With the market getting pounded day after day, it is hard to focus on the task at hand of examining the incentives at work in the investment markets and what might be done about changing them in ways that help us avoid such poundings in the future.the research puzzle | This is, in fact, the sixth posting in this series.  The last was in regards to “the mysterious waffle.” But here we go, and this time the net is cast much more broadly.

A couple of decades ago, the theorists and the practitioners of economic life found something that they could agree upon:  Awarding stock options to corporate managers would align their interests with those of shareholders.  We subsequently saw wide adoption of options in compensation packages, including some super-sized ones that I guess were meant to make sure that those managers were really aligned.

It was all a colossal mistake.  In response, some academics have been jumping ship from the thesis.  Others, like me, who have seen firsthand poor decisions being made to promote a stock instead of further a company, have railed against the practice.  But it still is ingrained in corporate America.

What stock options do is align the short-term interests of shareholders with managers.Which is why Wall Street didn’t do its job of evaluating them correctly; it benefits from the misalignment of incentives.  More on that in a subsequent chapter. Under the right set of circumstances, it can work out for the nimble, since managers are incented to promote their stock and make decisions today that will make the price go up tomorrow.  What they don’t do is make decisions that build lasting value.  Options aren’t adjusted for risks taken and their payouts versus other forms of compensation are skewed to the upside.  Small wonder that managers tend to take risk in a variety of ways that they otherwise wouldn’t.

As Michael Jensen pointed out a few years ago,SSRN | The Harvard professor’s paper is titled “Agency Costs of Overvalued Equity.” the pumping of a stock to an unreasonable level, no matter its source, can set in motion “forces that almost inevitably lead to destruction of part or all of the core value of the firm.”  Yet, by definition, stock option grants incent managers to seek to increase the price of their stock.

Such agency costs are part and parcel of a pattern of governance in which boards, compensation committees, and “independent” compensation consultants are controlled or significantly influenced by the chief executive, and who all seem to be infected with an incurable case of KUJ.the research puzzle | KUJ is, as early readers of this blog will recall, the great American pastime of “keeping up with the Joneses.”  Follow the link for a graph and posting that presciently looked for the same pattern in investor behavior last spring. More evidence of those realities will soon arrive, when firms reprice existing options or ramp up new option grants to compensate for the opportunities from past awards that now seem out of reach.

Instead of promoting the wise use of capital, firms got in the habit of repurchasing stock to offset the dilution that results from stock options being exercised, with the stock therefore being bought at higher prices.  The question is whether the purchases were made at reasonably higher prices or ridiculous ones.  Most firms have operated on autopilot, buying stock to offset the option game regardless of the long-term wisdom of doing so, with predictable results.Having bought high, now the firms don’t have the flexibility to “buy low”; when the definitive study on the damage is done, the capital misallocation will be astonishing.  For now, in the words of a recent headline, “Buybacks Fall Out of Favor as Stock Strategy.”  Amazing.

All of this is bad enough, but we haven’t even considered the worst aspect of stock options.  Structurally, none of these options should be tied to the absolute stock price, yet they virtually all are.  When the rising tide lifted all boats (can you remember back that far?), managers of subpar firms got fat and happy for no good reason.  Their stocks went up because the market went up.  Their options kicked in because they were breathing.  (The opposite is happening now, and those managers who have made sound decisions are seeing their options go underwater solely due to the general decline in prices.)

So what are the answers?  Should these instruments be banned?  Is government action needed?  I find myself in the uncomfortable position of thinking that an abrupt change in this misbegotten practice could only come about that way, but I hold out hope that “the market” will realize the problems and correct them.  Unfortunately, the market is somnolent and the entrenched interests rule the day.

At least some new ideas are being considered.  A recent paper argues for a move entirely to restricted stock awards rather than options.SSRN | The paper is by Sanjai Bhagat and Roberta Romana and is entitled “Reforming Executive Compensation:  Focusing and Committing to the Long-Term.” That would be a step in the right direction, but the approach retains the weakness that market movements generally would swamp company-specific actions in creating an executive’s ultimate payoff.

It is a theme of the postings I have done on incentives that easy answers have been favored over more complex and carefully-drawn arrangements.  The latter is what’s needed here; the incentives should be firm-specific, disengaged from the performance of the general market, and focused on very long-term value, not short- and intermediate-term stock price action.  In addition, managers should be prohibited from borrowing against their stock or entering into derivative transactions related to it, both of which distort the effects of whatever incentives are put into place.  There you have it, compensation committees:  Get to work.

As we approach the dénouement of this series, we will next look at investment professionals and others who didn’t act out their parts in the drama that we have witnessed.