What CEOs and Hedge Funds Don't Want the 99% to Understand

Zuccotti Park may be emptied and the Wall Street no longer occupied, but the anger of the 99% hasn't abated one iota as they watched CEOs cash in on the recovery and hedge funds make money hand over fist whether the market is going up or down. This shouldn't be a surprise. The fact is, because of the structure of their compensation, CEOs are rewarded for share price volatility not share price performance. And hedge funds make big money on the volatility that CEOs are incented to produce. So while the volatility of the past five years has devastated the lives, savings and pensions of vast numbers of the 99%, it has served CEOs and hedge fund managers very well indeed.

To understand the perverse structures, let's compare the compensation of two hypothetical CEOs, Bill and Sally, appointed on Jan. 1, 2007 and retired five years later on Dec. 31, 2011. The average US large company CEO has a compensation package of approximately $10 million/year made up half of salary/bonuses and half of stock-based compensation, so that is what we awarded Bill and Sally. Typically, the stock compensation is awarded annually on Jan. 1 of each year. If it is in the form of restricted stock, it vests as of retirement. If it is in the form of stock options, they typically must be exercised at the time of retirement. So that is how we structured their stock-based compensation.

It was a wild ride during Bill's and Sally's time. The S&P 500 (which accounts for 75% of US market capitalization) was 1,416 when they took over, shot up to an all-time high of 1,565 on Oct. 9, 2007, then plummeted in the fall of 2008 and bottomed out on March 9, 2009 at 676, then rose to the close of 2011, finishing at 1,258 -- 80% of that all-time high.

CEO Bill managed the company as if it was a proxy for the stock market; its stock followed the S&P500 exactly with the huge ups and downs. On January 1, 2007, his stock price was $100/share, making the share price at the beginning of 2008-2011: $102, $66, $80, and $90, respectively. When he retired, the price was $89. So in five years, he took his shareholders on a wild ride and ended up losing 11% of the investment of the shareholders who stuck with him the whole time.

CEO Sally was able to buck the market trend. She managed carefully and proactively and somehow kept the stock stable at $100/share from 2007 through to the end of 2011. So against the backdrop of five wild years in the market, she avoided giving shareholders scary ups and downs and left them with their investment whole -- 11% better than the market performance and 11% better than Bill.

Who is the more valuable CEO? Whose compensation should be higher? Should it be Bill, whose shareholders experienced massive volatility and a net loss of 11% over the period? Or should it be Sally, who avoided ups and down, protected investors' capital and ended up 11% higher than Bill? The answer, of course, is obvious -- Sally with both better returns and lower volatility. She should have made a hell of a lot more.

But that is not the way it works out in crazy America. Over the period, Bill made $57M in compensation to Sally's $50M if their stock-based compensation was in stock options; $51M versus $50M if it was restricted stock. It seems impossible: how could the valuations end up there when Sally's stock was 11% higher on the day the stock-based compensation was valued? It is primarily because of the huge value of Bill's stock-based compensation given to him on Jan. 1, 2009 when his stock price was languishing at $66.

Therein lays the fundamental problem eating away at the core of American capitalism -- and generating anguish of the 99%. American CEOs are paid to generate volatility -- so they did just great over the last five years while the 99% took it in the teeth. And that wasn't some kind of accident -- it is inherent in the current system.

The 99% would love nothing more than slow and steady growth, but that is not what maximizes incentive compensation for corporate executives. As far as CEO compensation goes, under the current stock-based compensation model, it is unambiguously better to have your stock plummet and then partly recover than to have the stock price stay steady over the same period. In fact, the most bloody-minded and self-interested CEO would be wise to drive its stock down immediately after taking over -- and blaming the prior administration for all the problems found -- and then get the stock back to the initial level. The CEO will make a small fortune doing that -- while shareholders make nothing -- and it is a lot easier than producing stock price increases from the initial level.

Though they wouldn't want to admit it, the crash of 2008 wasn't all that bad for the vast majority of big-company CEOs. With the exception of those few CEOs who were sacked, most had terrific air cover: "Our stock may be down 50% but so is everybody else. Really, I'm doing well, all things considered." Even better, CEOs got tranches of stock grants at super-low prices -- in some cases lots of them to keep the CEOs from being depressed that their existing options were "so far underwater." As the market dragged their stock prices up with everyone else's, these CEOs made out like, well, bandits.

Stock-based compensation has produced a volatility machine and that volatility is wrecking the American economy, while it makes CEOs and hedge fund managers rich. The crash of 2008 wasn't a rogue event and it will happen again as long as our rogue system of executive compensation stays intact.