Examining the long-term performance of tarp firms.

Author:Hollowell, Byron J.
Position:Report
 
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  1. INTRODUCTION

    2010 was a record year for executive compensation despite the protracted economic downturn. CEOs of the largest three hundred companies received on average $11.4 million in total compensation. This aggregates to a combined total of $3.4 billion in executive pay in 2010, the equivalent of over 100,000 wage jobs. And while cash bonuses fell significantly partly due to increased public scrutiny, however executive compensation total pay packages for Wall Street firms increased 5.7 percent to a record $149 billion in 2010.

    Starting in 2011, shareholders of publicly traded companies are required to be given a "Say-on-Pay" vote on executive compensation. Although these votes are not binding, they will encourage boards of directors to moderate their firms' executive compensation given industry standards, and subject to the company's share price performance. The public threat of its shareholders voting against their pay is a significant disincentive for any CEO of a publicly traded company (Almazan, Harzell, and Starks, 2008).

    The Troubled Asset Relief Program (TARP) designed to purchase depreciated assets and equity to strengthen the financial sector and to address the subprime mortgage crisis was signed into law on October 3, 2008. The program was originally expected to cost U.S. taxpayers up to $300 billion by the Congressional Budget Office (CBO). Of the $245 billion invested in U.S. banks, over $169 billion has been paid back, including $13.7 billion in dividends, interest and other income, along with $4 billion in warrant proceeds as of April 2010. AIG is considered "on track" to pay back $51 billion from divestitures of two units and another $32 billion in securities. Table 1 reports the total dollars actually dispersed through TARP is $573 billion dollars as of year end 2010.

    This includes money that was returned and paid to Treasury as interest, dividends, fees or to repurchase their stock warrants

    In June 2009, the Treasury Office issued a rule on the executive compensation and corporate governance standards that apply to companies that participate in TARP reform. Companies receiving "Exceptional Assistance" are under the obligation to review and approve compensation structures applicable to its top 25 executives. TARP issued proposed compensation packages for TARP companies requiring that:

    (1) There can be no guarantee of any bonus in the compensation structures.

    (2) Base salary paid in cash should not exceed $500,000 per year

    (3) Total compensation for each individual must be appropriate when compared with total compensation provided to similar positions in the industry and should targets the 50th percentile of total compensation for such similarly situated employees.

    (4) Incentive compensation paid to these employees will be subject to recovery or "clawback" if the payments are based on materially inaccurate financial statements,

    (5) Executives, and not companies, generally will pay for the costs of personal expenses, and therefore, other compensation and perquisites will be capped at $25,000.

    (6) Executives will provide for their retirements with wealth based on performance while they are employed, rather than being guaranteed retirement benefits beyond their jobs.

    Has the TARP reform led to a higher alignment between executive pay and firm performance? The antidotal CEO pay evidence in 2010 seemed promising. The overall cash compensation for 2010 decreased, on average, by 33% from the amounts approved for 2009. The total cash salaries approved were $500,000 or less for 82 percent of the executives. Contrary to predictions, 84 percent of the executives included in the 2009 rulings remain with the companies in early 2010. There was widespread speculation that many executives would simply go work for other companies that are not subject to the TARP restrictions. Although it appears there has not been a major exodus of the top 25 executives at these firms, it has been less than one year since TARP initial rulings. Only time can measure the ultimate impact of these compensation rulings on the executives at the five remaining firms covered by TARP rulings.

