CEO Chairman Split

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A long time shareholder proposal at many large U.S. companies has been to separate the roles of CEO and Chairman. CEOs resist this “attack” on their power by the owners of the company.

Joann Lublin reports in a 3/30/09 WSJ article that corporate leaders are now recognizing that splitting these two roles would help companies perform better. The article cites a Corporate Library report that “37% of companies in the Standard and Poor’s 500-stock index have separate chairmen and CEOs, up from 22% in 2002”.

Many European companies have these roles split. U.S. corporate bylaws are structured so that it is difficult for a stockholder proposal challenging the CEO to win a majority of votes. Many mutual fund shares are not voted, defaulting the vote to the company’s management.

Many CEOs want tight control of the corporation, believing in the strength of their vision and execution. When the company’s performance doesn’t measure up, these CEOs look more like a wily fox with a key to the hen house. The shareholders get a key to the poor house.

CEO Pay Survey

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On April 3rd, 2009 WSJ reported the results of their annual CEO Pay Survey.

Median salary and bonus in 2008 was $2.24M, a drop of 8.5% from the previous year. But that’s not the total package. Total CEO compensation also includes stock, stock options, stock appreciation rights (SAR), restricted stock units (RSU) and other long term incentives. That brought the median figure to $7.6M, a drop of only 3.4%.

Long time shareholders, who dutifully read the annual reports of the companies whose shares they own, will recognize this decades long ploy. No matter how much the company’s profits drop, most CEOs find a way to dip into the pockets of the owners, the shareholders of the company. The footnotes to the financial statements are where shareholders may find that performance goals for the CEO were changed during the year to reflect the “challenging environment”. The company’s profit may have fallen by 50% but the CEO met these new performance goals, enabling them to take home a fat bonus or other incentive. In short, shareholder dividends are reduced and the money put into the pockets of the executives.

Shareholders who have joined together to protest these sham practices are effectively brushed off by the executives. Mutual fund managers who, by proxy of the funds customers, own a sizeable portion of the company’s stock, are reluctant to confront the executives of the company to demand changes. The board can often be comprised of those who are either allies of the CEO or unlikely to challenge the CEO – a practice called “packing the board”. Some CEOs defend this practice as being in the “long term interests” of the shareholders on the basis that the board and CEO agree on the strategic approach to running the company.

The board, whose duty is to act in the interests of the shareholders, are reluctant to confront the CEO and, in effect, act in the interests of the top executives. An example of this practice is Rick Wagoner, the recently ousted chairman and CEO of General Motors (GM). When Wagoner assumed the role of Chairman in addition to his duties as CEO, seven out of 11 directors were replaced. For an interesting look back on this example of the principal-agent problem, see this 2005 Slate article.

There may be some hope for shareholders. The anger over AIG has “given boards the backbone to write stricter standards on pay”, reports WSJ.

As a disclaimer, I used to be a GM shareholder several years ago. I got wise to Wagoner for a small cost.

Cheating

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Investigations into the origins of the credit and housing crisis have revealed that it was a confluence of cheating.

AIG, the mega insurance company and hedge fund, bundled bad mortgage loans with good and wrapped the resulting loan package with a AAA safe credit paper of approval. Under pressure from the banks that securitized housing loans, ratings agencies developed an underwriting formula that would stamp these products as safe. Some mortgage brokers falsified credit applications for home loans or encouraged home buyers to do so. Home buyers fudged their income and expenses to buy houses that they could not afford.

Dan Ariely, a behavioral economist who wrote Predictably Irrational, reveals the results of several experiments on cheating in this video, beginning from about the 5 minute marker and ending at the 13 minute marker in the video.

Household Debt

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David Greenberg, author of Nixon’s Shadow in WSJ 3/21/09: “Reagan was struggling to pass his tax cuts when John Hinckley’s bullets landed him in the hospital. The outpouring of sympathy, aided by Reagan’s winning bedside humor, buoyed his popularity and helped him win a big victory. But that success didn’t foreshadow any continued mastery of Congress; his relations with the Democratic House, and later, the Senate, would deteriorate.”

For the first 6 years of the two term Reagan presidency, the Republicans controlled the Senate while the Democrats controlled the House. The last two years of his presidency, the Democrats controlled both houses.

