Stock Market Meltdowns – Why they will happen again and again and again

There is one major problem on Wall Street, that until solved, will result in meltown after meltdown in future years. I can’t say if the meltdown monkey will hit every 2,3, 5 or 10 years. But I can say with certainty that it will happen again. Why ?

Because Risk and Reward have been decoupled for CEOs on Wall Street
.

If you are the CEO of a major public company, once you qualify for your golden parachute there is absolutely no reason not to throw the Hail Mary pass, and do high risk deals every chance you get.

If you run a major hedge fund or fund of any kind, once you have put enough cash in the bank to get to your “F U Money Level” there is absolutely no reason not to throw the Hail Mary pass and make high risk investments every chance you get.

What is the down side ? Lets just say for example, you run Fannie May or Freddie Mac. You basically fuck up the entire housing economy. Your punishment ? You walk away with 9mm and 14mm dollars as severance. Would you take either of those jobs ?

Lets say you run Country Wide Insurance. You get the housing market plumped up, during which you sell $414mm dollars worth of stock, and then watch as it spirals out of control because you lent money to anyone with a pulse, and probably to some without. Your punishment ? A $110mm payday. Oh wait, he had to give some back. Sucks to be him doesn’t it.

Carly Fiorina got fired from HP and walked away with severance pay of $42mm in cash. Some people thought she was a good CEO. Some people thought she was horrible and her acquisition of Compaq was the final straw. Did she care what they thought ? Why should she ? She could do what she wanted, she had $42mm big ones waiting for her either way !

The list of CEOs who have walked away with huge severance packages is a long one. The problem however isnt how much they got paid.

There is zero downside to a CEO for taking chances beyond the embarassment of getting fired. Would you let someone fire and embarass you for a check for $20mm dollars ? So would CEOs.

Find me the one story where the headline is “CEO has to pay the company losses back for being an idiot ? ” or ” Risky moves cost CEO his lifetime savings” or “Hedge fund manager gives back bonuses and exits with $1500 dollars a month severance”

It doesn’t exist. Every public company CEO in the country knows it doesn’t exist.

Which is exactly why we need to re-establish a link between risk and reward in public companies. The first step should be the following law:

If the government must step in and provide any sort of financing or guarantees for any part of a public company’s business, then all officers and directors lose all rights to severance pay and all outstanding vested or unvested options or warrants immediately become canceled. In the event the CEO of such corporation is not fired, but instead chooses to step down voluntarily, then the last 12 months of earnings is considered to be an interest free loan which the CEO must pay back over no more than a 10 year period.

Honestly, i dont think it would have changed the actions of CEOs who have been bailed out. They would have thought it “couldnt happen to them”. But once it happened a couple of times to a couple of big company CEOs, it would be in the decision making process of every CEO running a huge financial company.

The 2nd option would be to prevent certain types of companies from being or going public. Law Firms can;t go public. Investment firms like Goldman Sachs used to not be able to go public. They were partnerships. Partners were paid for the most part in cash. If the partnership had money to pay, it got paid. If not, not. I promise you, their tolerance for risk was far lower than it is today for Goldman because there was a direct link between the risk and reward for partners. I also guarantee you that if the business makes sense, there will be other companies that step in to handle any business that a partnership cant grow to handle.

And what about the CEOs that just screw up companies, but not to the point of federal bailouts ? You cant protect against hiring a bad CEO. It happens. You can pass a law saying that officers and board members can’t be paid in stock. Let them take their cash earnings and go on the market and buy stock or options like everyone else. Putting their own cash money on the line will create a link between the risk and the reward. They will be in the same boat as every other shareholder . It’s their money on the line.

Crazy ? Some people might say that it would make it tougher to find CEOs for big companies. Companies couldn’t pay them enough. I say thats crazy. What are those potential CEOs going to do otherwise ? If the market for CEO pay isnt high enough for them, they can go out and start their own companies and take on the risk.

