Monthly Archives: March 2008

Healthy Hedge Funds, Sick Banks

This post is from Peter J. Wallison of the American Enterprise Institute.

I recently circulated an AEI Financial Services Outlook entitled Healthy Hedge Funds, Sick Banks. The essay discusses the regulatory implications of the unregulated hedge fund industry’s apparent health when compared to the financial weakness of the heavily regulated banking industry in the current subprime crisis. The principal question addressed in the essay is whether the regulation of banks allows an industry that is inherently unstable to function with a reasonable degree of stability or whether the regulation itself is responsible for the instability that has historically afflicted banking.

I argue that risk-taking and instability in the banking industry is enhanced because market discipline is reduced by moral hazard. In this context, moral hazard refers to the sense among investors and depositors that in the end the government will rescue banks and other private sector institutions from the consequences of their own errors. The numerous actions by the Federal Reserve to increase liquidity in the face of the subprime crisis provide direct support for this belief. As a result, I suggest that the actions taken to shore up banks adversely affected by the subprime collapse has increased the level of moral hazard, and thus increased the likelihood that another similar crisis will result in the future.

The positive experience of the hedge fund industry suggests strongly that market discipline is a powerful mechanism for controlling risk. In fact, it implies that market discipline may be more effective than regulation in maintaining an industry’s stability. I also argue that regulation itself must be significantly improved in order to be effective in overcoming the moral hazard it fosters. I incorporate both implications in my suggestion to introduce specialized subordinated debt into the banking industry. The subordinated debt would be designed to provide bank supervisors with a market-based signal about bank risk-taking that is roughly equivalent to what the market would do in the absence of government regulation.

The full outlook is available here.

AFL-CIO Proxy Voting: A Response to Agrawal and Kaplan

Editor’s Note: This post is from Daniel F. Pedrotty pf the AFL-CIO. The Agrawal study is described on our blog here; the initial AFL-CIO response is available on our blog here; two reactions to that AFL-CIO response – from Ashwini Agrawal and from Steven Kaplan – are available here.

Regarding the recent posting by Mr. Agrawal and Professor Kaplan,

Ashwini Agrawal, a graduate student at the University of Chicago, posted a paper on this blog that used a statistical model whose key variables were custom built by him to assert that the AFL-CIO votes its public company proxies based not on proxy voting guidelines, but on the union affiliation of public company employees. Through a series of e-mails (he has refused to meet in person or communicate over the phone) we told him he was completely and utterly wrong and asked him to release his data set. Mr. Agrawal accused the AFL-CIO of not responding to his questions after refusing to meet or release his data. University of Chicago Professor Steven Kaplan, who is advising Mr. Agrawal on this project, wrote a lengthy post defending these opaque methods.

Mr. Agrawal’s claim that he contacted the AFL-CIO and was denied information is false. Mr. Agrawal has never contacted a member of the AFL-CIO program staff to discuss his paper or ask for any data, and has refused every opportunity to meet and ask us questions.

Both posts also contain a series of important contradictions. Professor Kaplan and Mr. Agrawal repeatedly assert that the study can be easily replicated using publicly available sources of data. Kaplan emphasizes that this is “an important point. It does not rely on data that can be shaded by an interested party.”

Despite this, Kaplan later asserts that “in putting together a data set, a researcher spends a great deal of time and effort.” Which is it then? Is it a lengthy endeavor worthy of “great time and effort,” or something that’s “easily replicated?”

We continue to demand access to Agrawal’s data because it cannot be replicated. His data collection efforts were more subjective than mechanical. For example, when data on company unionization was incomplete Mr. Agrawal relied on information “from the Investor Relations departments of firms themselves.” [Appendix A, pg. 29]

The difficulty of replicating this skewed effort at data collection is obvious. How would the AFL-CIO go about determining which companies he contacted directly? Should we selectively call random Investor Relations departments and ask for the individual who spoke with Mr. Agrawal two years ago? What if the person he spoke with no longer works at the company? How do we know what source the Investor Relations Department used, and was it the same across all companies? Was a record of his phone conversations kept to back up his methodology?

Mr. Agrawal and Professor Kaplan assert that his paper has not been published, and that because it is not published they should be able to keep their data secret. It’s true that it hasn’t appeared in any peer reviewed setting–but it has been twice cited on the editorial page of the Wall Street Journal as evidence for repeated false accusations against the AFL-CIO, as well as being posted on this blog and widely circulated in academic and business circles.

Professor Kaplan’s defense that they won’t release data to a competing researcher is misplaced. We are the subject of a widely published study which makes false accusations based on unreproduceable statistical models. We are not seeking to complete a research project for a rival journal, but instead correct the record.

