My Two Cents

Jon Adler continues a scuffle with Brad DeLong that started a while back.  Roger Pielke, climate change, Todd Henderson, the whining rich, and Obama's plans for America are all in the mix, but so is this apparently erroneous summary of a Todd Henderson paper (as provided by one of his co-bloggers):

In "Insider Trading and CEO Pay," Prof. Henderson examines the effectiveness of insider trading as a compensation device using a study of 10b5-1 trading plans.  His findings are in line with Henry Manne’s original thesis from nearly 40 years ago that insider trading didn’t diminish firm market value on net and may serve a useful purpose as an executive compensation device to motivate managers to maximize the value of the firm...

Brad Delong was very critical of this argument; Jon Adler notes that the summary is flawed and does not represent the argument Henderson actually made.

But, in the finest spirit of learning something new every day, let me toss in the notion that, whether this is a fair summary of Henderson's view or note, Prof. DeLong's critique is erroneous.  First, over to Prof. DeLong:

Giving firm managers the freedom to use information they privately have as a result of their jobs to decide when to buy and sell shares of stock does not motivate managers to manage the firm in the interest of shareholders.

If managers free to engage in insider trading know that the next piece of news to be released will cause the stock price to rise, they will buy. If they know that the next piece of news to be released will cause the stock price to fall, they will sell and then buy back later. They don't care whether the news is good or bad--either way they will profit, and either way they will profit equally.

What the ability to engage in insider trading does is that it gives managers an incentive to make the price of the stock vary--they don't care which way. Thus it cannot "serve a useful purpose as an executive compensation device" and cannot "motivate managers to maximize the value of the firm" to shareholders.

Insider trading makes executives' portfolios' long not the company but long the volatility of the company. And shareholders don't want executives making decisions that make the value of companies they own more volatile: stock market investments are risky enough as it is without giving executives reasons to boost the volatility pot.

This claim that freedom to engage in insider trading aligns executives' interests with those of shareholders is so basically wrong, so obviously erroneous, so simply stupid that--well, words fail me.

Words fail?  I think basic financial principles may have failed him as well.  Shareholders in a levered firm with committed long term debt will surely benefit from an increase in the volatility of the firm's equity (since it can be modeled as a call on the firm's assets with a stike equal to the face amount of the debt).   Pedants should note that if the debt is short term and repriced frequently, the wealth transfer associated with a surprise increase in firm volatility will be much smaller.  This will also be a one-time transfer - bondholders with a memory won't be taken by surprise a second time.

And setting that aside, it is easy to conjure scenarios in which risk-averse firm managers with a large portion of their net worth tied up in the firm's stock (or their income stream tied up in not losing their job and having to seek another one) will strive to reduce the risk of their own undiversified portfolios by managing the firm conservatively.  Giving these managers an increased opportunity to profit from a more volatile situation may prompt them to undertake positve NPV projects that benefit the shareholders while also increasing their own portfolio risk to a previously uncomfortable level.

Or so I was taught years ago - that is a standard argument for including stock options in executive compensation, and I suspect it is an enduring classic.  If not, then I will learn something new by unlearning something old.

I should add that the undiversified managers argument also appears in the comments, so I am at worst a victim of a mass hallucination.  But let me proceed with confidence and assert that the argument Henderson never made is plausible and incorrectly rebutted by DeLong.

Well, that is my financial theory dump du jour.  Why oh why can't I get better Biloba Gingko?

FWIW AND APROPRO OF NOTHING:  Drawing, no doubt, on his familiarity with faculty meetings, Prof. DeLong wrote one of the funniest things I have read in my years of blogging.  It's blown up in his archives but Google has it.  Just to start:

In the Uttermost West [Revised]

Place: The Uttermost West, Before the Thrones of the Valar, in the Timeless Halls

Time: Between the Fellowship of the Ring and the Two Towers.

Maia 1: Olorin! How have you been! Seems like I haven't seen you for most of an age! What have you been doing?

Olorin: For thirty lives of men I have walked the roads of Middle-Earth till the bleeding cracks on my feet had bleeding cracks on them...

Maia 2: Oh, I remember. The mission. Coordinating the elves and men in that mopping-up operation against what's-his-name, that lieutenant of Morgoth, Gorthaur...