As long as we pay CEOs with lottery tickets, I mean stock, that they don’t have to pay for, risk and reward will be decoupled. As long as that is the case, you can count on many a future bubble and meltdown and there is absolutely nothing anyone can do to stop them.

62 thoughts on “Stock Market Meltdowns – Why they will happen again and again and again

  1. Pingback: Cash Gain dot Com » Blog Archive » Mark Cuban on the cause of bank meltdowns — it’s not short-selling!

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  3. The Answer to Golden Parachutes is a Simple Tax Law change.
    Any serverence Package greater than the person’s one year basic salary will be taxed at a rate of 99%
    These guys should be able to find other employment in less than a year.

    Comment by Jim -

  4. Mainly because of foreign investments,inflation of prices,natural calamities and political
    issues the Stock Market Meltdowns.

    Comment by campton-stock market investing -

  5. Federal Reserve is “Privately Owned” is not part of the Federal government. Watch the video THE MONEY MATERS.

    http://video.google.com/videoplay?docid=6076118677860424204

    Comment by MIA -

  6. Pingback: Financial Crisis Rundown: Day X of ??? » The Commentariat | SpecBlogs.com

  7. Mark, Thanks for the heads up! Could Microsoft be next???

    Microsoft Plans to Buy Back $40 Billion in Shares
    By THE ASSOCIATED PRESS
    REDMOND, Wash. — The software giant Microsoft said Monday that its board had approved a plan to buy back up to another $40 billion of its shares.

    The program expires on Sept. 30, 2013, Microsoft said.

    The company said it had completed its previous $40 billion stock repurchase program.

    Microsoft also raised its quarterly dividend to 13 cents, from 11 cents. The dividend is payable Dec. 11 to shareholders of record on Nov. 20.

    The company’s board has also authorized debt financings of up to $6 billion. As part of this authorization, Microsoft has established a $2 billion commercial paper program. The company plans to use the proceeds for general corporate purposes, including buybacks and financing for working capital.

    Hewlett-Packard said on Sunday that its board also had authorized an additional $8 billion in share repurchases.

    H.P. intends to use the additional authorization as part of its program to manage the dilution created by shares issued under employee stock plans and to repurchase shares opportunistically.

    Comment by Ron Wade -

  8. Hi Mark,

    I wish it was so easy to offer a solution. I would agree that decoupling risk and reward must be fixed. It doesn’t look like John Thain at Merrill Lynch did very well

    see http://www.247wallst.com/2008/09/how-much-will-j.html which notes that “shareholders can take some comfort in the fact that Thain isn’t getting rich off the deal.”

    A small but high profile exception.

    Comment by Jason Kemp -

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  10. Pingback: Severing Risk And Reward « Roissy in DC

  11. Mark,
    I’ve been writing about this for years on my site.
    I recently ran for Congress and tried to talk about our Casino called Wall Street., and no one wanted to talk about this, or campaign finance reform, or the costs of our privately run “health insurance” system that picks and chooses who gets treatment and who doesn’t. Instead, it was about who would endorse you, how much money you could raise to pay the media for ads that say nothing, or your position on hot button issues like guns, god and abortion, which is beyond our ability as individual congressmen to change.
    What we have given our CEO’s is a free pass to sit at a high stakes poker table- where just for being given the opportunity to play- they still win.
    The market has focused on quarterly performance, since it’s no longer about corporate performance- but about the “mood of the market.” Google and Apple haven’t changed their business model in the last week- both are sitting on a mound of cash, and yet, both companies have had huge swings in their stock value.
    This isn’t investing- it’s gambling.
    If we took some of the volatility out of the market- making large institutional investors hold stock at least a year, still allowing smaller investors to move faster- but eliminate all “day trading” we’d see some return to real “investing.”
    The volume of shares traded in a day now exceeds what was traded in a year 40 years ago. As a business owner, the idea of selling a part of my business for a few hours is absolutely insane. Yet, this is now SOP on Wall Street.
    It’s now impossible to relate a company’s performance to its share price. Until they are related- it’s also impossible to evaluate a CEO.
    No matter what, there are very few CEO’s who should be able to take home the kind of money that we’ve been seeing. Steve Jobs, Bill Gates, you- got paid for your ideas- the rest of these false gods of business, have never had an original idea- or risked their own money- that too, should put a limit on what they can pull out of the stockholders pockets.
    Thanks again for this amazing post- one of my readers linked to it. I hope a lot more people start talking about this, before we don’t have any real investment money left in this country. Look how many of our huge companies have been sold to foreign investors over the last 8 years- we don’t even have an American beer company anymore. This problem should be the first thing we’re talking about.
    Not the flag pin, not the Pledge of Allegiance or “experience.”
    Do you want to run for President?
    btw- on a Mac, with Firefox- your comment entry box doesn’t adjust width proely.

