Monday, October 10, 2011

Executive Stock Options

Ron Elmer who writes "Investor Cookbooks" has posted a lengthy discussion of why executive stock options are bad, and why, in his opinion, they should be outlawed.

He makes some very good points.  I have a few comments.

First, I fully agree that the big problem with Wall Street firms is that they converted from being partnerships to being publicly traded.  As Ron points out, when they were partnerships, risk management was everyone's business.  The banks became public largely because the existing partners wanted a way to cash out.  They benefited and risk management suffered.

Second, I disagree that options do not align incentives.  The example given assumes that a manager will exercise his options at some future date and convert the gains straight to cash.  The important thing to remember here, is that up to the time when he cashed in his options, his incentives were very much aligned.  In fact, well in the money options are very much like stock.

Third, I agree that options represent a huge unknown in compensation because we really don't have any idea what they will be worth 5 or 10 years.  But I think the issue here is with the quantity of options that are being issued, not the option per-se.  Firms seem to make very large option grants that end up being worth huge amounts in the future.

Finally, Ron alludes to the bigger question of whether US CEOs should make 300 to 400 times what the rank and file worker makes.  This ratio is higher in the US than for most developed countries and I am also pretty sure it is higher now than it was, say 30 years ago.  I don't know what the correct ratio should be, but 400 seems high.  Having said that, I note that movie stars and professional athletes make stupid amounts of money for doing stuff that seems pretty unimportant in the big scheme of things.