We would be happy to receive Mr. Agrawal’s data on the strict condition that we won’t turn it over to competing researchers or publish it in a competing paper. As outlined above, we need to review the accuracy of Mr. Agrawal’s data and statistical model, and when given the opportunity to talk to him, inform him of the serious flaws in his research.

A copy of the AFL-CIO’s recent report, Facts About the AFL-CIO’s Proxy Votes, is available here. We repeat our request that Mr. Agrawal release his data set or withdraw his paper.

Hold-up, Asset Ownership, and Reference Points

This post is from Oliver Hart of Harvard University.

On March 17, I presented my paper titled Hold-up, Asset Ownership, and Reference Points in the Law, Economics, and Organization Seminar here at the Law School.

This paper studies two parties who desire a smooth trading relationship under conditions of value and cost uncertainty. The existing literature in this area has found that trading relationships become problematic in situations where the gains from trade are unevenly divided under an existing contract. Under these situations, one party will engage in costly opportunistic or non-cooperative behavior in order to renege on or renegotiate the contract. However, the existing literature does not explain why the parties cannot negotiate around the costs of opportunism.

I show that there is a range of self-enforcing prices, which depend on the state of the world, such that, if the long-term contract price lies in this range, hold-up is avoided; while if it lies outside this range hold up occurs. Under this formulation, a contract fixing price works well in normal times since there is nothing to argue about. However, when value or cost is exceptional, one party will deviate from the contract and hold up the other party, causing deadweight losses as parties withhold cooperation. I show that contract indexation can help by making it more likely that price remains within the “self-enforcing” range. In addition, a judicious allocation of asset ownership increases efficiency to the extent that it raises the correlation between parties’ outside options and their value inside the relationship, since this reduces the likelihood of hold-up.

In contrast to much of the literature, the driving force in this model is payoff uncertainty rather than non-contractible investments. One notable benefit of the approach used in this paper is that I am able to formalize hold-up costs by introducing behavioral features. The analysis provides useful insights into the empirical contracting and the vertical integration literature.

The full paper is available for download here.

How Fair are Fairness Opinions?

The recent acquisition of Bear Stearns by J.P. Morgan has cast a spotlight on the reliability of fairness opinions. On March 16, when the board of Bear Stearns agreed to sell the company for $2 a share, the investment banking firm Lazard Ltd., who was acting as Bear Stearns’ main adviser, provided the board with a fairness opinion that $2 a share was a fair price for the company, which was then teetering on the brink of bankruptcy. Eight days later, on March 24, when J.P. Morgan agreed to raise its offer to $10 a share to address shareholder discontent, the same investment bank issued a fairness opinion indicating that $10 a share was a fair price. If $10 a share is a fair price, how could $2 be a fair price as well?

This turn of events vividly illustrates how little has changed in the world of fairness opinions since the publication in 1989 of the first critical academic study of fairness opinions, Fairness Opinions: How Fair Are They and What Can Be Done About It? by Lucian Bebchuk and Marcel Kahan. This study highlighted two issues that generate serious problems with fairness opinions. First, investment banks have significant discretion in arriving at the fair price. Second, investment banks do not have incentives to provide an accurate valuation and might have incentives to provide a fairness opinion supporting the position of the party inviting the opinion. The study went on to advocate a judicial approach that takes these issues into account.

The Bear Stearns event suggests that the problems identified by the academic critics of fairness opinions might well persist. It also highlights the limits on the ability of investors and courts to rely on such opinions.

Up Close and Personal: House Hearing on CEO Pay and the Mortgage Crisis

Editor’s Note: This post is from Broc Romanek of

Up Close and Personal: House Hearing on CEO Pay and the Mortgage Crisis

My colleague Dave Lynn wandered down to the House Hearing on severance pay recently and wrote up these thoughts (for other reports, see the WSJ article and NY Times article):

“The hearing of the House Committee Oversight and Government Reform on CEO pay was a little disappointing. It had all of the potential to be the sort of public spectacle that the same Committee’s hearings on steroid use in baseball had become, but instead it was a relatively straightforward identification of some CEO pay abuses, juxtaposed to the people that are unfortunately losing their houses to foreclosure in the midst of the mortgage mess.

In addition to testimony from some experts on the state of the mortgage crisis and issues with executive pay (which was covered by Nell Minow of The Corporate Library), the hearing featured Angelo Mozilo from Countrywide, E. Stanley O’Neal formerly at Merrill Lynch, and Charles Prince formerly at Citigroup. The respective compensation committee chairmen from those organizations also appeared, including Richard Parsons, Chairman of Time Warner.

