Thursday, October 22, 2009

How to Destroy $2,000,000 in Just Hours

Yesterday, Treasury Department’s special master for compensation under President Obama, Kenneth Feinberg, put severe limits on compensation to top earners at seven companies that received “exceptional help.” This is getting the expected commentaries around the economics blogosphere here, here and here.

It is possible that shareholders are being duped into offering “excessive” compensation. If so, such outside help would mean that shareholders get to keep more of the profits from company operations. On the other hand, it is possible that these were efficient labor contracts that “incentivized” top earners to work hard. If the former, market value of affected firms should rise. If the latter, it should fall.

As they say, let’s role the tape from yesterday. I was able to find intra-day stock market data on three of the affected firms, AIG, BofA, and Citigroup. (I am not smart enough to find General Motors, Chrysler and the financing arms of the two automakers.) The drop off in share price in the late afternoon after the announcement for all three was pretty consistent. They each fell about 2.3% but the market as a whole fell too. Subtracting off the fall in the S&P500 of -1.8% over the same period yields returns in excess of general market trends. (For you finance guys, this assumes beta is one). The closest I could find for market value this morning was the shares outstanding in December, 2008 from CRSP. Multiplying shares outstanding by the “excess” change in price sums to ~$1.8 million for these three firms.

Firm Share Price Pre Share Price Post Percent change Excess Returns Market Value
Excess Return
AIG 39.97 39.03 -2.35% -0.87% -$911,591
BofA 16.90 16.51 -2.31% -0.82% -$683,071
Citigroup 4.53 4.42 -2.43% -0.95% -$227,651


  • Rarely does one see such stark and quick confirmation of the government’s ability to destroy wealth.
  • Perhaps the problem is that the pay czar is only concerned with bridging the chasm between Wall Street and Main Street and not on shareholder wealth. Perhaps his compensation should be tied to the performance of the firms he oversees.

David from the comments is right that my "back of the envelope" exercise misses some key subtleties. I agree that these assets are likely riskier than average (beta may be greater than one) meaning that the announcement would have had a smaller effect. Also, as he points out, Pr(intervention) > 0 before the announcement and Pr(intervention) <1 afterward, which would inflate my estimates. Moreover, some of my “control group” (the S&P500) were likely also 'treated.' That is, the announcement may have lead market participants to think there is greater chance for government oversight of management compensation more broadly and some of the drop in the S&P is due to the announcement. To tease this out, one might compare the affect on firms based on the likelihood that they are immune to the intervention (healthier, lower compensation levels). All said, the back of the envelope calculation is a just that and my claim about that this was ‘stark confirmation’ was too strong.

Still, for a policy intervention, I would shift the burden of proof. One should have evidence that the intervention has positive and significant effects before a decision to implement.


  1. I think the fact that it was such a relatively small correction shows that the market doesn't believe that the regulations are going to stop the companies from finding another way to recruit and retain talent. If this were the case I think we would have seen a much bigger drop.

    Put plainly, the self interest of creative and intelligent people and organizations will out smart regulations made for political purposes any day. I am amazed however, that the government wouldn't want the best talent they could find (and therefore the most expensive) running their organizations, but I guess that doesn't get people elected.

  2. Recognizing that this was a back of the envelope exercise and not a full fledged event study, I still don't think that there is enough here to support even a blog post. First, the market yesterday and perhaps today should only be pricing the news. That compensation would be restructured and constrained downward was not really news. The news component if any would only be the difference between the actual proposal and the market expected proposal. Further, the market may yet expect that the proposal will be modified before becoming a policy. So even with a stronger design, what could be said on the basis of this one announcement window is limited to estimating the size of the market's estimate revision which is certainly not the same as the total estimated net cost-benefit.

    As you point out your calculation is biased as these distressed firms are almost certainly more risky than the value weighted market average. Your abnormal return measure is almost certainly inflated. Further, there is a lot of valuation noise in stock prices. Averaging across the 500 stocks in your market basket, there will be a lot of noise cancellation. For individual stocks the signal-to-noise ratio will decrease as the window is narrowed. So even with a better proxy for abnormal returns, you'd need to adjust for the size of the typical abnormal return over the same window size in order to make an informed judgment as to whether the estimated abnormal return was large enough to be considered significant.

    Based on your BotE, this doesn't seem like a promising topic for a paper.

    (Sorry if this is a repost, I got an error the first time.)

  3. I agree with both of the comments here. Where there is a will there is a way, so the companies will find a way to compensate and armed-chair theorists will find a way to come up with numbers to justify what they want! And of course an average person will try to figure out who is hanging him/her dry!

  4. @2nd Anonymous:

    It's not clear whether your second sentence was intended as an independent editorial or you meant it to be a synopsis of the first two posts. If the former, everyone is welcome to form their own opinion. If the latter, you have failed to understand the first two postings.

    A1.1: $2M doesn't seem economically significant.

    A1.2: This suggests the market isn't worried that there will be much impact from the policy.

    A1.3: One explanation is that the market expects that the policy will not have the intended effect of reducing financial incentives.

    A1.4: Shouldn't the government want strong incentives.

    D1.1: The market reaction should not be taken as a measure of the market's estimate of the net cost of the policy.

    D1.2: Technical issues that Prof. Ward no doubt knows but may have overlooked for whatever reason.

    A better summary of these two posts is that in the absence of a stronger test there is no reason for a rational individual to update his or her prior beliefs.

    Prof. Ward's post suggests that his prior belief is that the labor market is better at setting compensation than are government bureaucrats. While the data in this particular case are not inconsistent with that very reasonable belief, they don't do much to support it.

    I'm not sure whom you intended to label an "arm-chair theorist", but I don't see any justification for applying such a label to Prof. Ward or for ascribing to him the questionable motives that you seem to imply.