Reference no: EM132297436

HERDING , RPE AND THE 2007–2008C REDIT CRISIS

One of the clearest examples of how random factors can affect measured performance comes from the very top of most organiza-tions. Pay for top executives like chief execu-tive officers, chief operating officers, and chief financial officers is frequently tied directly to the price of the firm’s stock through grants of equity or equity-based instruments such as stock options. The theory of financial markets suggests that the price of a firm’s stock will move up or down for a variety of reasons. Share prices are clearly affected by any news bearing directly on the firm’s future cash flow, but they are also affected by overall movements in the market. For example, during the late 1990s a major bull market pulled all U.S. share prices up by 25 percent or more annually. Even mediocre firms saw great gains in their share prices over this period. Similarly, the declining stock mar-ket during 2001 to 2002 saw nearly all firms’ share prices fall—even those of firms with good operating performance over the period. As a result, some analysts believe that a better performance measure might be the firm’s per-formance relative to competitors or market indices. Jeff Zwiebel argues that while relative performance evaluation has some benefits, substantial costs are present as well. 18 Zwiebel notes that relative performance evaluation could encourage “herding.” Herding is a phenomenon whereby individuals ignore their own information about the best course of action and instead simply do what every-one else is doing.Zwiebel’s argument is this: Suppose a manager is likely to be fired when her firm’s performance is poor relative to industry rivals but will keep her job otherwise. Suppose also that the manager faces the following strategic choice: she can “follow the herd” by making strategic choices that are similar to those made by competitors, or she can adopt a new, prom-ising, but untested strategy. Following the herd means the manager’s performance is unlikely to be much different from that of rivals, and so she is unlikely to be fired. The contrarian strategy has a higher expected pay-off than the herd strategy, but its newness means that there is at least some chance it will fail. If the contrarian strategy fails, the firm’s performance will lag the industry, and the manager will be fired. Under these conditions, the manager may well stick with the herd, even if she knows the potential returns to the con-trarian strategy are high. As we noted at the start of this chapter, Merrill Lynch CEO O’Neal seems to have been comparing his firm’s trading performance to that of rivals. One reason for his insistence on matching Goldman may have been that his continued job security depended on achieving earnings similar to Goldman’s. Could this form of rela-tive performance evaluation have led to herd-ing on Wall Street? It is difficult to say for sure, but it is clearly the case that many, many financial institutions were actively involved in financing risky subprime mort-gages. As housing prices rose through the late 1990s and early 2000s, mortgage default rates stayed low and these risky investments paid off handsomely. Any firm choosing not to play this risky game would show poor relative performance. Managers of such firms might begin to feel the heat from sharehold-ers, as Zwiebel suggests. Any manager with the contrarian strategy—taking, say, a short position in the subprime mortgage securities, betting that default rates will rise—would have incurred losses through the 2000 to 2006 period. But this strategy would have earned huge profits as house prices fell and the subprime mortgage market implod-ed in 2007. Would a contrarian manager have kept her job long enough to earn those profits? Or would the poor relative performance between 2000 and 2006 have led to that man-ager’s firing?

Give a brief synopsis of the example.

Demonstrate how this example can be applied to another business situation not mentioned in the text.