren Buffet’s and the Jack Welch’s of the world. They are the people who, if the company were to lose them, they would potentially lose billions of dollars of value. The average CEO is not that person. He or she is skilled or intelligent, but there are many skilled and intelligent people in the world. The only difference between the two groups is that one is being paid millions and millions of dollars, while the other may be making little over what the average worker makes. I see that as a cruel injustice which polarizes our society and harms our economy. It must be changed.

Luckily, executive compensation has become a top issue in our government today. Considering the fact that the United States government is making hundreds of billions of dollars available to these companies, it absolutely should be an issue. Taxpayers should not be the ones supporting the lavish lifestyles of the people who caused the economic downturn in the first place (see right). Unfortunately, the current bailout package has loopholes in it that would allow this spending to continue unchecked, a fact which some legislators have not overlooked. They are calling for caps on CEOs salaries if they receive money from the bailout. While the bailout is a special situation, I think that there should be broader changes across the market. Stockholders, not a board of directors, should be the ones who determine how much a company’s executive makes. They are the ones who stand to make or lose money depending on how the company performs, and so they are more likely to reward smart, sustainable decisions. There may be better ways to remedy this issue, but the fact of the matter is that the amount CEOs of American companies make is excessive, and as such, is a problem. It is a detriment to the growth of a company and disease that, if allowed to continue, will keep our economy from truly regaining its health.

Bear or Bull: Has the Stock Market Bottomed Out?

Over the past few weeks, I have spent time discussing various issues in the economy, from the $700 billion bailout plan to presidential fiscal policies. In the end, no matter what any analyst or I think of these issues, the ultimate judgment is made by the stock market. It is the number one indicator for the health of the economy, and over the past year the S&P 500 has declined ­­­34 percent, making it one of the worst bear markets yet (see below, left). The thing that makes this market so odd is not the fact that it has been declining; many people anticipated the burst of this current bubble. It is how volatile and unpredictable this market has been that makes it so odd. Drops of hundreds of points one day are followed by gains of hundreds of points the next. Negative economic news makes the market rise, positive news makes it drop. Recently, however, the market has been especially unpredictable. October was the worst month in 21 years, but the last month of October marked the largest weekly gains the market has seen in 34 years (see below, right). Does this indicate the market has bottomed out, or is it just another example of the market’s odd and irrational volatility? With this question in mind, I decided to explore the blogosphere and see what others believed. Like before, I found two blogs that had especially interesting discussions about the topic and left my feedback on them. In the first blog, The Big Picture, Barry Ritholtz discusses other predictions for the bottom in an entry titled “Race to Call the Bottom.” He does not try to predict the end of the bear market but instead talks about the absurdity of some of the predictions out there as well as how unlikely it is for someone to be able to know the market well enough to predict when it is going to bottom. In his blog on the website Seeking Alpha, Ian Cooper tries to address the issue in an entry entitled, “The Economy’s Worst is Still Ahead of Us.” He believes the worst of the crisis is ahead of us, and quotes Nouriel Roubini, a New York University professor, in order to back his point. Roubini was one of the few who has predicted this financial crisis for years and, according to Cooper, has emerged as a leading commentator on the crisis. For your convenience, in addition to posting my comments on each respective blog, I have copied them below.

“Race to Call the Bottom”
Comment:
Thank you for your article about the absurdity of trying to predict a bottom of the market and how every media outlet is searching for “experts” to give them a number the market is going to bottom out at. The entire concept that a person is able to accurately predict a number at which the stock market will bottom out, even within 100 points, is asinine. There are so many factors that control and direct the stock market. Some are measureable, others are not. I can understand how analysts arrive at their estimates and their importance to investors, but in the end, they are only estimates. For a news outlet to take those numbers and quote them as if they are an assertion of fact by that analyst is just irresponsible. I especially liked your example of Peter Boockvar being quoted in the New York Times as believing the Dow would bottom at 5,000, despite the fact that he had really only come up with a range of 5,000 to 7,000 in which he could see the market reaching its bottom. His quote is especially meaningful, when he says, “No one’s smart enough to answer the question as to where we’ll be a year from now. I think it’s silly to pick a number.” Is this fact such a difficult concept to grasp? As you say yourself, “The track record of economists and strategists is notoriously poor, no one ever consistently gets the year out forecasts correct several years in a row – it’s just totally random.” Do reporters and analysts actually believe that they are going to be correct when they throw out these seemingly arbitrary numbers of where the market will bottom, or are they only creating these numbers for others to read so that they can get some publicity or sell copies of their articles?

All in all, thank you again for this commentary on the folly of market forecasts, especially the narrow forecasts we have been seeing lately. In the future, I would love to see more discussion of the extreme forecasts you mention earlier in your article or a continued discussion of other forecasts for this particular market. Really, all an analyst can do is give a broad range of numbers he or she believes the market will drop to or give an opinion as to whether the current market is at its bottom at the time. I believe these specific forecasts to oftentimes be little more than publicity tools, yet people will continue to look upon them as fact until more people like you come out and call them out for what they are: overly speculative educated guesses.

“The Economy’s Worst is Still Ahead of Us”
Comment:
Thank you for your interesting piece about how the market has not reached its bottom. It is interesting to see how often Wall Street is dominated by a group think mentality. I feel that all it takes for a temporary spike in the stock market is for a handful of analysts to come out with a positive outlook on the market and everyone else will buy into it. Are these people not supposed to be some of the brightest in the country? Are they incapable of looking at some of these facts and realizing that, although we do not know exactly when the market is going to turn around, it probably is not at this exact moment? Looking at the past week, it is shocking to see how irrational the market has been. Consumer confidence fell to an all time low (almost 15 points below the Street’s estimate) and yet the market rallied nearly 900 points. Additionally, the United States GDP declined for the first time since 9/11 and real consumer spending fell for the first time since 1991, and the most since 1980. I am not sure which part of this news indicates to investors that the market has bottomed out.

If what you and Roubini say is true, and that hundreds of hedge funds will go belly up and the Option ARM loans result in a second financial crisis, those optimists are in for a rude awakening. On that note, I wish you had gone into greater detail about why the hedge funds are going to fail or when the Option ARM loans are going to begin resetting. The prediction that the hedge funds will go belly up loses some of its credence when you do not back it with any reasoning, only repercussions. You explained the Option ARM loans well, but by not including an idea of when to expect that crisis to begin, all you did is raise my blood pressure. However, those two do not take away from the fact that this was an eye opening piece about where the market has the potential to go. I am hoping none of your predictions come true, but look forward to continuing reading your blog in the future.