Tuesday, January 26, 2010

Theory vs. Reality?

A letter to the editor in the WSJ the other day caught my eye, because it highlighted a divergence between theory and how at least one investor perceives reality.

According to standard theory, shareholders actually want managers to take risks. In fact, corporations are in many ways designed to discourage managers from being too risk-averse. As Jonathan Macey said in a WSJ op-ed "the public shareholders of these companies tend to be highly diversified against the risk of failure at any particular financial institution, so they have a strong personal interest in seeing the bankers who manage their leveraged investments swing for the fences." 

One letter writer did not agree:
Jonathan Macey lays the blame for the fury about bank bonuses on the government's too-big-to-fail approach, stating that shareholders actually want the banks to take risks in the hopes of outsized returns ("Obama and the 'Fat Cat Bankers'," op-ed, Jan. 13).
Perhaps some amorphous institutional shareholders seek that, but the individual shareholder surely does not. We have not seen the fruits of these new profits the banks are earning. The bankers are still getting millions of dollars and stock (diluting our holdings), while we have seen our stock values fall by two-thirds or more and our dividends cut by as much as 80% or 90%. I also don't buy the argument that talent will leave. There is plenty of talent out there, and frankly, there aren't that many places to go these days.
Former Citigroup CEO John Reed is not mistaken that the bankers "don't get it." The government doesn't get it either, but don't fault the shareholder. We are not "enjoying the rewards" of this risk-taking, nor do we endorse it. Try being a small shareholder and getting heard by bank management or the board of directors.
Sure, we could sell our stock to express our displeasure, but at greatly reduced prices because of the bankers' actions. Banks should be giving something back to shareholders and reducing bonuses proportionately to do so, before rewarding more risk taking by their staffs.
Annie Eagan

I thought the letter highlights two interesting issues:

First, the theoretical view clearly doesn't reflect the desire of some individual shareholders, especially when it relates to institutions such as banks. Certainly, many people invest in mutual funds (which should give them some diversification) but  I imagine many of the individual shareholders in the largest banks (such as Citigroup) and other "blue-chips" such as General Electric invested large portions of their holdings in these companies because they considered them "safe and steady" investments (maybe that's dumb, but it's not that point). They wish these companies took fewer risks, not more.

Second, there is clearly a conflict of interests between the institutional shareholders (who might hold some power) and the individual shareholders (who probably don't have any). Granted, the institutional shareholders are in a sense just proxies for the individuals with stakes in their funds, but I assume managers' priorities are not in harmony with those of the underlying shareholders because of various other incentives and motivations in play. Even if the individual are diversified (through owning a mutual fund, for instance), would these individual investors prefer that the institutional shareholders push the managers to be more risk averse?

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