The questioning was relatively light – both in volume and in tone – given the sparse turnout from Committee members on an unusual Friday hearing (the day when many members are heading home to their district). Much of the questioning focused on issues outlined in the Committee’s majority Staff memorandum, which outlined a number of issues that tend to be wrong with the CEO pay process – “confusion” about for who a compensation consultant is working (i.e. the CEO, the comp committee or the company), questionable use of 10b5-1 plans, awards that don’t seem to make sense in light of the circumstances or the rationale, extraordinary low performance targets, and payment of performance bonuses and the awarding of retirement and severance benefits even in a year as bad as 2007.

The battle lines were clearly drawn, with Chairman Waxman (D-CA) and his colleagues in the majority pointing out the financial distress that many Americans face while these three executives reaped rich rewards. Meanwhile, Representative Tom Davis (R-VA) repeatedly drew the old sports and entertainment analogy for executive pay – saying that no one expected Ben Affleck and Jennifer Lopez to pay reparations for Gigli.

Both sides were careful not to sully the reputations of the three CEOs who all represented classic American success stories, and clearly the CEOs (particularly Mozilo) seemed to be emboldened as the hearing went on and the “light” touch was evident. The only thing that tripped up Mozilo were questions concerning a threatening email that he sent seeking reimbursement of taxes for his wife’s travel on company aircraft – he apologized, noting that he was an “emotional person” – but Representative Issa (R-CA) was quick to jump to his defense and note that many of his colleagues in Congress fly their spouses all over the world on government aircraft because they need to have their spouse with them when conducting business.

One of the particular areas of questioning was on Mr. Mozilo’s sales of substantial amounts of stock under Rule 10b5-1 plans while Countrywide was conducting an accelerated share repurchase program. Mr. Mozilo asserted that all of his stock sales were done pursuant to a plan to diversify his holdings in anticipation of retirement and were unrelated to the stock repurchase program. The Chairmen of the Merrill Lynch and Citigroup compensation committees noted that these kinds of sales were unlikely at their companies, given their very high stock ownership and retention requirements.

While the Democrats on the Committee may not have been able to establish these CEOs as suitable scapegoats, the majority was certainly able to put some questionable pay practices under the microscope at a time when most people are worried about paying for their house – as opposed to paying for taxes on spousal travel on the company jet.”

My Ten Cents: It’s too bad the committee members did such a poor job of questioning the hearing’s compensation committee members. Had they simply followed the path of the Committee staff’s memo, they could have called for an explanation of each of the actions by the compensation committees (although some of the meaty issues were addressed, like why did Prince get a bonus for 2007?).

My primary “take-away” is that when a successful CEO throws a temper tantrum over pay – even if the demands are unreasonable – the board caves in. My guess is that all too often boards are told the consultant is hard to work with – or is not responsive or does not understand the company – and has to go. Boards comply – and there is typically no explanation other than “the board thought it was time for a change.”

I can’t resist addressing the mistaken comparison between CEO pay and the pay levels in the sports & entertainment industry. Putting aside the fact that only the top 1% of athletes and actors get paid astronomically – remember all those starving actors and baseball players buried in the minor leagues – it’s apple and oranges because the processes by which the relative amounts are established are completely different. I recently addressed this point by posting a comment on this compensation consultant’s blog. I guess the argument that public company CEOs will be flocking to hedge funds doesn’t hold much water anymore…

“Redeveloping” Corporate Governance

This post is by Lesley Rosenthal of Lincoln Center for the Performing Arts.

Once-in-a-generation capital projects at nonprofit cultural institutions require heightened involvement by trustees. Because major projects impose unusual legal, financial, risk management, and other obligations on charitable organizations, the familiar principles of not-for-profit good governance become amplified and require even greater attention. What special obligations do trustees have to help their organizations manage such an undertaking? What are the broader impacts of the project on the organization as a whole—on its balance sheet, on its institutional identity, on its program and its future plans? If the project is funded in part or in whole with public funds, or if the project involves acquisition of or changes to publicly owned or accessible spaces, how might trustees facilitate needed communications with the public and with government officials? How should trustees, staff, and government work together to see the project through to successful completion and operation?

Because of the dearth of study materials pertaining to governance of mature not-for-profit institutions in a time of growth and transition, it is exciting to have access to documents and individuals that detail how governance matters are handled during a major capital project at one of the nation’s most respected institutions. My article, entitled “Redeveloping” Corporate Governance Structures: Not-For-Profit Governance During Major Capital Projects, discusses in detail how the Board of Directors of Lincoln Center for the Performing Arts has risen to the challenges of major capital projects, and assesses the performance of the organization’s governance practices under evolving standards, with special attention to how those standards play out during a time of institutional transition.