 You have to love LOTR, but who doesn't?

Comments

[Danube of Thought]

I remember reading Manne's argument in 1975 and not quite following it. Nothing has changed...

I choose to sit this one out.

[Breakthrough Institute.]

Piellke Fils is an Honest Broker, but he still believes in carbon management.
=====

[Ignatz]

DeLong is a smart and talented man who subsumes his intelligence and reason (and often his manners) to his idealogy. I gave up on him as fundamentally unserious some time ago.

[matt]

insider trading maximizes the value of the firm to insiders.

[Dave (in MA)]

You have to love LOTR, but who doesn't?

That would be me.

[NK]

DeLong MAY be smart and talented, I wouldn't know. all I know about him is what he puts on his Blog, and more than 8 years ago he succumbed to the vapors of GW hatred, so what he blogs on about is bogus. His academic writing? I'd have to read that.

[Danube of Thought]

The problem I have with the Manne idea is that it disregards individual shareholders. If an insider with private knowledge of a coming loss sells before that knowledge is made public, the buyer has been defrauded, both under Rule 10b5 and under ancient common law principles. It is cold comfort to him that in the long term shareholder value may be improved.

[Clarice]

It must be smack down DeLong day on the net. Everyone seems to be doing it.
Anyway, I'm with you , DoT. Come sit by me and pour.

[jag]

Look at any commentary on DeLong and you'll inevitably see someone comment on how Delong edited or deleted a observation they made that DeLong disagreed with (I include myself in that, illustrious, group).

People can be smart, often offer cogent analysis, yet be asses. DeLong, in my opinion, fits in that group as he has no interest in debate. Anyone can run their blog anyway they see fit but in order to be taken as a reasonable, fair minded, person you don't delete and block people who, politely and reasonably, disagree with you.

[Rob Crawford]

Yeah, DeLong is so smart and talented he feels the need to declare a man anathema for relating that his financial situation, appearing on the surface quite comfortable, is actually quite precarious, and further increases in tax rates will force his family to consume (and therefore employ) less.

Real smart, talented totalitarian, that DeLong.

And, frankly, this case is one of the straws that broke my temper and has me in an even more intolerant mood than normal. The reaction to a calm explanation of how a seemingly high level of income is eaten up by taxes, college loans, and other obligations was met with a shower of excrement, character assassination, and what in a mirror case we would call McCarthyism.

No attempt to ascertain the facts, no attempt to even treat the fellow like a human -- no, he was ENEMY, and had to be destroyed. I get the sense that they're particularly appalled that he's Of Their Class but not buying into their bullshit, that every one of them thinks the guy should be thanking them for letting him keep a single dime, and that the DeLong types would have him standing in front of a bullet-pocked wall if they could. Failing that, they "don't see how he can be employed".

I'm sick of everyone who bases their entire ethos around envy, who demands government confiscate the wealth of others to provide for them, who lusts for the whip handle.

[Latte]

DeLong dishonestly blogs and edits/deletes/bans comments in the style of Adler's co-blogger Orin Kerr.

I have no respect for either of them - nor for any other enbubbled professor who behaves as they do - and consequently feel unmotivated to waste my time reading whatever garbage they happen to be spouting today.

Still, it's nice that Adler provided an easily-referenced rebuttal to this particular volley of nonsense. (And of course it's also nice that Google's cache, the Wayback Machine, etc. allow for the exposure of DeLong's 1984-ish attempts to rewrite history.)

[steve]

... If they know that the next piece of news to be released will cause the stock price to fall, they will sell and then buy back later... either way they will profit, and either way they will profit equally.

Huh? Is it just me or is this nonsensical?

If I sell stock in advance of a decline, I have 'profited' only to the extent of the decline, but that's profit in a conceptual form only (I'm not paying tax on that gain, am I?). And his assertion that the manager will profit 'equally' from either a sale or a purchase also makes no sense. Even notwithstanding that losses avoided are not real profit (think of the profit I made not buying Enron..?), the manager only has the same 'profit' if the rise and fall in stock value are the same and the manager buys/sells the same number of shares.... which assumes facts not in evidence. In fact, the manager can only 'profit' from a decline to the extent he has shares (assuming company policy forbids a manager from selling short or using options) while his upside profit is limited only by the number of shares he decides to and is able to buy.