In 1980, total Federal receipts, including Social Security taxes of almost $120B, were $517B. In 1988, total receipts were $909B, including SS taxes of almost $264B (U.S. Dept of Treasury).

In 1980 the Federal Debt was $907.7B; in 1988 it was $2602.3B. The deficit had almost tripled.

At the end of 1980, the CPI-U index was 86. It was 120 when Reagan left office.

In 1988, the top marginal tax rate was 28%. In 1980, it was 70%. Some argue that lowering tax rates dramatically raises tax revenues. The data above shows that tax revenues did increase, although the increase was not dramatic. Excluding Social Security tax receipts and adjusting for inflation, net tax revenues increased 16% in 8 years. Will lowering marginal income tax rates always produce increased tax revenues? Is there some optimal income tax rate? I’ll look at different theories on that subject in a future blog.

How much of this tax revenue increase came from capital gains taxes? The Dow Jones index stood at 930 when Reagan took office. It was 2239 when he left. I will take a look at that in a later blog but here is a 1997 congressional committee discussion of capital gains tax rates.

The data does show one very clear point. Increasing tax revenues can not offset runaway spending.

Buffett Sense

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Berkshire Hathaway, the holding company headed by Warren Buffett and Charlie Munger, owns Clayton Homes, the largest producer of manufactured housing in the U.S. Clayton Homes finances almost 200,000 homeowners. The market they serve is below average in credit risk and with a thin cushion, at best, when times get tough.

From Warren Buffett’s annual letter to shareholders: “[Clayton’s homeowners’] median FICO score is 644, compared to a national median of 723, and about 35% are below 620, the segment usually designated ‘sub-prime.'” Yet, they have had no unexpected losses.

The “delinquency rate on loans we have originated was 3.6%, up only modestly from 2.9% in 2006 and 2.9% in 2004. Clayton’s foreclosures during 2008 were 3.0% of originated loans compared to 3.8% in 2006 and 5.3% in 2004.” In contrast, TransUnion reported that the national average for mortgage delinquency was 4.58%.

“Though Berkshire’s credit is pristine – we are one of only seven AAA corporations in the country – our cost of borrowing is now far higher than competitors with shaky balance sheets but government backing. At the moment, it is much better to be a financial cripple with a government guarantee than a Gibraltar without one.”

“The present housing debacle should teach home buyers, lenders, brokers and government some simple lessons that will ensure stability in the future. Home purchases should involve an honest-to-God down paymentof at least 10% and monthly payments that can be comfortably handled by the borrower’s income. That income should be carefully verified.”

“Putting people into homes, though a desirable goal, shouldn’t be our country’s primary objective. Keeping them in their homes should be the ambition.”

Amen, Warren.

House Walkaway

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The following is not a script from a Monty Python episode.

In a 3/29/09 NY Times article, Susan Saulny reports: “Banks are quietly declining to take possession of properties at the end of the foreclosure process, most often because the cost of the ordeal – from legal fees to maintenance – exceeds the diminishing value of the real estate.”

After vacating the house in anticipation of foreclosure, the “former” homeowner finds that, to the city, they are still the “current” homeowner and the city wants them to clean up and maintain the abandoned property.

It does sound like the “dead parrot” episode from Monty Python, doesn’t it?

House Visas For Sale

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Here’s an interesting idea by Richard LeFrak (of LeFrak Org, builder of LeFrak City in Queens) and Gary Shilling, an investment advisor, in a WSJ op-ed 3/17/09. The authors present the problem of the huge inventory of excess houses, estimating the total at 2.4 million, and offer a solution.

“Offer permanent resident status to the many foreigners who are clamoring to get into the U.S. – if they buy houses of minimal values (not shacks). They wouldn’t need to live in those houses, but in order to remove the unit from the total housing market, they couldn’t rent them. Their temporary resident status grant upon purchase would become permanent after, perhaps, five years, if they still owned the houses and maintained clean records.”

A good idea but I see several problems. What kind of background check will these foreigners be subject to? This situation would be ideal for drug dealers in foreign countries who want to set up shop in the U.S., where the demand for their goods is strong. Who will monitor whether the new owners will rent the house? It could cause a “land rush” as the demand for those 2.4 million surplus houses would be strong, possibly stronger than the supply, thus causing another housing bubble.