The article is available here.

Executive Compensation 2008

This post is from Theodore Mirvis of Wachtell, Lipton, Rosen & Katz.

My partners Michael J. Segal, Jeannemarie O’Brien, Adam J. Shapiro and Jeremy L. Goldstein recently issued Executive Compensation 2008, a memorandum outlining key recommendations for directors to consider as they address executive compensation matters in the year ahead. The memorandum considers the importance of rewarding long-haul performance, paying for performance and retention, planning for executive succession, and using wealth accumulation analyses and internal pay equity studies. The memorandum also discusses the disclosure of executive compensation, including the merits of disclosing the terms of confidential compensation arrangements.

Responses to AFL-CIO’s Critique of the Agrawal Study

We received two responses – from Ashwini Agrawal and from Steven Kaplan – to the AFL-CIO post responding to the study by Mr Agrawal of the AFL-CIO’s proxy-voting record. The Agrawal study is described on our blog here, and the AFL-CIO response is available on our blog here.

Ashwini Agrawal wrote to us:

In my study, Corporate Governance Objectives of Labor Union Shareholders, I examine the proxy votes of the AFL-CIO Reserve Fund and Staff Retirement Fund. I compare the votes before and after the AFL-CIO split into two groups: the AFL-CIO and the Change to Win Coalition. After the breakup, the funds become relatively more supportive of directors of firms in which workers become primarily affiliated with the Change to Win Coalition.

In his blog post and letter, Daniel Pedrotty makes a number of mischaracterizations regarding my study.

For example, in the paper I note that the AFL-CIO proxy votes are cast by a third party fiduciary in accordance with AFL-CIO proxy voting guidelines; I do not argue otherwise, as Pedrotty claims. AFL-CIO proxy voting guidelines can be found here.

In another example, Pedrotty states that changes in AFL-CIO voting patterns solely reflect changes in governance characteristics. To investigate this, I look at the votes of other institutional investors who take governance characteristics into account, such as mutual funds Fidelity, Vanguard, TIAA-CREF and union pension funds associated with the Brotherhood of Carpenters (UBCJA). I find that these other investors do not change their voting patterns in the same ways as AFL-CIO funds, suggesting the AFL-CIO votes are not solely based on governance characteristics.

Pedrotty also erroneously claims I treat all firms with mixed union representation as though they are affiliated with the AFL-CIO only. Based on publicly available data, I distinctly categorize a company based on whether a significant fraction (at least 90%) of the unionized workers at the firm switches affiliation from the AFL-CIO to the Change to Win Coalition. This is meant to capture significant decreases in the AFL-CIO’s labor representation across firms. For example, if 50% of a firm’s unionized workers remain part of the AFL-CIO, while the other 50% switch to the Change to Win coalition, then I assume the AFL-CIO still has substantial labor representation in this firm. If labor interests do not influence proxy votes, this categorization should not impact the findings in the paper.

Pedrotty asserts I gather data on certain Change to Win funds but that I do not compare their voting behavior with the AFL-CIO. This is incorrect; I compare the UBCJA pension fund votes (a Change to Win affiliate) with those of the AFL-CIO funds. Upon joining the Change to Win Coalition, the UBCJA funds become relatively more opposed to directors of firms in which workers are primarily affiliated with the Change to Win Coalition.

Pedrotty also claims that I made no effort to inquire into the methods by which AFL-CIO proxies are voted. When I requested this information from the AFL-CIO Office of Investment (in May, 2007), I was told by the AFL-CIO Office of Investment that this information would not be disclosed to me (in June, 2007).

The AFL-CIO’s claim that their voting fiduciary cast votes the same way for certain CTW funds does not change the findings as they pertain to AFL-CIO affiliated funds. In addition to the AFL-CIO not disclosing the sizes of these CTW funds and the extent to which AFL-CIO proxy voting guidelines are applied to them, the AFL-CIO’s claim could reflect agency issues within the voting structure of union pension funds. However, making any such assessment is beyond the scope of my paper.

This study can be easily replicated using publicly available sources of data. Both the sources and methodologies are described in the paper, available online here. It should also be noted that I use publicly available data because it is verifiable by other researchers and because my requests to the AFL-CIO for access to their own database on union membership were denied. I am happy to incorporate the AFL-CIO’s internal data into my study, however this data has still not been given to me.

