Thursday, July 30, 2009

Managers Suck

With rapt attention, I listened to Edmund Andrews explain his wonderment at the mortgage crisis. Andrews, author of the book "Busted: Life Inside the Great Mortgage Meltdown", was explaining the situation of companies who really should have known better than to give him, and others like him, a loan. In addition to devastating the borrowers, the companies went bankrupt. This got me thinking, is there something wrong with the market?

Yes and no. I think the free market is the best mechanism to create and allocate wealth. It has it's problems, but those problems stem from an even larger problem, people. Many have said it before and many will say it again, but people are not angels. Treating them as such is a recipe for disaster.

We have created a structure in this country call a publicly traded corporation. This entity is managed by people like you and me. Not saints nor sinners. They have their own concerns and they respond to incentives just like everyone else. So what happened in the mortgage crisis? Here is one possible explanation.

Executives like their big salaries and this means they don't like risk. They are typically judged by how well they do relative to their peers, other executives. Let's say there is a bubble forming and you as a really smart executive see it, what do you do? You can get out of the business, right? This sounds perfectly rational, but it's not. Even though you know it's a bubble, you don't know when it will burst. Let's say you get out of the business and the business continues to...bubble. At this point you are doing worse compared to your peers and you are probably going to be out of a job soon. The logical thing to do is to match what your peers do even if you know it is the wrong thing to do.

Look at it this way, when the bubble is forming the executive is in a no win situation (not really no win for him because he is compensated quite generously) with regards to his options. He can, to his own detriment, do the "right" thing for the long term success of the company. Who in their right mind would do that? Not you and your downward glare. It's human nature and only saints would be that self sacrificial. This explains why saints are so special and fiduciary responsibility such a joke.

The only solution to the problem is to change the structure and that means putting shareholders more in charge of the companies they supposedly own and knocking managers down a peg or two. Only in a backwards entity known as a public corporation are managers little gods and shareholders putty in their hands.


Phillip said...

Greed, for lack of a better word, is good. Greed works...

An interesting point brought up in the famous Wall Street speech is that in the past many executives have had substantial personal investment in the company. This of course brings to mind modern entrepreneurs who often have substantial percentages of personal wealth at stake with the overall success of the company. It would be interesting to see if Fortune 1000 companies wanted to emulate this by forcing medium to long term stock investment in the company of ~20% of an executives wealth for new hires. Obviously a deployed system would have much more complexity, but it would be interesting to see.

It is also surprising to me that financial companies would think in such short terms considering how corporate accounting works. Buildings depreciate over 50 years. Manufacturing over ~10 years. (IIRC from my Intro to Eng & Business class) However, I think you hit the nail on the head of the personal incentive over the group incentive -- because if they look mediocre because they are sticking to solid business practices there really is no incentive to insure long term success of a company since it is likely safeguards could be overturned.

Another change in structure that I would like to see is for executives to get slammed when they break the law. Not so extreme as China where they executed the execs in the tainted milk problem but some 20 year sentences without parole would get attention. The manner in which the securities were sold was dishonest (don't know the legal term) and there should be some ramifications for those who allowed this to happen.

Solid post Adam.

Adam Freund said...

Thanks Phillip,

Corporate accounting is a tool like everything else and can be manipulated.

Slamming executives is probably not the best option. Outright fraud on their part should be punished severely but most of the time the line between bad decision making and fraud is very blurry.

One structure which should reduce the power of executives is to get rid of limited liability for the shareholders. Limited liability aids in capital formation by making an investment decision less risky but it also makes the shareholder's passive and elevates the managers. This is where the structural imbalance lies.

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