Fannie Mae: the implied story, Part 2: Maximizing executive bonuses
[For the introduction, see Part 1.]
[Quotes in green are from the OFHEO report (full document, .pdf), on which Fannie Mae declined to comment. Sentences are occasionally reformatted (bullets, boldface emphasis, inconsequential brief elisions) for clarity.]
Every melodrama needs a villain, and OFHEO leaves no doubt at whom its finger points:
When Franklin Raines became Chairman and Chief Executive Officer (CEO) of Fannie Mae in 1999, he sought to lead
As we will see in Part 3, “core business EPS” is a defined term that Fannie Mae defined very counter-intuitively — and favorably for management.
Under Mr. Raines, executive compensation was revamped into three rings, each of which touched more employees, all of which focused on that critical measure: core business EPS.
Under the executive compensation program, senior management reaped financial rewards when Fannie Mae met EPS growth targets established, measured, and set by senior management itself.
Beyond the basic package of salary and benefits, three components of compensation depended directly on reaching EPS targets. Page 5.
The outer ring was most inclusive, and had the longest cycle, maturing in 2003 after five years’ energy and effort:
1. The EPS Challenge Grant, a company-wide program championed by Franklin Raines that tied the award of a substantial amount of stock options to the doubling of core business EPS from 1998 to 2003. Page 5.
Thus everyone in the company was motivated to double core business EPS over a five-year period. Nothing intrinsically wrong with that.
“Not that there’s anything wrong with that!”
In 1999, Mr. Raines set a goal to double Fannie Mae’s EPS within five years, from $3.23 in 1998 [Itself botoxed! -- Ed.] to $6.46 in 2003. Mr. Raines’ goal and the related EPS Challenge Option Grants intensified the focus at Fannie Mae on the achievement of EPS targets and reduced attention to other objectives. Pages 3-4.
Indeed, OFHEO is judicious that the goal by itself was only one step, by itself not all-corrupting:
Earningssssssssss per sssssssssshare …
It is clear the corporate culture at Fannie Mae under Franklin Raines focused intensely on attaining EPS goals. Without an element of impropriety, such goals are appropriate and are typical goals for corporations. Improving shareholder value is one of the primary goals for any board of directors, and increasing EPS is a recognized way to improve shareholder value. Page 43.
But the Ring of Earnings, says OFHEO, worked its will:
A problem arises, however, when a goal becomes so dominant that an organization is driven to achieve it at any cost and through any means necessary. That was what happened at Fannie Mae. Page 43.
“I can feel how to grow earnings per share.”
Next came extra incentive for group leaders:
2. The Annual Incentive Plan (AIP), under which by 2003 more than 700 employees were eligible for bonuses. Page 5.
As we shall see, the Annual Incentive Plan was tied very specifically to meeting very precise yearly earnings targets which were set and then reset each year by Messrs. Raines, Howard, and the senior leadership. And what motivated them? Beyond the AIP and challenge grants, top management received an even larger special bonus:
3. The Performance Share Plan (PSP), which granted stock to the 40-50 senior executives based on 3-year performance cycles. Page 5.
If you want to motivate the troops, pay them well:
The AIP bonus pool grew from $8.5 million in 1993 to $65.1 million in 2003. Page 5.
In other words, AIP bonuses grew to average $90,000 per employee — enough to make you notice when bonus time rolled around.
Bonus awards for senior executives often totaled more than annual salary.
As befits a CEO, Mr. Raines was the best paid of all, reaping over $20 million annually in good years.
For senior executives, EPS-driven compensation dwarfed basic salary and benefits. Page 5.
The system worked:
“Now that I’ve got your attention, double-oh-seven.”
Fannie Mae’s corporate culture was intensively focused on attaining EPS goals. Decisions by Mr. Raines shortly after he became CEO in 1999 set an inappropriate tone at the top that permeated the
‘Magic bullets’ and ‘piggy bank’, as we shall see, refer to earnings management tools (to come in Part 5) that could be gamed (to come in Part 3) if by misfortune the basic turbocharged engine sputtered (Part 4). These tools were used:
The message from Mr. Raines was clear: EPS results mattered, not how they were achieved. In the following years, time and time again, Fannie Mae employed last-minute adjustments that enabled it to meet its EPS target, whether on a quarterly basis to meet analysts’ expectations, or on an annual basis to meet compensation targets. Page 3.
People so motivated could — and, in OFHEO’s view, did — let their personal financial interest sway their judgment, even when their job description required them to be disinterested whistle-blowers:
“We are completely unswayed by management’s latest pronouncements.”
Most inappropriately, Mr. Rajappa, Senior Vice President for Operations Risk and head of Fannie Mae’s Office of Auditing, the corporate financial watch-dog gave a speech to his internal auditors which encapsulated the tone at the top and corporate culture of Fannie Mae under Mr. Raines’ stewardship. Pages 3-4.
Indeed, the excerpt does not do justice to Mr. Rajappa. Here are his actual words:
“By now every one of you must have 6.46 branded in your brains. You must be able to say it in your sleep, you must be able to recite it forwards and backwards, you must have a raging fire in your belly that burns away all doubts, you must live, breathe, and dream 6.46, you must be obsessed on 6.46.
“After all, thanks to Frank, we all have a lot of money riding on it.
“We must do this with a fiery determination, not on some days, not on most days, but day in and day out, give it your best, not 50%, not 75%, not 100%, but 150%. Remember, Frank has given us an opportunity to earn not just our salaries, benefits, raises, ESPP, but substantially over and above if we make 6.46. So it is our moral obligation to give well above our 100%, and if we do this, we would have made tangible contributions to Frank’s goals.”
Page 4, underline in original, boldface added
Recall that this is the organization’s Senior Vice President and head of Fannie Mae’s Office of Internal Audit, the chief referee, and to judge by this quote, its chief cheerleader.
Six — four — six! Six — four — six! Completely unbiased!
In effect, the bait of bonus steak put the watchdogs into contented sleep:
Fannie Mae’s executive compensation program gave senior executives the message to focus on increasing earnings rather than controlling risk.
Senior executives, including the CFO, the Controller, and the head of the Office of Internal Auditing … Page 5.
All of whom, let us be clear, are supposed to be concerned principally with risk management and minimization.
… consistently reminded managers and other employees of their personal stake in meeting EPS targets. Page 5.
And remember, what was that earnings target?
We will return to this in Part 5, where we focus on earnings smoothing.
So the team was on the field, and well motivated, with very large financial incentives of 1, 3, and 5 years’ gestation.
What game were they playing? How would they keep score?
[Continued tomorrow in Part 3.]