I encourage blog readers to read both my study and the AFL-CIO’s report to reach their own conclusions. Peer review, comments, and criticisms are welcome.

Steven Kaplan wrote to us:

I would like to respond to Daniel Pedrotty’s post on Ashwini Agrawal’s work. I am a member (but not the chairman) of Mr. Agrawal’s dissertation committee so I know his work well. His committee consists of four professors at the University of Chicago Graduate School of Business.

Daniel Pedrotty’s post (criticizing Ashwini Agrawal’s study) does not in any way contradict Mr. Agrawal’s study. Mr. Pedrotty claims the paper makes a “serious and completely false accusation of voting behavior.” That is not true. Mr. Agrawal’s paper reports the results of his data collection and analysis. Mr. Agrawal’s results use publicly available data and are replicable. Using data on AFL-CIO votes and data from public sources regarding AFL-CIO union representation, Mr. Agrawal finds significant changes in AFL-CIO votes. After the split of the AFL-CIO and CtW, the AFL-CIO pension fund was much more likely to vote for management and directors of companies with unions primarily represented by the CtW than before the split. At the same time, the AFL-CIO pension fund remained less likely to vote for management and directors of companies still mainly represented by the AFL-CIO. The union voting behavior that Mr. Agrawal’s analysis reports is more consistent with union self-interest than with shareholder value maximization. While any such behavior cannot be proved beyond a shadow of a doubt, the results are very statistically significant.

Mr. Pedrotty has not attempted to replicate Mr. Agrawal’s methodology or tests. He presents some other data and claims that are irrelevant to Mr. Agrawal’s analysis. And, therefore, Mr. Pedrotty’s post does not have anything substantive to say about Mr. Agrawal’s results. Given this, it is extraordinary that Mr. Pedrotty request Mr. Agrawal to withdraw or revise his paper.

Let me examine Mr. Agrawal’s paper and Mr. Pedrotty’s post in more detail.


The Corporate Governance Role of the Media

This post by Luigi Zingales is part of the series of posts on corporate governance articles accepted for publication in prominent Finance Journals.

A forthcoming article in the Journal of Finance titled “The Corporate Governance Role of the Media: Evidence from Russia”, which is co-written by Alexander Dyck, Natalya Volchkova, and myself studies the effect of media coverage on corporate governance. The article focuses on Russia during the period 1999 to 2002 to answer two main questions: Can hedge funds (or shareholders in general) increase the level of coverage received by certain companies? And if so, does this coverage have any effect on corporate governance outcomes? The article develops four main conclusions:

  • News coverage is driven not only by the intrinsic appeal of each piece of news, but also by the lobbying effort exerted by those with an interest in the news being published.
  • Media coverage is not just a mirror of reality, but it can have important effects on reality itself, and in particular on corporate governance.
  • Media coverage is effective only when a behavior violates norms that are widely accepted in society.
  • The effect of media can be economically large—One more article in the Financial Times or the Wall Street Journal increases the probability of reversing a corporate governance violation by five percentage points.

The article notes that an egregious corporate governance violation is more likely to be covered by newspapers regardless of any effort by hedge fund managers, and it is also more likely to generate a reaction. To attempt to disentangle these effects, we employ an instrument—the portfolio composition of the Hermitage Fund, an investment fund that consciously played a media strategy in post-1998 Russia—to provide further evidence that there is a causal link from press coverage to the governance outcome.

The full article is available here.

Law and Economic Issues in Subprime Litigation

This post is from Allen Ferrell of Harvard Law School.

I have recently finished a paper, with two co-authors, Jennifer Bethel and Gang Hu, titled “Law and Economic Issues in Subprime Litigation”.

The losses suffered by mortgaged-backed security (MBS) holders, collateralized debt obligations (CDOs) holders and security holders in investment banks, mortgage originators, bond insurers and credit rating agencies is generating, and will continue to generate, an enormous wave of litigation. In the paper we provide some basic descriptive statistics and institutional details on the mortgage origination process, MBS and CDOs, including the evolution of MBS tranche structure over time, the underwriting quality of mortgage originations, CDO trustees and liquidations, and the identity of MBS and CDO sponsors. In addition the paper also discusses some of the main issues that will likely be critical in much of this subprime litigation; issues such as whether the subprime crisis was foreseeable; the distinction between ex ante expectations and ex post losses; the distinction between the transparency of the quality of the underlying assets being securitized and the transparency as to which market participants are exposed to subprime losses; and the distinction between what investors and the market generally knew and what individual entities in the structured finance process knew.

The paper can be found here.

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