Monday, October 06, 2008

Who gained, who lost in sub-prime crisis?

I've been travelling a bit, hence this lull in posts on the blog.

There's a lot of stuff on losses and gains in the sub-prime crisis. Let me explore two contentions.

1. Executives of financial firms are big losers, they have been punished heavily for their sins: The point being made is guys like Richard Fuld of Lehman and Jimmy Cayne of Bear Stearns have seen their personal fortunes in the form of stocks tied up in their own firms plummet in value, so it's not as if they have not been punished for their follies.

Well, yes, they have suffered losses on their stocks. But, this is not the complete story. These are people who base pay is huge- say, upwards of $20 mn. Many executives also get cash bonuses. Last, many have cashed out some portion of their stocks. One needs to add up all these to get an idea of the accumulated rewards. The value of their stock holdings at the time of their firms' demise, while large, is only one component of their overall reward. Now, this total is not small in absolute terms. It could typically amount to over $200-300 mn- no mean sum f0r destroying shareholder value.

The short point: top executives will be big losers only if base pay is kept smaller and variable pay comes in the form of stocks that vest over a very long period, say five to ten years.

2. Shareholders of firms such as Fannie Mae and Freddie Mac have paid a price because they've got nearly wiped out, so it's not that they gained from implicit government support: As a shareholder in such firms, you would be wiped out only if you invested at the beginning and held on till the end. Let's say one set of shareholders, who bought at the beginning, sold out at the peak. They would have made huge gains. Another set of shareholders who bought from the first at the peak would have lost heavily.

Shareholders as a class
would have made zero gains (not a loss) but that does not mean that individual shareholders did not make huge gains when the going was good.


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