Second, why does he state the manager will buy back the stock? Sellers don't as a rule rush out to buy back the stock of a company they've deemed a loser. A seller may subsequently purchase stock, but only if and when they anticipate a jump in the stock price.. and any gain would result from the subsequent purchase, not from the inside-information prompted sell. Thus, the selling and the buying are two independent events.

[Charlie (Colorado)]

Yeah, DeLong is so smart and talented he feels the need to declare a man anathema for relating that his financial situation, appearing on the surface quite comfortable, is actually quite precarious, and further increases in tax rates will force his family to consume (and therefore employ) less.

Yes, exactly. It's not that Henderson's work is right or wrong; it's that now he has been revealed as a class enemy, he must be destroyed.

[sbw]

So people actually read DeLong?

[Jeff]

steve,

you decry facts not in evidence then assume facts clearly not in evidence ... (companies forbid short selling) ...

even so consider the following ...
Manager a owns 100k of stock worth 5 million should he sell it at todays price ...

if he knows knows that the next announcement will drop that value down to 4 million and sells all his stock today for 5 million and buys it back after for 4 million are you really trying to say he has not profited to the tune of $1 million ?

[Clarice]

I don't, but I read about him and apparently to Brad, tat's sufficient for critical purposes.

[MayBee]

Loving Rob and Charlie right now.

[Janet]

OT -
Anybody heard from Frau lately?

& FYI concerning Soylent. I haven't heard anything lately, but the last email (Sept. 17th) he said he was going on a 60 day rotation & might be out of touch for awhile. Care pkgs are on hold until we hear from him.

That's it. Over & out....

[matt]

The commission investigating the administrations handling of the BP oil spill has determined that it was either incompetent or withholding information. LUN to the WSJ article.

[Ann]

Powerful video from the RGA:

Four Weeks - Remember November

Don't miss the last 5 seconds.

[Foo Bar]

Words fail? I think basic financial principles may have failed him as well. Shareholders in a levered firm with committed long term debt will surely benefit from an increase in the volatility of the firm's equity (since it can be modeled as a call on the firm's assets with a stike equal to the face amount of the debt).

OK, maybe DeLong didn't state his point as carefully as he could have. What about the bondholders, though? Yes, shareholders are *long* a *call* on firm assets. Bondholders are ....? You know the answer, TM. So can we say that increasing the volatility of the assets is in the interest of investors in the firm, generally speaking, where we include both equity and credit?

There are also plenty of unlevered firms out there, too. Asset volatility does stockholders no good in that situation, unless they have a particular appetite for risk.

[Janet]

Wow Ann! You find the BEST videos...

[RichatUF]

Hummm...insider trading. Run for congress, problem solved.

...the administrations handling of the BP oil spill has determined that it...

The administration or BP...

[steve]

Jeff: he's profited by that amount only if you define profit to include amounts not lost. And using your example, if he doesn't buy the stock back, he makes even more profit?

By the same standard, if the stock doesn't go up, has he 'lost' money?

[Danube of Thought]

The instant before he sells, he has stock that he (but not the buyer) knows is worth only $4 million. The instant after he sells, he has $5 million, and he is indifferent to whether he buys the stock back for $4 million or invests the whole $5 million elsewhere.

He would consider that he has "profited" by selling something worth $4 million for $5 million, but his accountant and the IRS would only want to know what he paid for the stock in the first place.

[Danube of Thought]

I should add that under current law, in the eyes of the SEC and the courts he has defrauded the buyer out of $1 million.

[hit and run]

http://www2.journalnow.com/news/2010/oct/06/man-obama-mask-robs-store-ar-438738/>Well:

The robber entered the Sheetz Convenience Store on Somerset Center Drive about 3:25 a.m., took out a handgun and demanded cash.

He fled with an undisclosed amount of cash, driving off in a silver or gold compact car, police said.

No one was injured.

The robber is described as a white male, about 6 feet tall, with an average build and wearing dark clothing.

Imitation is the sincerest form of flattery.

[Clarice]

O's costing the Chinese a fortune as their Treasury investments and dollar holdings keep losing value. How long before they do a reverse Hsu and work to get rid of him?