    Comment by David Esrati -

  12. Dear Mr. Cuban,

    As early as 2006 I already advised my classmates who are now American citizens and residents to stay away from Wall Street beginning the last part of 2007 up to the last part of 2009. This period is like the Great Depression of 1929. Somehow it is the nature of things that once in a while a great equalizer comes along and penalizing those who get ahead using foul and fraudulent ways.

    Based on the karmic bias of the years 2008 and 2009, the earth will swallow up water, wherein water (among the five elements of fire, earth, metal, water and wood), represents money.

    Wall Street will start to bounce back in 2010 and the year 2015 will be a boom year.

    I also calculate karmic biases of people and I can determine which set of players can win your team an NBA title.

    joey aberilla

    Comment by Joey Aberilla (Philippines) -

  13. Pingback: Mark Cuban on the cause of bank meltdowns — it’s not short-selling! | Finance Newsfeed Update

  14. Totally agree, the risk should be bigger at at least equal to
    the reward.

    Comment by Shaun -

  15. The fall out on wall street. HAPPY DAY more poor white folks in America. The tables have turned.

    Comment by Greg -

  16. Amen

    Comment by Brian -

  17. Forcing a 5 year vesting period, and forcing liquidation upon vesting would go a long way

    Comment by andy -

  18. In fact, top executives should not be able to own significant shares while operating in that capacity. They should have significant unvested shares, however, that don’t vest until the long-term implications of their actions become evident.

    Comment by andy -

  19. I don’t think any sane person can disagree that CEO pay is not in line with long-term viability of a company, but it is incredibly hard to come up with a compensation clawback agreement that makes sense. How long should a CEO be on the hook for his predecessor? That’s an incredibly difficult question to answer.

    I think the answer somehow involves extreme deferred compensation. A majority of a CEO’s pay should be stock, and unvested until a significant amount of time elapses. That’s the only way I can envision this problem being solved. People shouldn’t be able to get rich for one quarter’s worth of manipulated earnings.

    Comment by andy -

  20. Great Blog Mr.Cuban,I’m just regular “Joe Lunch Box”,Do you think this finicial collaspe is One Huge “Ponzi” scheme?

    Comment by Alex -

  21. Agree 100%… Like you mentioned in an earlier posting, paying the officers and board members in stock and options just ends up hurting the stock investors by diluting their holdings. Furthermore, I don’t really see any downside to enacting a law that would prohibit paying them in stock. Like you said, they could still take the cash and buy the stock just like all of us other schmoes, and this would take shares off the market rather than adding to the supply.

    How about instead of a golden parachute, a lead parachute–a sign on bonus in cash that they CEO uses to buy stock that they can only sell after they get fired or retire.

    Comment by Mike -

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  23. Just as I was thinking no one would mention this, Eric did. “As you are well aware (after all, you were one of the candidates for Mr. Icahn’s slate of BoD for Yahoo), corporate boards in America for the most part do not work as it should. We essentially have executives from company A on BoD at company B, all high-fiving each other with compensation packages.”

