A Nobel Idea to Pay CEOs What They’re Actually Worth [Wall Street Journal]

Next month, Bengt Holmstrom, a professor at MIT, is slated to accept a Nobel Prize in Economics for his pathbreaking contributions to contract theory. Congressmen and corporate boards might want to take note: Mr. Holmstrom’s innovative proposal for indexed stock options, which aren’t yet widely used, could be one solution in the running political debate over whether CEOs are fairly paid for performance.

Almost all stock options today have a fixed exercise price: The holder buys the company’s stock at the market price on the day the options were granted. The idea is to align the interests of CEOs and their shareholders. If the stock rises, the executive buys at the old price and makes a profit. On the other hand, if the company’s stock is flat or down, the options become worthless.

Unfortunately, as Mr. Holmstrom pointed out in 1979, fixed-price options can easily reward poorly performing executives during times of rising markets. Suppose a drug company grants 50,000 options to its CEO with an exercise price of $100 a share. If in three years the stock rises by 30%—to $130 a share—the CEO exercising his options would make a profit of $1.5 million.

Sure, sometimes this profit might reflect the outstanding work of this CEO. But suppose the stock prices of comparable drug companies rose by 60% on average during the same three years. Suddenly the CEO’s options look like a windfall instead of a reward for his superior managerial skills.

Read the rest at brookings.edu…

Corporate Boards Need to Abolish Mandatory Retirement [Real Clear Markets]

The resignation under duress of the CEO of Wells Fargo, after being pummeled in a Congressional hearing, raises a fundamental question: how can corporate boards hold management accountable for performance problems? One trendy answer from several governance mavens — limit the terms of independent directors so they do not become unduly deferential to the CEO.

The most typical limit on independent directors is mandatory retirement at age 72. This is the tenure limit for the Wells Fargo board. It is a significant limit because most directors do not join large company boards until age 60.

The tenure limit for independent directors is even stricter in UK. After serving for 9 years, a director of a UK public company will not be considered independent unless the company makes a special disclosure justifying longer service for that director

However, I believe that these uniform limits on director tenure are counter-productive. By relying on these automatic rules, boards may get stuck with a relatively young director who is not making a significant contribution to managerial oversight. Meanwhile, these many directors with valuable expertise and real independence are forced to leave boards at age 72 or after 9 years.

Read the rest at realclearmarkets.com…

In defense of corporate quarterly reports

Executives, fund managers and even politicians have criticised publicly traded companies’ undue focus on generating profits in the next quarter instead of making investments with good five-year prospects.

To encourage these companies to take a longer-term perspective, several regulators have shifted corporate reporting requirements from quarterly to semi-annually.

Most prominently, in 2013 the European Commission amended its Transparency Directive to abolish the requirement for quarterly reports by publicly traded companies in favour of semi-annual reports.

After an impact assessment, the commission concluded that “quarterly financial information is not necessary for investor protection”.

But a recent study severely undermines the commission’s conclusions.

Read the rest at brookings.edu…

Is the Bond Market in a Bubble? [Wall Street Journal]

Bonds issued by governments and companies are priced high these days. In the seesaw relation of bond prices to their yields, prices are up, and yields are smacking hard against the ground, at record lows.

Investors, wary of stock valuations and looking desperately for yield, have poured money into bonds and bond funds.

There was a brief scare in September when bond prices suddenly fell over concerns that the Federal Reserve and other central banks might end their “easy money” policies.

But that pullback quickly vanished, with investors convinced that the Fed will move slowly in eventually raising rates. Bond prices recovered.

So, are we left with a valuation bubble that will burst, as tech-stock investors experienced more than 15 years ago? Or are the worries merely another false alarm, which bond investors have heard before for many years?

Robert C. Pozen, a senior lecturer at MIT Sloan School of Management and former mutual-fund executive, argues that the situation is verging on a bubble as yield-hungry investors are gravitating toward riskier bonds. Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott in Philadelphia, says he doesn’t see the credit excesses that would qualify this market as a bubble.

Read the rest at wsj.com….

US money market funds: the gain isn’t worth the pain [Financial Times]

Next month the new rules of the Securities and Exchange Commission (SEC) will become effective for money market funds (MM funds).

Most importantly, MM funds with any assets from institutional shareholders – e.g., corporations, pension plans and insurance companies – will no longer maintain a constant net asset value per share of $1. Instead, the net asset value of institutional MM funds will fluctuate on a daily basis – for example, 99.8 cents per share on one day, and $1.01 per share on the next.

The new SEC rules apply to institutional MM funds investing in short-term debt of cities and states – called “municipal” MM funds. The new rules also apply to institutional MM funds investing primarily in short-term debt of banks and top-rated companies – called “prime” MM funds.

However, the new rules do not apply to institutional “government “ funds — investing almost all their assets in short-term debt issued by the US Treasury or federal agencies, loans backed by such debt or cash.

Read the rest at ft.com…

No More Dizzying Earnings Adjustments [Wall Street Journal]

Whether Microsoft’s $26.2 billion purchase of LinkedIn makes sense might depend on where you look. Glancing at LinkedIn’s press release for the full year 2015, you will see a prominent projection for “adjusted” earnings this year of $950 million.

Yet if you closely read the press release and its appendix, you can figure out that the company’s projected 2016 earnings under GAAP, the generally accepted accounting principles required in securities filings, are minus $240 million.

What accounts for that enormous difference? Like many companies, LinkedIn reports one set of figures to the Securities and Exchange Commission but touts adjusted figures elsewhere. LinkedIn’s adjusted projection excludes large expenses: $630 million for stock awards to executives and $560 million for depreciation and amortization.

Read the rest at wsj.com…

Relief for Cities’ Budget-Busting Health-Care Costs [Wall Street Journal]

Co-authored with Joshua Rauh

The budgets of many cities and states will soon be disrupted by new accounting rules for retiree health plans. Local governments pay most of the health-insurance premiums for their retired employees—for example, from age 50 until Medicare at age 65, and sometimes for life. Nationwide, the total unfunded obligations of these plans are close to $1 trillion, according to a comprehensive recent study in the Journal of Health Economics.

The accounting rules, adopted in June by the Government Accounting Standards Board (GASB), require local governments for the first time to report their obligations for retiree health care as liabilities on their balance sheets. Local governments must also use a reasonable and uniform methodology to calculate the present value of these liabilities. These are both steps forward, enhancing transparency and accountability.

The new rules further provide an incentive for local governments to establish a dedicated trust with assets invested today to help pay health-care benefits in the future. But here the GASB takes one step backward, by allowing local governments to make overly optimistic assumptions, including excessive returns for the trust.

Read the rest at wsj.com…

SEC’s new rules give US money market funds a floating feeling [Financial Times]

Coauthored with Theresa Hamacher

After years of heated debate, the Securities and Exchange Commission, the US regulator, recently adopted stricter rules for US money market funds. The new rules are intended to limit the potential systemic risks of money market funds by reducing the likelihood of runs on these vehicles.

The rules will have the biggest impact on money market funds serving institutional investors, which will have to move from a constant to a floating net asset value. The rules will also put pressure on most institutional and retail money market funds to impose liquidity fees and suspend redemptions during financial crises. But neither set of rules will apply to money market funds holding 99.5 per cent or more of government securities.

Thus, the two critical questions are what constitutes a government security, and what differentiates an institutional from a retail money market fund?

Read the rest at FT.com…