[jimmyk]

Jeff, the point is it's not symmetric. If he owns $5M worth of stock, if he can do something to make the stock worth $6M, he profits by $1M. If he can do something to make the stock worth $4M he can protect himself by first selling the stock, but he still doesn't benefit from making the stock go down (unless the "something" is stealing from the company).

[Ignatz]

Wish I'd been able to sell my Foo Bar stock a month or two ago.
He was making some pretty good factual catches for awhile but his price per share is plummeting on these last few lame-o gotchas.
Foo Bear?

[Danube of Thought]

Jimmyk, the issue isn't presented in the case where the insider does something to cause the stock to decrease in value. The case I'm discussing is one where the insider knows that a forthcoming disclosure, of which the public is still ignorant, will cause the market value to drop from $5 million to $4 million. He will have converted $4 million in stock to $5 million in cash, which he may well consider a profit, although it's not in an accounting sense.

[Danube of Thought]

Foo Bar, how does insider trading affect the value of the bondholders' stake?

[Foo Bar]

Foo Bar, how does insider trading affect the value of the bondholders' stake?

DeLong's point is that allowing insider trading gives managers an incentive to increase the volatility of the firm's value rather than increase the firm's value in and of itself. TM's argument is that an increase in the volatility of the firm's assets can lead to an increase in the value of the firm's stock (for a firm with significant debt).That may be true, but the same finance theory which dicates that in increase in asset volatilty lead to on increase in stock price also dictates than an increase in asset volatility leads to a decrease in the value of the bonds the firm has issued. So the incentive that management is given from being able to do insider trading is not good for the firm's bondholders.

[Ignatz]

Even if insider trading were legal it would only be legal in the sense that employees could buy or sell on insider news beyond their control. It hardly gives the right to management to harm shareholders by intentionally taking actions simply to raise and especially lower the value of the company shares solely for their benefit.
Legal insider trading would give management an unfair advantage but not extinguish its fiduciary duties. Stock price manipulation would still be illegal.

[Melinda Romanoff]

Foo Bar-

An interesting way of looking at it, I must say.

And can I take the other side of every one of Delong's trades?

Insider trading is in direct conflict with market participants enforced belief that price reflects all available information about that underlying asset. To act with insider information belies the fundamental trust within the maketplace. If allowed, all prices then become suspect. The market ceases to operate for all when the participants no longer trust the market. Which would appear in the form of 22 straight weeks of mutual fund redemptions.

Price volatility reflects the level of trust in the particular asset. And in particular, bonds, they trade with three primary criteria: the strength of the bond covenant, the ability of the entity's credit worthiness, and inflation. More than likely, the bond prices would have fallen long before the stock price volatility began.

Just my two.

[jimmyk]

DOT, I thought the whole issue was managerial incentives. That means incentives to do things that affect the value of the firm.

[Rob Crawford]

And... you're missing the story, falling for DeLong's diversion.

The left formed a posse to destroy this fellow, for heresy and lese majeste. Why not discuss that, and what we can do about it?

[Melinda Romanoff]

"the ability of the entity's credit worthiness"= The ability of the entity to PAY UP!

Sorry, that made no sense, I was distracted when the young thing sat down next to me on the train.

[AL]

For how long one should keep the shares of the company to qualify for capital gain tax reduction?

[Shalom Patrick Hamou]

_______________________________________

I am inviting you today to

Vote for Your Economy, Now.
_______________________________________

When was the last time you were given that opportunity?

We don't intend to replace the prevalent system but to expend the number of your options.

We will add a significant amount of jobs, income and investment.

This is the only election in which the law of the majority is not binding on the minority.

If you don't participate you are still be making a choice:
the choice of relying exclusively on the prevalent system.
_______________________________________

Vote Now for the Credit Free, Free Market Economy
Add Jobs, Revenues & Investments.
Prosperous, Fair, Stable & Peaceful.
http://post-crash.com
_______________________________________

On September 10th at 10:00 AM EST
I will post a video on that site describing the voting process.
_______________________________________

Is the fulfilment of these ideas a visionary hope? Have they insufficient roots in the motives which govern the evolution of political society? Are the interests which they will thwart stronger and more obvious than those which they will serve?