    This was my experience on the first BoD I ever had exposure to: I called it a “white man’s fanny patting club.” They couldn’t/didn’t call each other or the company execs on anything for fear of not getting asked again to serve on a board. They don’t watch out for shareholder interests–they watch out for their own, and by extension, each other’s. (I worked in a startup that eventually went public, and I benefited; but let me mention the scales fell from my eyes with that–and I suspect any other–BoD.

    Comment by Marcy -

  24. I’m a first-time reader, and I’m impressed. This is the most enlightening article I’ve read about all this “financial crisis” news. How do these goons get away with this?

    Comment by Zach -

  25. Hi Mark,

    I usually don’t comment on your entries (although I do follow your blog), but I felt unusually compelled to contribute a bit more.

    First, one comment above stated “At the end, one could also say that the shareholders were ultimately responsible to give such an non-sensical compensation package.” That’s not entirely correct. Year after year, especially in recent days, activist shareholders have tried to pass a so-called “shareholder say on executive compensation”… only to be denied year after year. Of course, the board of directors, who are supposed to have shareholders’ interests, consistently recommend you vote against the deal. Why is this?

    As you are well aware (after all, you were one of the candidates for Mr. Icahn’s slate of BoD for Yahoo), corporate boards in America for the most part do not work as it should. We essentially have executives from company A on BoD at company B, all high-fiving each other with compensation packages.

    Another problem (and you briefly indirectly mentions this in your entry) is options compensation. Options are literally options. In other words, you can fail with no penalty (unless you count missed opportunity a penalty). Assuming that the executive is awarded at-the-money option (and we haven’t even touched on well-in-the-money ones), that executive is always compelled to, quoting your words, do a hail-mary. Why is this? If it’s a touchdown, the stock goes up and executive reaps in huge compensation from options. If it’s an interception, the stock goes down, but executive is okay because it’s just an option, and you can just get those repriced at a lower strike price.

    Comment by Eric -

  26. Pingback: VictorBenjamin.com » Blog Archive » Why Wall Street Sucks 101

  27. Mark – couldn’t agree more. I just posted on the incentives that entrepreneurs have to create value, but I think that you do a much better job hitting on the incentives that financial services CEOs have. It shouldn’t surprise anyone that when you give a CEO an incentive, he’ll act on it. Since investors in a start-up own preferred stock (they get paid first), the entrepreneur only gets paid if he creates value for his shareholders. Not surprising that the entrepreneur will run like hell to create real value. Many of the CEOs at the banks were more focused on claiming value via complex swaps rather than creating real value by allocating capital efficiently and living with their capital allocation (i.e. holding the debt on their own books). Why? When the average CEO tenure is so short and their option packages are so unbalanced, it’s a no brainer for the CEO to swing big, hoping to juice the stock and walk away loaded. http://www.coffeeshopproject.com/2008/09/18/a-lesson-for-wall-street-from-start-ups/

    Comment by zachclayton -

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  29. I agree. In the start-up world, I would like to add one thing: We need to also remove all equity and stock-based compensation from employees. All it does is it makes employees think about exit strategies…in effect, every employee of the business is working towards an exit strategy. This does not make make for sound strategy at the product and sales levels. Everyone is interested in valuation more so than in earnings…and since certain types of fad products are worth more than earnings at certain periods, the incentive is to focus on trends that have a high perceived value on exit rather cash flow potential.If you are against lottery tickets for CEO, why not also be against lottery tickets for rank-and-file employees. If the company goes nowhere, the employees are pissed that their stock is worthless, if the company is mediocre or underperforming…they will complain because it is not higher…if the company does phenomenally well, you have lottery winners where the reward is not proportional to risk or job performance. The $30 million Google Masseuse…So no stock for you.

    Comment by No Stock for Employees Either -

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  34. Mark Cuban for President!!!

    Comment by John Skulavik -

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  36. I like everything in the post, but, uh… broadcast.com… I think that Mr. Cuban is smart about this from personal experience.

