The Moral Hazard of Underwater Stock Options

I just came across this blog post from Felix Salmon advocating that we wipe out common stockholders when we bailout companies.

The post had great insight as to one reason that might be a bad idea:

Update: Some great comments below. Apparently boards do start having fiduciary obligations to non-shareholders when a company enters the “zone of insolvency”. (But hasn’t GM been there for many years now?) And dWj comes up with a wonderfully wonky slogan: “You want moral hazard, give control of a company to a class of people who are longer vega than they are the value of the company.” There’s a line to whip out at your next dinner party.

Longer vega than the value of the company means that the CEOs of bailed out companies where common stock has been almost wiped out (like AIG) have more incentive to increase expected volatility, i.e. uncertainty, than value, so actually causing even greater financial armageddon will increase their compensation more than managing well (assuming they have share options or common stock as either holdings or part of their compensation package).

Wonderful.

Technical Explanation

To understand what the hell “longer vega than the value of the company” means, and how it matters here, here’s a short primer on some aspects of options valuation:

Volatility is expected future standard deviation of returns over the lifetime of the option. It’s usually called implied volatility since it’s usually not measured directly, but the Black-Scholes options pricing model is used to solve for it, since you can measure the other variables and parameters directly by looking at market prices. Also, because asset distributions have fat tails, moving away from the strike price increases volatility.

Vega is pseudo-greek that’s the “derivative” of option price w.r.t. volatility. Pseudo in that volatility is technically a parameter not a variable, so you’re not allowed to differentiate on it, since you already assumed it was a constant to get/solve the Black Scholes SDE, therefore it gets a name that sounds like a greek letter but isn’t. For out-of-the-money (underwater) options, increasing volatility increases vega (e.g. vega gamma, or vomma, is positive).

Vega is closely related to (not numerically equal) the market value of an option above what you’d get for exercising it - the option value.

High implied volatility == wide dispersion of estimates == high uncertainty about correct price, and is often correlated with panic. The bailed out financial institutions are uniquely able to cause financial system panic if managed to do so - that’s why we bailed them out!

Of course, executive stock options usually aren’t tradeable, so it’s difficult for an executive to actually make money from vega. It’s still terrifying enough to consider.

If you look at common stock as a call option, executives of insolvent companies can be long vega if they actually own shares (which are often tradeable and liquid, once they pass the restricted timeframe and the executives file the appropriate SEC paperwork) rather than share options!

Also, being longer vega than enterprise value means that in some cases (depending on exactly what the numbers are and how efficient the market for securities of bankrupt companies actually is), the CEOs are actually incented not only to increase volatility, but also to make the company worse off financially!!! (though not so much that the stock is cancelled) Rick Wagoner might not realize it, but I’m confident that at least Vikram Pandit (Citigroup) is well aware of this given his derivatives background.

Giving stock as compensation to executives of nearly insolvent firms might be a horrible idea, especially when their enterprise value can change violently anyway because the balance sheet is full of illiquid marked-to-market assets.

Comments

[stockdog:]

Employee stock options like the ones CEOs get don't have a secondary market. They are only transferrable in cases like death, divorce, etc. So how can they have any value other than excercise value? How does any of this volatility voodoo talk impact what a CEO might do other than try to get the stock price up? You put in a throw away line about these options not being tradable but go on to say that its terrifying anyway. If they aren't tradable then the whole argument goes completely away. Alot of wind over nothing.

2008 Dec 05 09:38 AM

[Urbane Gori...:]

UFO "grassy knoll" stuff... jegan

2008 Dec 05 10:56 PM