With the notable exceptions of WaMu and LEH most holders in debt of financial orgs were made whole and it was equity holders who got shafted. Look at Fannie, Freddie, AIG, BSC, C etc. This bondholders got bailed out because they were politically sensitive, such as the chinese and Russians who stood to get killed if the GSEs defaulted or pension funds who invested in “safe debt”.

Also debt is usually considered LESS risky than equity. You are senior in the capital structure and like equity the most you can lose is your principal and you have a contractual arrangement to receive coupon payments unless you are a zero. The only thing that he says that sort of makes sense is that in a near insolvent company a bondholder has more incentive to force a bankruptcy than shareholders because of this seniority

Needless to say if your assumptions are wrong that casts doubt on your conclusions.

HBC, you may have accidently said something intelligent, although I strongly suspect it is not what you actually meant. There is an artificial distinction between “debt” on one hand and “equity” on the other. Both are claims on the cash flows of the company, the standard distinction being that debt carries a fixed return and has priority on cash claims but these days there are many many hybrid products which are one thing to one regulator and another to another regulator.

It’s not just debatable accuracy in the numbers – it’s what you mean by “debt” in an age of shifting sands, which might boil down to anything a major corporation can’t get the taxpayer to pay for. Which by recent experience values equates to: “not a whole lot, really”.

The epitome of an American CEO in plausible denial these days seems to be not knowing your assets from a hole in the ground, but getting paid anyway.

ExaminerCarter, I agree that TBTF financial institutions are a special case where incentivizing managers to maximize equity value is dangerous.

Felix didn’t specify that debt compensation is a good idea primarily for financial firms or firms near insolvency. More generally, I don’t think that executives should be incetivized to protect naive bondholders at the expense of shareholders.

-James Altucher

I’m a bankruptcy attorney. While the law varies from state to state, there is generally some sort of fiduciary duty to creditors when the company is or is nearly insolvent.

In some jurisdictions, this doesn’t give any creditors new rights – its just a gloss on the well-established creditors’ rights to bring suit to avoid fraudulent or preferential transfers.

In other states, directors’ loyalties are flipped to the creditors as the company approaches insolvency (the assets are treated as being held in trust for the creditors).

In yet a third group, the directors have a duty to maximize corporate value, not shareholder value, and so the court will judge whether the levering up was for the benefit of the corporation or just the shareholders.

Executive Compensation and Risk Taking
June 2010 Number 456
JEL classification: G21, G34

Authors: Patrick Bolton, Hamid Mehran, and Joel Shapiro

Abstract
This paper studies the connection between risk taking and executive compensation in financial institutions. A theoretical model of shareholders, debtholders, depositors, and an executive suggests that 1) in principle, excessive risk taking (in the form of risk shifting) may be addressed by basing compensation on both stock price and the price of debt (proxied by the credit default swap spread), but 2) shareholders may be unable to commit to designing compensation contracts in this way and indeed may not want to because of distortions introduced by either deposit insurance or naive debtholders. The paper then provides an empirical analysis that suggests that debt-like compensation for executives is believed by the market to reduce risk for financial institutions.

This proposal only makes sense for a systematically important financial firm, where the American taxpayers are short a credit default swap and receive no premium. It is therefore important that executives are incentivized to consider taxpayer interests as well.