I do not attempt an answer in this place. It would need a volume of a different character from this one to indicate even in outline the practical measures in which they might be gradually clothed. But if the ideas are correct — an hypothesis on which the author himself must necessarily base what he writes — it would be a mistake, I predict, to dispute their potency over a period of time.

At the present moment people are unusually expectant of a more fundamental diagnosis; more particularly ready to receive it; eager to try it out, if it should be even plausible. But apart from this contemporary mood, the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else.

Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.

I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas. Not, indeed, immediately, but after a certain interval; for in the field of economic and political philosophy there are not many who are influenced by new theories after they are twenty-five or thirty years of age, so that the ideas which civil servants and politicians and even agitators apply to current events are not likely to be the newest. But, soon or late, it is ideas, not vested interests, which are dangerous for good or evil.

_______________________________________

[Danube of Thought]

That may be true, but the same finance theory which dicates that in increase in asset volatilty lead to on increase in stock price also dictates than an increase in asset volatility leads to a decrease in the value of the bonds the firm has issued.

What theory is that, and where is it published? It is my understanding that the changes in value of issued bonds is entirely a function of interest rates.

[Foo Bar]

What theory is that, and where is it published? It is my understanding that the changes in value of issued bonds is entirely a function of interest rates.

Not corporate bonds. The value of corporate bonds is dependent on interest rates but also very much dependent on the risk of the company defaulting on its debt.

The theory TM is citing is sometimes referred to as the Merton model, for Nobel Prize winner Robert Merton.

If you follow the link, you'll find the following after equation 4:

the asset value model treats the firm's equity as a call option on the value of the firm struck at the maturity value b of its debt. By put-call parity, the firm's debt comprises a risk-free bond that guarantees payment of b plus a short put option on the value of the firm struck at b

Bondholders are short a put option on the value of the firm, i.e., the amount that they lose if the firm goes bankrupt and cannot pay off its debt in full is equal to the payout of a put option.

The value of options increases when volatility increases.So yes, increased volatility in the value of the firm would increase the value of equity, but it would also decrease the value of corporate debt. The basic idea is that at the point in time when the firm has to pay off its debt, the value of the stock is what's left over of the value of the firm after it pays off its bond, or 0 if the firm goes bankrupt. The value of the bond is either the principal of the bond (i.e. what the firm owes to the bondholders) or (if the value of the firm goes below what the firm owes to its debtholders and the firm goes bankrupt) the value of the bond is the value of the firm, which might be just a little bit less than what the firm owed or might be a lot less. If the volatility of the firm's assets increases, then the range of likely values of the firm's assets at the point its debt is due gets larger. For stockholders, increased volatility is all upside, since in the good scenarios for the firm's assets, the stock is worth more, while the stock is still worth zero regardless of whether the firm's assets are a little less than what it owes or a lot less. For the bondholders, it's all downside, since the bondholders get the same amount of cash (what is owed to them) if the firm stays solvent regardless of whether the firm's assets are just barely enough to pay off its debt or much higher. The bondholders get much less in bankruptcy if the firm's assets are far below what it owes than if the firm's assets are slightly below what it owes.

Regarding where it's published, you can follow the 1974 link on the page I linked and check out the paper in the Journal of Finance if you're really that interested.

[Tom Maguire]

Foo bar:

OK, maybe DeLong didn't state his point as carefully as he could have. What about the bondholders, though?

Hmm. Let's reprise DeLong's point:

This claim that freedom to engage in insider trading aligns executives' interests with those of shareholders is so basically wrong, so obviously erroneous, so simply stupid that--well, words fail me.

We agree that DeLong is wrong about this as he presented it. And he referred to "shareholder" repeatedly.

By way of contrast, I explicitly mentioned that increasing firm volatility is a possible one time wealth transfer from bondholders to equity. I think it would be fair to say that I was clear and accurate, not to mention fair and balanced.

In any case, the other argument - shareholders don't want professional managers running the internet start-up like a regulated utility or acquiring Campbell Soup just to stabilize their own jobs and salaries - is banal and unrefuted.

Why oh why can't we have better apologists.

And to be clear, I am hardly arguing that because this incentive alignment argument is true that insider trading ought to be allowed.

