« Do We Overcompensate Tort Victims?: Reading Stumbling on Happiness | Main | Temporary CEO's? »

May 30, 2006

TrackBack

TrackBack URL for this entry:
http://www.typepad.com/services/trackback/6a00d8341c031153ef00d8342bd37b53ef

Listed below are links to weblogs that reference The Prime Directive:

» Deepening Insolvency: The Third Circuit Steps Back from the Breach from Bankruptcy Litigation Blog
At my alma mater's faculty blog, my friend and former classmate, Professor Bob Rasmussen, writes about a business's Prime Directive; that is, first hire the rights person as CEO, [then] ensure that the CEO is shown the door at the... [Read More]

Comments

Feed You can follow this conversation by subscribing to the comment feed for this post.

ToddHenderson

Welcome! Nice point. It relates to a paper I'm writing on the role of credit derivatives in corporate governance. Do you have any idea what the rise of new loan risk sharing mechanisms, like credit default swaps, has on this analysis? The credit derivative market has grown tremendously in recent years, allowing banks--who write these covenants that you rely on--to offload loan risk, and thus the reason for vigorously enforcing the covenants, onto others, such as insurance companies, hedge funds, and smaller banks. One can imagine a variety of market-style mechanisms that keep firms from obvious moral hazard problems when it comes to investment decisions (e.g., rating agencies rating loans, which they do now, reputation effects, etc.), but the case you mention might be one in which these mechanisms are less effective. Any thoughts?

ToddHenderson

How do you respond to the following baseball quote attributed to a variety of managers: "Give me 9 guys in the last year of their contract, and I'll win the pennant." This intuition is buttressed by some statistics, showing that production (along various metrics) for the average player increases dramatically in a player's contract year, that is, the year before they go on the market, and then falls steadily and significantly thereafter. This phenomenon doesn't happen as often for truly great players, but these are anomalies. Doesn't this suggest that incentive contracts really matter?

BobRasmussen

Todd raises a couple of nice points. The first has to do with the stability of the current system. In addition to credit default swaps which Todd brings up, there is also the secondary loan market. Most syndicated loans these days are traded on these markets. While it used to be the norm that the lead bank would take a big chunk of the loan and hold onto it, this norm may be changing. It is still unclear what the effect of these changes will be. Before, the lead bank would take primarily responsibility for monitoring and holders of the loan would generally go along with their recommendations. On the one hand, things like credit defaults and the ability to sell you interest may lessen the incentives for the lead bank. On the other hand, the folks that are buying loans in the secondary markets are not passive investors. They make their own decisions on whehter to go along with waivers and the like.

As to incentive contracts, sure they matter, and I would never contend otherwise. But the main point is that they are limited by the human capital of the CEO. Give me Kobe's contract, and I'm still a terrible basketball player. Also, it is unclear to me that it is as hard to induce effort from the type of person who wins the tournament to become CEO as it is to induce performance from a 20-something athlete.

ToddHenderson

Thanks for the response, Bob.

As to the point about Kobe's contract, I think the important thing to focus on is the marginal case. Sure, you won't be converted into a great hitter under the right incentive contract, but is the .250 hitter going to be a .300 hitter if he knows that it will make him millions? The data suggests that, again in the marginal case, the answer is "yes". The great players and the terrible players aren't impacted by this, but the average guy is. What might we take away from this:

First, does this finding also obtain for CEO contracts? If we looked at CEOs in the last year of their contracts, do we see them performing better? You could look at firm performance, say Total Return to Shareholders, in the final year of a CEO's multi-year contract (something they all have), to see how it compared with the prior several years and the followng several years. You'd have to adjust for all the other confounding variables, but it seems like an easy empirical test. If it looks like the baseball data, the performance (for the average guy) will ramp up to the final year (or be flat then peak in the final year), and then will fall off like a curve of radioactive decay. Stock option vesting rules and the like may complicate things, but it seems like you could correct for this.

Second, it is interesting that the incentives that work (at least in the baseball case) are not micro incentives but macro incentives: players are motivated not as much by individual contractual incentive clauses like "if you get 200 hits we'll give you $100,000" or "make the All-Star team and we'll give you a new truck" as by the total value of a new contract in free agency, that is, the implicit knowledge that if you play great in the last year of your contract, you'll strike it rich with your team or another. This might suggest that firms should rely less on narrowly tailored incentives (like meeting sales targets) and focusing more on the big picture, like the stock price. While this was the norm for years, there is some evidence that it is changing, with firms going more to the micro or itemized approach. The literature on incentives and the above intuition suggests this is a mistake.

Third, the fact that it is the marginal case where incentives work, suggests, perhaps counter-intuitively and counterfactually, that folks like Jack Welch and Michael Eisner don't need the incentive contracts; they'll do it anyway, for the love of the game. So why do they get such big incentives? Maybe their contracts send important signals to those marginal employees down in their organization. This seems related to your point about motivating CEOs versus 20-something athletes. I think that the right way to make this distinction is along a scale of greatness, not age.

James

I'm not sure I understand Professor Henderson's latest analysis. Why would it be the case that the best and worst CEO's aren't really affected by contractual incentives, but the middle ones are? One can imagine these variables (skill of CEO and responsiveness of CEO performance to incentives) being completely uncorrelated.

To put it another way, I don't read Rasmussen as saying that the Kobe's of the world disprove the importance of contractual incentives. Rather, Rasmussen is making a point about the relative importance of talent identification vs. optimal contracts. You're better off hiring Kobe and setting up a contract that extracts x% effort than you are hiring me and extracting 100% effort for just about any positive x. This is not to say that x doesn't matter, it's just a shift in emphasis to what seems to be the more important variable.

What's more, I suspect that Rasmussen would agree that at some point the board's marginal dollar is best spent figuring out a good contract instead of continuing the search for the next Kobe, or the next Jim Kilts:
http://www.theonion.com/content/node/33930
He is simply pointing out that the opposite seems to be the case for academia - the marginal hour is better spent understanding the selection process.

Dirk van de Broek

worst CEO's are always gettingthe long end of the stick

Verify your Comment

Previewing your Comment

This is only a preview. Your comment has not yet been posted.

Working...
Your comment could not be posted. Error type:
Your comment has been saved. Comments are moderated and will not appear until approved by the author. Post another comment

The letters and numbers you entered did not match the image. Please try again.

As a final step before posting your comment, enter the letters and numbers you see in the image below. This prevents automated programs from posting comments.

Having trouble reading this image? View an alternate.

Working...

Post a comment

Comments are moderated, and will not appear until the author has approved them.