Rush just proved himself wrong, ( but for the right reasons)

one man's opinion....

[ken5050]

In a most excellent rant against Sen McCain, Rush correctly explained the the dramatic rise in the use of stock options began after the 1993 Clinton tax bill, which limited the amount of deductible compensation corporations could pay to their top executives. Spot on. Being ingenious, businesses found a way around the rule. They began giving the top execs most of their compensation in stock options. Which is why the option grants should, and must, be expensed at the time of issue.

[ken5050]

Options grants ARE compensation, and should be expensed when isued. It's a basic tenet of accouting fairness. Rush is absolutely correct that doing this will devastate the markets. I wrote this after Bush's speech, that was remarkable in it was what wasn't said, i.e. the need to expense option grants as compensation.

If forced to do so, Microsoft and Dell, to name two examples, would see most of thir earnings wiped out for the last decade.

Nevertheless, if you want to clean up the abuses in the financial marketrs, and there are a great many, you have to deal with the problem of not expensing options, which is one of the root causes of all the financial shenanigans. If you have a leaky roof, temporary patches may solve some of the problems, but you know for sure that the only way to fix it is to replace the whole roof, indeed, NOT to do so will be far more expensive in the long run.

So Rush, while you are correct that the Dems would like to implode the markets to help them in this fall's election, that doesn't make it the right thing to do, but rather the political choice, for now.

BTW, all the Dems efforts will be for naught. We will take out Iraq this fall, the GOP will pick up seats in the House, and retake the Senate. Then, after the election, look for Bush to propose that options be expensed. That will tank the markets, but then they'll start to recover nicely, right up to the 2004 election. So, stocks probably aren't the place to be till mid 2003, at the earliest.

[Thane_Banquo]

Rush is absolutely correct that doing this will devastate the markets.

Not necessarily. Many asset managers already know about this accounting loophole, so the market may have discounted the issue already, since the market knows that these options are really expenses.

[Oldeconomybuyer]

Heard Rush, and your observations are interesting. Thanks.

[BillM]

How are they a current expense?

[razorback-bert]

If my dividend is cut, because more shares are dividing the earnings, this is not a hit on earnings?

Oh yea, it doesn't matter, since most of these companies are not paying dividends.

[Illbay]

"The market is always right." That's another slogan Rush often utters.

[Alberta's Child]

I'll take it one step further:

The combination of the 1993 income tax hikes and the 1995 capital gains tax cuts resulted in an enormous "spread" between top the income and capital gains tax rates (39% vs. 20%). This effectively served as an incentive for high-ranking company executives to use their stock portfolios as a means of reducing their tax liability. An executive with an adjusted gross income of $10 million, for example, could save himself $1.9 million in taxes by converting that income to a capital gain.

In my opinion, the later tax bill (1997, I believe) that reduced the minimum "holding time" of an asset from 18 to 12 months (any capital gain on an asset that was held for less than this time was taxed at the same rate as the seller's income tax rate) only made things worse. It meant that a company executive only needed to keep his house of cards standing for 12 months in order to cash out.

It's also worth noting, BTW, that this "spread" between the income and capital gains tax rates is precisely what drove the entire economic boom of the late 1990s. The strongest areas of the economy in that period were those with the highest potential (at least the highest perceived potentual) for long-term capital gains -- growth stocks and real estate.

I'd love to see if anyone here has seen this kind of assessment published anywhere else. At the risk of sounding arrogant, this all came from inside my head and I'm not even an economist.

[Thane_Banquo]

That's another way of putting it. I was referring to Efficient Market Theory, which holds that for perfectly efficient securities markets, like the U.S. large cap stock market, all news outstanding will immediately be reflected in the price of the stock. I'm arguing that the market already knows options deplete a firm's cash position, so they already price it into the stock. So I don't think the market would tank if the SEC required options to be expense in financial statements.

[Frumious Bandersnatch]

Then what happens to those options that are not exercised?  Is it fair to expense them?

Options are only exercised if they rise above the strike price.  The exercising of them will affect the stock price (though quite often, this is not noticeable) as now the supply of stock has (in many cases) increased - thus diluting the company's equity.  But what about those cases where options are covered up front by treasury shares?

Stock options by themselves are valueless.  They are merely promissory notes to sell shares to the holders at a certain price.  How are you going to determine fairly what is the value of the options?  Are you going to use the current price of the stock?  That's not fair for several reasons.  One of which is that stock, by it's very nature is volatile, and can go up or down.  So the options may never be exercised.  Also, one can quite often buy options to long or short the market for a fraction of the cost of the actual stock itself.

[RAT Patrol]

No need to worry about arrogance. You deserve a pat on the back for that one.

[razorback-bert]

Most shareholders — that is, the vast majority of the public that buys stock on the market — have the potential for loss as well as gain. With an option, the potential for loss is quite small; if the share price falls below the option price, the option simply becomes worthless. But the potential for gain is huge. The asymmetry encourages executives to downplay risk, if not ignore it, in the quest for returns.

That is why the 90's produced burdensome excess capacity in many industries, especially telecommunications and the technology industry, where option awards are most common. For executives, it made sense to go for broke with expansion plans. Big option payoffs came only with rapid growth, not with steady earnings.

So what can be done? There can be no real reform without honest accounting for stock options. A decade ago, the Financial Accounting Standards Board recommended that options be counted as a cost against earnings, like all other forms of compensation, but corporate lobbyists resisted and Congress did their bidding. Alan Greenspan and Warren Buffett, among others, are calling for the same change now, but it remains to be seen whether the accounting profession can act without Congressional interference. Treating options like other forms of pay would make executive compensation transparent, diminish the temptation to cook the books and make managers less inclined toward excessive risk-taking.