    As a result, companies not under TARP are under pressure by shareholders to eliminate practices that are red flags for investors. tax gross-ups, golden parachutes, corporate jet travel, preferential pensions and perquisites unrelated to performance are now under the microscope. Some executive compensation is becoming more long-term and linked to measurable performance. The Wall Street Reform Act also provides other protections for investors; wherein Board of Directors' compensation committees now must consist almost entirely of independent directors. And financial companies must ensure that their incentive pay plans do not create excessive risk. Goldman Sachs, responding to public criticisms over its profits, announced in 2011 that its top 30 executives will not receive cash bonuses this year, despite record profits. Instead, the Goldman investment bankers will receive bonuses in the form of company stock, which could be even more lucrative than large cash payments assuming Goldman's share prices continue to rise over time (Babchuk and Fried, 2008)

    Some CEOs disapprove of the requirement that companies disclose to investors the pay disparity between the CEO and the typical worker. Congress required disclosure of this information because investors are concerned about growing CEO pay and its impact on pay disparities within companies. The Treasury Department through the office of Ken Feinberg has set pay levels for a few companies that remain beholden to the government due to massive federal bailouts. The government bought 61 percent of GM last year with $50 billion in assistance as the company went through bankruptcy. In October, Feinberg limited pay at GM for most of the top 25 executives to less than $500,000 per year. Salaries for most were cut 31 percent, with total compensation cut 20 percent, the News reported. "Given the rigors of the job and demands and the accountability, I would say we are being paid way, way, way below market," Lutz said.

    Robert Benmosche, chief executive officer of American International Group, threatened to quit over U.S. Treasury pay restrictions, sources close to AIG said. Benmosche told the AIG board of directors he was considering stepping down after four months on the job due primarily to the Treasury's control of salaries for top executives of companies that received extraordinary assistance from the Troubled Asset Relief Program, The Wall Street Journal reported Wednesday. Benmosche made the threat despite his status as the top-paid executive among the companies where the Treasury controls some salaries. The company has received $180 billion in federal assistance. Treasury pay master Kenneth Feinberg, nonetheless, approved a $10.5 million pay package for Benmosche, Benmosche succeeded government appointed Ed Liddy, who worked for no salary.

    Complete and perfect market theory predicts that executive compensation structure should not alter firm value. However, if management is unable to replicate the role of financial markets, then capital may be misallocated and an executive compensation, by improving investment decisions, may enhance the value of the divested assets. Schipper and Smith (1983) contend that the creation of publicly traded firms results in new information that empowers stakeholders to more closely monitor the activity of managers, thereby reducing agency costs and enhancing shareholder wealth. The prevailing view of executive compensation in corporate finance theory is that the price of a firm's stock should reflect the market's best estimate of the firm's long-run value. If, however, the stock value of a diversified corporation sends a weak signal of the productivity of a CEO, then a highly-aligned CEO pay package firm could dominate a non-aligned CEO pay package firm. 5.8%

    To summarize the empirical findings of this paper, the average four-year holding period returns for a portfolio of TARP firms from 2006 to 2010 is 146.23%. The holding period return is measured from the closing market price on the first day in 2006 to the 60-month anniversary. A matched portfolio of high pay CEOs from 2006 to 2010 only return 5.59% over the same period. I document that every dollar invested in a portfolio of TARP firms purchased at the closing market price on the first day of trading in 2006 and held until the four-year anniversary results in a terminal wealth of $2.46 (146.23% gain); while every dollar invested in the equally weighted stock market index over the same period results in a terminal wealth of just $1.21 (2.05% gain). In the long-run, TARP firms outperformed the market. The remainder of the paper is organized as follows: in the next section, I discuss the relevant literature. Next, I discuss methodological considerations. The paper continues with a discussion of the data and the presentation of the empirical results. The paper closes with concluding comments.

  2. LITERATURE REVIEW

    From a compensation growth perspective, the nineties were a great time to be a top executive in a large U.S. company (Evans and Hefner, 2008). Table 2 shows the median total compensation of CEOs nearly tripled from $2.3 million in 1992 to over $6.5 million in 2000 in the S&P 500 Industrials (S&P 500 companies excluding utilities and finance firms). The primary driver of this remuneration spike was the dramatic growth in stock options that grew from 27 percent to 51 percent of total compensation.

    However, as reported in Table 3 CEOs sometimes profited greatly even as their firms and stakeholders suffered financial downturns (Harris, 2008). In some instances, the board of directors adjusted performance targets to make meeting benchmark standards much easier to achieve. There are a number of examples of companies in...

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