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Bail-Out Banks Stuff CEO Pockets With Stock

Eight financial services companies that took billions of taxpayer dollars through the Troubled Asset Relief Program, stuffed their executive's pockets with stock options just as financial stocks were languishing near their two-year lows earlier this year. As the government bailout stabilized the industry, stock prices have climbed and left these executives with a windfall of roughly $90 million in paper profits, according to a report released this week by the Institute for Policy Studies.

"It's just another sign of business as usual in an environment where we really need to change the pay system," said Sarah Anderson, director of the Global Economy Program at IPS and co-author of the report. "The argument that stock options ensure 'pay for performance' is a total crock. It's like alchemy. Instead of turning lead into gold, these guys are turning falling profits, and even global economic crisis, into million-dollar windfalls."

Stock options give you the right (but not the obligation) to buy company shares at a set price in the future. Option exercise prices are normally set at the market price on the date of grant. Executives are typically given 10 years to exercise these rights by buying the shares. Presumably the value of the stock would rise over that period, making the right to buy stock at 10-year-old prices valuable.

Let's say, for example, that you were given rights to buy 100 shares of XYZ Corp. at $10 a share. If the company's stock price appreciated an average of 10% a year over 10 years, it would have more than doubled by the time the executive needed to exercise these rights and buy the shares. At that point, his profit would be the market price of, say, $20, minus the exercise price of $10. He walks away with $1,000. The only difference between that example and real life is that executive stock option grants are issued in blocks of hundreds-of-thousands, not hundreds. Real profits have been in the tens of millions and, often, hundreds of millions.

Companies have long argued that giving executives options aligns their interests with the interests of shareholders because executives only profit from options when the company's stock price goes up.

However, this report underscores the long-standing disconnect between stock option theory and corporate reality. Companies habitually give their executives new option grants when stock prices fall and the old options become worthless. Unlike shareholders who suffer real losses when stock prices fall, executives have none of their own money at risk. After all, they're not forced to buy the underwater options.

In fact, they often profit from volatile stock prices because their boards may give them extra-large grants to compensate for the previously granted options that became worthless, in addition to providing new options for current performance. In our example this would equate to waiting until the company's stock price fell to $5 a share, and then giving the executive 200 shares (instead of 100) to compensate him for the fact that his $10 options are at least temporarily worthless. Now when he exercises those shares, he not only doesn't feel common shareholder's pain--he's profited from it. His net profit will be three times larger--$3,000. (Market price of $20, minus his $5 cost, multiplied by 200 shares.) And that assumes that the original grant expires worthless. If not, his profit is four-times higher, or $4,000.

Until a few years ago, in fact, companies habitually "repriced" executive stock options the moment stock prices fell, giving executives guaranteed profits for doing nothing more than getting the company back to ground zero. Regulators objected to the practice, so companies changed strategies and instead of "repricing" they just issue more shares.

Anderson, a long time critic of sky-high executive pay, says the report provides further evidence that pay caps are necessary to reign in greedy executives.

Charles Tharp, executive vice president for policy at the Center on Executive Compensation, disagrees, saying that arbitrary caps often do more harm than good. CEC, which represents the human resources divisions of 65 large companies, posts an eight-point "best practices" compensation guide on its web site, but also doesn't support an effort to allow shareholders an annual vote on executive pay.

The financial institutions providing the biggest windfalls to executives, according to the IPS report included JP Morgan Chase ($20.6 million); American Express ($17.9 million); PNC ($17.9 million); Capital One ($16.3 million); SunTrust ($7.9 million); and Wells Fargo ($6.2 million).

Notably, the Obama Administration's Special Master for Executive Compensation, Kenneth Feinberg, is now reviewing compensation packages for the institutions that received the lion's share of TARP funds. Officials in his office note that all compensation, including bonuses, golden parachutes, luxury expenditures and other forms of payment will be examined. TARP also authorizes Feinberg to consider whether the government should seek repayment of amounts paid prior to the law's enactment--a provision referred to as a "clawback." He launched this review at the beginning of September and has vowed to stay mum until the review is complete at the end of October.

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