The president's speech, unfortunately, was not as strong as it should have been. And whether Congress is up to the job of reform is questionable. It may fall to investors — individuals and institutions — to force the necessary change.

Walter M. Cadette, a senior scholar at the Levy Institute of Bard College, is a retired vice president at J.P. Morgan & Company.

[Illbay]

I am nothing like a market expert, but I've noticed that my not getting much involved in it means that I'm always skeptical about it.

I remember having a conversation with folks in my office, who were comparing their portfolios to see whose was the biggest. I just made the comment "all these incredible tech-stock returns are a fluke. They go against the historical record, and there's going to be a comeuppance."

Their response was basically that I just didn't understand how the market had "changed," and how this new tech-heavy world was turning all the rules on their heads.

A year later, the bottom drops out, and they're scrambling to recoup a fraction of their total investments.

To me it was just common sense, but they were blinded by the huge paper profits they saw in their own portfolios.

OTOH, I think the downturn in the market really reflects confusion and mistrust right now, not a TECHNICAL factor. IMO, the market would be in the toilet if the profits were REALLY all gone.

[lepton]

A less painfull step would be to undo the 1993 CEO tax.

[Thane_Banquo]

Posted by Illbay to Thane_Banquo On News/Activism Jul 12 10:55 AM #12 of 13 I am nothing like a market expert, but I've noticed that my not getting much involved in it means that I'm always skeptical about it. I remember having a conversation with folks in my office, who were comparing their portfolios to see whose was the biggest. I just made the comment "all these incredible tech-stock returns are a fluke. They go against the historical record, and there's going to be a comeuppance."

Good call on your part: In economics, if an industry make higher than the going rate of profits, determined as a percentage of assets invested to make the profits, more firms will open in that industry, attracted by the higher profits, until the industry makes exactly the going rate of profits, which is happening right now in the technology industry.

Actually, economists say if an industry makes profits at all it will attract new firms, but they say that because economists calculate profits much differently than accountants do. You make profits if your return on investment is greater than the going rate. You make no profits if you are making just the going rate of return on your investment, and you are losing money if you make less than the going rate of return. In all three cases, however, you can be making accounting profits (Revenues greater than expenses).

[Southack]

All expenses are already legally required to be on a corporation's accounting books.

Even stock options under the rules of today, when they are exercised, will show up as an expense on a company's books.

The hue and cry to "expense" options prior to the options being exercised is merely an attempt to pre-emptively guess at the future value of them.

But if one knew the future value of options, then one would get quite rich trading options on Wall Street.

Most options will expire worthlessly. A few options will end up with some small value, and a rare number of options will be worth fabulous amounts of money.

AT&T Wireless has been issuing stock options to its management for years, but I don't believe that a single AT&T Wireless-issued option has ever been worth a penny.

Why make companies "guess" at whether or not options will be worth something? What's the motivation? How does that fix any corporate accounting problems?

No, it doesn't fix accounting problems, it causes more!

Change the rules so that companies have to "expense" stock options and companies will have to guess at what they will eventually be worth. Invariably their guesses will NOT be the market reality, forcing the company to constantly revise its accounting books.

Such a rule change would force an enormous amount of complexity and sheer guesswork onto an accounting system that needs to be simplified, and guesswork has no place in accounting to begin with. Adding guesswork simply makes our whole accounting problem worse.

But it sounds catchy. Idiot talking heads can parrot "they're not expensing options" and a few uneducated nutballs will believe them.

It's not true, however.

All options eventually show up as expenses on corporate books, it's just that under existing rules companies don't have to guess at what they'll be worth (instead, the market is allowed to price them).

[Maelstrom]

Repeal Clinton's crap should fix the problem too...

If you force options to be expensed not only will the market be devastated, but another loophole will be found...one with perhaps even more severe consequences when it is found out and closed.

[Dog Gone]

The hue and cry to "expense" options prior to the options being exercised is merely an attempt to pre-emptively guess at the future value of them.

That is exactly right, and that's why it baffles me that anyone can even argue that they should be expensed.

And do these people want it take it one logical step further? Should the companies be able to write them off as an expense on their federal income tax? The options don't cost the companies a cent unless they are exercised, but if the companies could take the tax deduction now, gosh, what a deal!

[Frumious Bandersnatch]

Options themselves have no value, so how can you count it up front as a cost against earnings - especially since you have no idea how much it will cost to redeem them (unless they are being redeemed against treasury stock, in which case the entire exercise is moot)?

The problem is not one of options or how they are accounted for, but rather getting honest execs in place.  No matter what you do, dishonest people will find a way to be dishonest.  And the more rules you make, the more ways dishonest people will find to get around them.

Too often, CEOs are hired who have running decent companies into the ground as their only qualifications(see HP for an example of this).  Also salaries of execs are quite often not in the best interest of the company (CEO Michael Eisner and his $500,000,000 salary for example).

An example (among many) of where stock options do work wonders is Lee Ioccocca's turn-around of Chrysler.  He took that job for $1.00/year.  However, he ended up very wealthy because of his stock options.

[Southack]

It's nice to see your posts. Not everyone on FR is dumb-enough to fall for Rush's rants...

[razorback-bert]

Options themselves have no value

Options must have a value, otherwise no one would want them.