The authors continue: “The blueprint for a program to sell surplus housing to immigrants is already in place with the EB-5 visa program. Each year, 10,000 EB-5 visas are available for foreigners who each invest $1 million in a new enterprise ($500,000 in economically depressed area) that creates at least 10 full-time jobs. After two years, the entrepreneur and his family can become permanent residents.”

This is free market citizenship at its best.

Protectionism

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“Punitive” import duties are a classic case of protectionism. The most famous example is the Smoot Hawley act which raised duties to 60% on imports into the U.S. during the depression. This caused other countries to do the same and is regarded by some as the single greatest contributor to the global depression of the 30s.

Any increase in U.S. import duties from their current levels are labeled by “free marketers” as protectionism. What are current levels?

In 2007, the U.S. imported $1.9 trillion. On that amount the U.S. collected $26B in import duties, or 1.3%. What do other countries charge?

U.S. favored trading partners in Europe charge US companies over 5% for imports into their countries. China recently reduced their import duties to 9.8%. Essentially, U.S. import policy makes it more cost efficient for US companies to move their manufacturing base outside of the US, then import the goods back into the US.

Pay As You Go

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For some historical perspective, here are some notes I made January 20th, 2009.

As of early October, Obama’s plan was still pay as you go. Pelosi and the blue dog (economic moderates) Democrats were convinced this was a doable plan even with a recession. However, the economic malaise has since proved to be so systemic both in this country and around the world, that revenues will probably fall short.

WSJ reported today (1/20/09) that, after the increase in the AIG bailout last night, there was talk among Democrats over the weekend that the bailouts are probably going to cost more than $700B even before Obama takes office. Secondly, the promised return of some of the money to the taxpayers from AIG is going to take longer than Paulson and Bernanke predicted.

Lastly, there was a cute little move that Paulson announced in September that went under most people’s radar – a change in Sec 382 of the tax code. It voids the tax that banks pay when they merge. The only ones who did notice this change were the mergers and acquisitions guys at US banks. It may mean as much as $140B in tax revenue gone this year and next. It sweetens the after tax bottom line for banks who want to merge.

I’m sure Paulson did this to encourage banks to buy failing assets and banks instead of the Treasury bailing them out but he made no announcement and the CBO was not notified to change their tax revenue projections because of the change. Corporations pay about $350-$400B in taxes each year so a $140B tax break to merging corporations is huge.

Barney Frank is questioning whether Paulson’s move was even legal, given a law that was passed in 1986. At any rate, tax revenues will be far less than even recently revised projections.

Obama can probably get some savings by drawing down troops in Iraq, which is costing us over $10B a month. General Petraeus is calling for more troops in Afghanistan so it is doubtful that there will be any savings in that combined military theater in the next 6 – 12 months. Iraq currently has a $70+ billion surplus and the U.S. may be able to get a down payment on the amount of money we have put into that country.

There is always cleanup to be done when Presidents like Reagan and Bush champion low taxes and high security. Reagan tripled the U.S. debt in his eight years, Bush has doubled it in his 8 years. Neither of them were very analytical, preferring to trust their guts and “shoot from the hip”. Each of them talked small government but delivered bloated government. Now we have a president who talks big government. Maybe we are living in a “bizarro” backwards universe where events turn out the opposite of presidential promises and projections.

Roth Conversions

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For those of you who have traditional IRAs or 401Ks, the recent sharp decline in stock prices can be a tax boon if you convert the IRA or 401K to a Roth IRA. You will need to pay taxes on the conversion but the tax is based on the value of the account at the time of the conversion.

As an example, let’s say you put $5000 into an IRA stock mutual fund in 2007. Let’s say the account value is $3000 now. If you convert the account to a Roth IRA, you pay taxes only on the $3000 value. All future gains are tax-free. There are no required minimum distributions. Plus there are additional benefits for your heirs.

But wait, there’s more! If you convert in 2010 (that year only), you can pay the taxes on the conversion over two years.

Also, the $100,000 income limit for Roth conversions expires in 2010.