    Comment by nic -

  37. Mark – what’s the difference between stepping down from a company that eventually fails and selling a company that eventually fails? At what point would you apply the law? ‘Within 6 months of departure, the CEO will be held responsible for the failure…” etc. Months? Years? Thanks,

    CPM

    Comment by clayton -

  38. Couldn’t agree more Mark! The incentives for CEOs are so out of whack with reality. CEOs are humans like everyone else – as long as their is no downside, they will keep swinging for the fences.

    Another way to stop investment firms from going public is to highly regulate them, which I think is going to happen. This should be enough of a disincentive to keep these firms as private partnerships.

    Comment by Faraz Qureshi -

  39. right on.

    Comment by chris tackett -

  40. Pingback: Mark Cuban: The Era of Stock Market Meltdowns Has Arrived - Money & Investing - Banks.com

  41. If you remove companies’ ties with government you’ll solve your
    financial problems. A government regulated company always seems to
    flop. Let a company fall on its face, don’t bail it out, and don’t
    reward people for incompetence. Just makes sense.

    Comment by Michael Orr -

  42. SHORT-TERM REWARDS FOR LONG-TERM RISK.

    Until that equation is changed, history is doomed to repeat itself.

    Oy.

    Comment by douglas -

  43. Stop paying executives of companies that get bailed out,
    and instead of seeking a bailout that would save
    employees’ jobs, they’ll milk the company all the way
    down to nothing, Darl McBride style.

    Comment by Don Marti -

  44. Mark –

    I loved this post. The question now is…what to do…I tend to lean toward better board governance. But its tough. I’m not sure what the answer is, I like your suggestion: the government must step in and provide any sort of financing or guarantees for any part of a public company’s business, then all officers and directors lose all rights to severance pay and all outstanding vested or unvested options or warrants immediately become canceled.

    http://www.daseducation.com

    Comment by Nicole McInerney -

  45. On the other hand, selling a company with little or no prospect of making money, to a largetr company that doesn’t know better, and walking away with a huge payday, is perfectly OK?

    Comment by Mike -

  46. Perhaps Warren Buffet will let you write a paragraph or two in his annual shareholder letter? Good stuff.

    Comment by Ben -

  47. You had me until the last three paragraphs. Yes, the golden parachutes aare awful and need to go. Yes, we should force certain types of firms to stay privately held. But no, the answer to irresponsible CEOs isn’t to pay them in cash. The answer is to pay them entirely in stock.

    Don’t pay them in options. Don’t pay them a penny in cash. Give them and equal number of shares of stock every year, and they are only (by contract) allowed to sell 5% of those shares in any given year. Which means the CEO can’t afford to let company die for the next 20 years, or he loses everything. And he’s got no incentive to do a short-term artificial inflation of the stock, because he can only sell 5% of his holdings at the inflated price.

    Comment by Chuck -

  48. Well thought out. I’ve had some of the same ideas during the S&L crisis 10 years ago or so.

    The only mitigating factor is that the CEO’s staffs don’t share in his risk/reward calculus and thus tend to tamp down the risk. In company’s that I’ve worked for, once you get over 1000 employees the CEO has no clue what’s actually going on, except through his VPs.

    Comment by Miles Archer -

  49. @ Judith

    A “democrat” ? I read Cuban’s blog occasionally, and without presuming to know his personal politics, he has some very, VERY libertarian leanings. This post is no different. And if you’re concerned about the high utility prices you pay in Texas, I can assure you that the market there is *anything but* deregulated. “Deregulation” is usually a euphemism for “managed regulation,” which is to say that a handful of well-connected corporations were able to secure (for themselves) a monopoly privilege.

    Comment by David Z -

  50. Mark, as with many of your posts, what you write reeks of common sense; hence it has little chance of moving forward to any type of policy. Reminds me of our former NH Senator: Bob Smith at a Rotary meeting. He got asked why congressmen have so many perks the average person doesn’t have. His answer: because you (his electorate) let us do it. Well, no I didn’t let hom do it, I/we just wasn’t in a position to stop it.

