Authors: Sanjai Bhagat (University of Colorado at Boulder) and Brian Bolton (University of New Hampshire)
Publisher: University of Colorado Working Paper
Date Published: January 2011
This paper represents the analysis of billions of dollars’ worth of stock trades made by the CEOs of some of the top financial institutions in the U.S. in the years leading up to the 2008 economic crisis. Highly lucrative compensation programs encouraged many of the CEOs to sell their company stock, researchers found, raising the possibility that higher sales were associated with greater levels of imprudent risk-taking.
The researchers studied the executive compensation structures between 2000 and 2008 at the 14 largest U.S. financial institutions at that time: AIG, Bank of America, Bank of New York, Bear Stearns, Citigroup, Countrywide Financial, Goldman Sachs, JPMorgan Chase, Lehman Brothers, Mellon Financial, Merrill Lynch, Morgan Stanley, State Street, and Wells Fargo.
Drawing on trading data from the Thomson Financial Insider database (now called Thomson Reuters Insider) and information from the U.S. Securities and Exchange Commission, the study focused on the CEOs’ buys and sells of company stock in the eight years before the downturn. During this period, the CEOs collectively exercised stock options 470 times, purchasing a total of US$1.66 billion in shares. They made direct purchases on their own 73 times, for $36 million. But they sold their shares nearly 30 times as often — on 2,048 occasions. Overall, the sales came to $3.47 billion, netting them $1.77 billion after the cost of their options and direct purchases was subtracted. That works out to almost $16 million per year, on average, for each of the CEOs. They also received cash compensation of $891 million during these years, or another $8 million annually, on average.
The researchers widened their scope to look at trading in company stock by all officers and directors at the 14 institutions. Excluding exercises of stock options, these insiders purchased shares 1,671 times but sold them 14,687 times. After subtracting the cost of the options, the authors found that this group netted $126.9 billion.
Not everyone did equally well, the researchers reported. At the high-return end were the CEOs of three institutions that were particularly battered by the crisis: Lehman Brothers (which filed for bankruptcy in September 2008), Countrywide Financial (acquired by Bank of America in July 2008), and Bear Stearns (acquired by JPMorgan Chase in May 2008). In trades of their company stock, these CEOs netted about $428 million (Lehman), $402 million (Countrywide), and $243 million (Bear Stearns). In contrast, the lowest net earnings were at AIG ($7 million), Mellon Financial ($17 million), and Bank of America ($24 million).
As a group, the CEOs ultimately didn’t escape the punishing reach of the financial crisis — in 2008, the value of their remaining holdings in their company stock went down $2.01 billion. Even with that huge paper loss, however, the CEOs at 10 of the 14 companies came out ahead for the eight-year period, given the volume of their earlier stock sales and their cash compensation.
The problem with all this, according to the researchers, is that many executive compensation programs allow top managers to own significant amounts of vested shares and options while they are still on the job and making decisions that affect company strategy and risk levels. In the run-up to the financial crisis, some of the CEOs made an abnormally high number of trades, the researchers reported, indicating a deep lack of confidence in their own firm’s future. Indeed, the researchers concluded, some CEOs were acting as if they knew that the performance of their institution could decline precipitously and were pulling their money out while they could.
If the trading levels before the crisis had been normal, the researchers said, it would have implied that the CEOs did not know that serious trouble was looming. In that case, the executives could have been seen as diligently working in tandem with the interests of their long-term shareholders and as being taken by surprise by “unforeseen risks” in investments and trading strategies that plunged the institutions into crisis.
The researchers recommend that executive incentive compensation consist almost entirely of restricted stock and options, meaning CEOs would not be able to sell the bulk of their holdings for two to four years after their last day on the job. To offset concerns over liquidity, the authors suggest that CEOs be allowed to sell a small amount of stock each year, at a capped dollar value. This structure would provide the CEOs with more incentives to look at the long term and avoid short-term risks, the authors conclude.
An analysis of the 14 largest U.S. financial institutions in the eight years leading up to the recent economic crisis shows that top executives sold an unusually high amount of their company stock. The highest levels of stock sale came from banks that failed — specifically Lehman Brothers, Countrywide Financial, and Bear Stearns. The researchers raise the question of whether executive compensation should be structured to provide less incentive for making risky decisions oriented to short-term gains.