Paying with stock is more perception than reality

The Wall Street Journal today raises once again the never ending debate over compensation of bankers. The special pay master seems to want to make sure everyone is paid stock, which vests over long periods, rather than cash. Generally, I think this is not a great idea.

I assume senior managers of financial firms have a better idea of what the stock in their company is worth than government overseers. This may not be the case for certain, but it seems reasonable.

Second, I assume financial professionals are just that: financially astute professionals at evaluating risk and taking risk. This means they understand what diversification means. That also means they more or less understand that the value of stock depends on two things: (a) the future earnings generated by the underlying company, and (b) what price the market assigns to the uncertain future earnings at any given time. Capital markets theory implies they are uncorrelated. Reality shows they are not very highly correlated.

What does this mean for the Special Pay Master and the American Taxpayer? First, they are on the losing side of information when it comes to deciding to pay in stock versus pay in cash. The senior managers know the relative difference in value (whichever way) between $100 of stock and $100 of cash. So, we can assume We The People lose on the first leg of the trade.

Second, We The People are forcing smart finance guys to take a very large, undiversified position (that they presumably cannot hedge effectively, but we'll come back to that...) which by definition means it needs to have a higher expected return than cash. Why? If I give them $1 million cash, they use that cash to buy their optimal basket of risk. If I give them $1 million of stock in their own company, we know that's a sub-optimal basket of risk, so it needs a much higher expected return for them to hold it. Remember, you cannot force them to work.

Third, if you're still with me, you just gave them a larger call on the equity market risk premium because you over-loaded them with a very large slice of cheap stock, which is likely cheap for two reasons: they know more about the future earnings, and (many would agree, I suspect...) market multiples are depressed against long term earnings of the economy. (Note: I am not taking a stance on this point. I'm not sure.)

(Back to my hedging comment: senior managers probably have the ability to hedge this aspect of the stock, if they chose eliminate that risk. Their comp gives them a call on the market multiple of their company. This multiple has very high correlation with the market as a whole. So, if the volatility implied in their compensation structure is priced too dearly, they could sell it off. This would leave them only with their insider knowledge. I don't think many people do this, or think about doing it. They probably should.)

So, my conclusion: It costs the tax payers more to pay stock than cash. It probably doesn't align incentives any better because the individual cannot be forced to work. He or she must be at least indifferent between the cash and stock compensation to stay in the job.