    Comment by Joe -

  51. Bingo Mark. There is really no consequences… because either way,
    they are walking with millions of dollars and that’s the bottom line.

    Comment by Performance Shop CT -

  52. I also agree with Mark and it goes even deeper. As well, these CEO’s have a huge war chest of public investments to fund litigation and defend their actions when they know they have committed illegal acts. Why do they do it? The obvious answer as Mark points out is greed and because they think they can get away with it!

    Comment by wifiscott -

  53. Amen Brother. Mark Cuban for Chief Finance Czar!!
    I would’ve said President but your too socially liberal.
    LOL :)

    Comment by Rob Thrasher -

  54. Thirty years ago CEOs were blamed for extreme risk aversion resulting in value destruction which has lead to use equity based compensation and golden parachutes. And today we are blaming them for overt risk taking as a result of these compensation mechanisms. Interesting…

    If you want 30-day government bonds, go buy them. But you might want to avoid the US government.

    IMHO today’s problems are more about over leveraging. Gearing up that has been allowed by governments so they can be re-elected in x years; pushed by to extremes by our penchant for herding; and not critically analyzed by a media that continually acts like the cheerleading squad for team call “Short-term Luck”.

    Comment by Eric -

  55. Mark,

    From personal experience I can tell you that they don’t teach this sort of honest discussion of CEO risk and reward in b-school.

    I think putting the rascals in prison would be a greater deterrant than merely applying financial penalties. Nothing like the notion of a few years in the hole to make you think twice about pushing the limits.

    That said: How much necessary innovation would be discouraged were we to adopt such measures?

    Comment by Terry Johnson -

  56. ‘As long as we pay CEOs with lottery tickets, I mean stock, that they don’t have to pay for, risk and reward will be decoupled.’ – I don’t really understand this statement. If you pay a CEO with stock then if they mess everything up then the stock becomes worthless. This would seem like an incentive to not mess everything up. How would paying them in cash help?

    Comment by Andrew -

  57. I think this was really an excellent entry. These are the sorts of issues that the presidential candidates, media, etc. should be discussing.

    Comment by Tim -

  58. I agree a lot. It seems that the CEO compensation is not aligned with the interest of shareholders.

    But I am not sure whether more regulation needs to be introduced. At the end, one could also say that the shareholders were ultimately responsible to give such an non-sensical compensation package. So, maybe tools to make shareholders smarter and informed should be introduced as well as new kinds of compensation schemes like you mentioned.

    Some people talk about better boards… It seems an important area to be improved.

    But I am rather skeptical about the notion and practice of ‘public’ companies. As long as the shareholders are not very knowledgeable about the company and the management, I think there will be top management who will ‘game’ it. Either there should be a public company 2.0, or there should be a decline of public companies. With all the Internet technologies, I wonder if the way compaines are run as a ‘public’ company has changed at all since the beginning of the industrial age.

    Comment by hyokon -

  59. Well put. Excellent examples of executives who destroyed good companies and go tpaid . Without risk reward built in these things will happen again and again. We continue to allow for large pay packages and bail outs and it can only result in more major blow ups like these. Carly is a perfect example of someone who failed, got paid and now moves into politics where she can do some real damage to the country. Yikes!

    Comment by Dan -

  60. Spot On!

    Comment by Ryan Petty -

  61. Great post, Mark. I just knew you were a Democrat deep down. There
    just wasn’t as much outright GREED in Adam Smith’s “invisible hand”
    days, was there?

    Total deregulation has almost destroyed our country. We deregulated
    electricity in Texas–and now pay higher rates than anyone else in the
    US. Gee, wonder who thought up that scheme?

    Conservatives will NEVER allow the law you outline above to be
    passes. Why should they?

    Comment by Judith -

  62. Exactly right! I agree completely with this, it seems so obvious yet no company seems to understand it.

    Comment by Zoran -

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