We could even continue down the trail noted by Melinda and note that, since we are puzzling over principal-agent problems, it may be that a firm that explicitly allows insider trading will have its debt systematically under-priced (since where is the trust?). For example, a firm that wants the best price for its next bond issue might credibly bar insider trading and include covenants barring a major change in the direction of the business.

We could even note that firms engaged in the release of independently audited financials prior to the law requiring it, since it does increase trust and consequently, the value of both the debt and equity.

All very interesting, but it doesn't salvage DeLong's claim.

[Foo Bar]

By way of contrast, I explicitly mentioned that increasing firm volatility is a possible one time wealth transfer from bondholders to equity.

I agree that you make reference to it, which I should have acknowledged in my comment (sorry about that). I don't think you made it as clear as you think you did, though, which may be hard to realize since you're much more knowledgeable about finance theory than your average reader. For instance, you've got Danube of Thought a few comments above thinking that the value of bonds only depends on interest rates, so he clearly didn't get the message that managers who increase asset volatility can screw over credit investors.

[Danube of Thought]

Thanks for that link, Foo Bar.

[Danube of Thought]

he clearly didn't get the message that managers who increase asset volatility can screw over credit investors.

Indeed I didn't. But having got it now, it seems to me tnat in a market where it was known that insider trading was permitted, and thus share price volatility might be sought after by management, the company would necessarily have to offer higher yields, and the bond purchasers would be getting what they bargained for--higher risk, higher yield.

[cathyf]

Over the long term, a stock price can be modeled as a long call, but over a shorter term (the term of a typical executive's tenure), a stock is a long call and a short put. (Ok, long call + short put more properly equals a stock forward, but the difference is the risk-free rate because all of the volatility risk of the long call is equal and opposite to the volatility risk of the short put.)

First of all, employment is in and of itself a long call option. And when employees are also given more call options it gives them an even larger incentive to increase the volatility of the stock.

If investors believe that managers have more than a minimal ability to rip them off, they will take their investments elsewhere. Leaving no company to employ the potential insider-trading managers. If capital cannot go to its highest-valued use, then less wealth is created, and everyone is worse off.

[glasater]

Milton Friedman

laureate of the Nobel Memorial Prize in Economics, said: "You want more insider trading, not less. You want to give the people most likely to have knowledge about deficiencies of the company an incentive to make the public aware of that." Friedman did not believe that the trader should be required to make his trade known to the public, because the buying or selling pressure itself is information for the market.

[bgates]

How much is Friedman's argument affected by the scale of the companies involved? Suppose an insider at Citibank saw what was coming in February 2007, dumping 500,000 shares and collecting $27M. There were nearly 80 million shares traded the first week of February, and 28 billion shares outstanding. It seems like an insider at a big company can make gigantic amounts of money without providing any detectable signal to the market.

[glasater]

As you point out bgates the 80 million shares traded within those outstanding shares is really a nothing in the big picture. But the information is there for anyone looking.
The problem with the financial collapse wasn't in stocks but in bonds.

[Ignatz]

--I agree that you make reference to it, which I should have acknowledged in my comment (sorry about that).--

Foo Bar,
If you'd acknowledged it in your original comment there would have been no point to your original comment because it was predicated on noting precisely the point that TM himself made re stockholders vs bondholders as though he hadn't made it.
Like I said before your standard for good fact checking seems to be falling which is unfortunate because I've appreciated it in the past.

[Foo Bar]

Ig:

I don't think TM made it as clear as he should have. Danube of Thought didn't get the message, after all.

The last comment you objected to was when TM indicated that Jewish coaches are underrepresented in the NBA. This is simply false, as I demonstrated. Maybe in some cases TM doesn't care if what he writes (and thousands of people read) is false. However, I can't guarantee that I won't continue to point these cases out in the future, even if you consider them too nitpicky.

In any event, it's not like I'm spamming the blog with a steady stream of unnecessary comments. I only show up here once in a blue moon these days. The comment about the NBA was more than a month ago.

[Ignatz]

Foo,

I'm not saying you're spamming the blog, just that you're more recent comments have been more pedantic than anything else, to use TM's word.
If I wasn't being clear it's actually a sort of compliment. Despite disagreeing with you opinion-wise I do value the good catches you tend to make regarding important salient facts rather than peripheral nits or interpretations.