Affordable Housing Institute : US

Those of us of a certain age can recall as if it were yesterday the Watergate hearings, and Senator Howard Baker’s recurring compound question: “what did the President know, and when did he know it?”

 

Say, whatever happened to that lawyer on the left?

 

For Baker and for many, this was more than an exercise in epistemology or hermeneutics, it was the central question on which hung the President’s culpability. 

 

Your President never used big words like those

 

The same question, slightly modified, lies at the heart of accounting, which concerns transactions that involve exchanges of money over long periods of time:

 

What did I earn, and when did I earn it?

 

Accrual-basis accounting seeks to place earnings at points in time different from when cash is actually received.  Take the simplest case: I dig a ditch for you, and you pay me a week later.  When did I earn the money?  When I dug the ditch. 

 

Now the more complex case relevant to housing finance: I borrow $102 from you, which I promise to repay in equal installments over 360 months.  Of this, $2 is a fee I pay you for originating the loan, and $100 is what I use to buy a house, but I am repaying on the full $102, in increments.

 

When did you earn the $2?

 

Before you answer, let’s go back to our ditch-digger for a moment.  Suppose I dig the ditch, and you promise to pay, but a week later you abscond, and I am never paid.  Did I earn the money when I dug the ditch, then un-earn the money when you defaulted?

 

I got the cash, and you’ve got the risk!

 

That, in financial terms, is the conundrum of accrual-based accounting that underpins so much of the agency risk motivation of originators, lenders, and other subprime dramatis personae, as chronicled in The Wall Street Journal:

Deal Fees Under Fire
Amid Mortgage Crisis

Guaranteed Rewards
Of Bankers, Middlemen
Are in the Spotlight

 

I love Journal headlines, they have a Burma-Shave-meets-tanka quality suitable for reading in individually calligraphed poles at eighty miles an hour.  Doesn’t it sound zen?

 

 

When then, grasshopper, is the sound of a loan not being repaid?

 

Grasshopper, you will come to learn the value of ‘residuals’

 

To understand a root cause of the financial crisis shaking global markets, take a look at Kevin Schmidt’s paycheck.

 

Mr. Schmidt arranges mortgages in Shreveport, La. He earns his money upfront, taking a percentage of each loan once papers are signed. “We don’t get paid unless we can say YES” to loans, his firm’s Web site says.

 

The problem, which Mr. Schmidt says he sees clearly: Brokers have little incentive to say “no” to someone seeking a loan. If a borrower defaults several months later — as Americans increasingly are doing — it’s someone else’s problem.

 

I’ve posted many times about the agency risk of purely contingent motivation numerous times, starting with Who works for whom?

 

At every level of the financial system, key players — from deal makers on Wall Street and in the City of London to local brokers like Mr. Schmidt — often get a cut of what a transaction is supposed to be worth when first structured, not what it actually delivers in the long term. Now, as the bond market wobbles, takeover deals unravel and mortgages sour, the situation is spurring a re-examination of how financiers get paid and whether the incentives the pay structure creates need to be modified. This week, Congress asked three prominent executives to testify about their pay packages.

 

The Journal then provides a marvelously compact time-moves-left-to-right chart showing the payment stream, and who walks away from the table, with cash in his or her pocket, when:

 

 

Upfront commissions and fees are well established on Wall Street.  Investment banks get paid when billion-dollar mergers are inked.  Firms that create complex new securities are paid a percentage off the top.  

 

That’s not illogical.  Payment is normally rendered when the service is completed and the value is provided.  What is the service performed?  Structuring the transaction, arguing for up-front compensation.  When is the value provided?  When the loan performs, or rather, as the loan’s risk of non-performance diminishes to zero.  So in abstract terms there is a case for payment up front (service performed) and a case for payment over time even if front-ended (risk diminishment).

 

You want interests aligned, but others want something else

 

Meanwhile, there’s a competitive market, and the risk of non-performance goes far beyond the originator’s activity, and into that of the loan servicer or asset manager. 

 

Rating services assess the risk of a new bond in return for fees on the front end.

 

I’ve previously excoriated the rating agencies’ role in this (A Symbiote’s Lot is not a Happy One, a fit in five parts, Part 1, Part 2, Part 3, Part 4, and Part 5), for they get paid a fee up front and have no downstream liability whatsoever.  The only thing they imperil is their brand, and that’s a big amorphous creature which undoubtedly many individuals doubted they could ever harm. 

 

Burnishing the brand

 

Critics argue this system can give people a vested interest in closing a deal, regardless of whether it turns out to be a good idea over time.

 

Yes, of course it can.  It does.

 

Why am I surprised?

 

“It is not clear that existing compensation mechanisms effectively ensure that traders take into account the long-term interests of the bank for which they work — i.e. its survival,” Pierre Cailleteau, the chief international economist for Moody’s Investors Service, wrote in a report released last week.

 

In various forms, a similar pay structure exists at the top of the financial world, where executives can reap lucrative pay packages, even if deals made on their watch later go south.

 

If my deals go south, I’ll still be hanged a rich man

 

Merrill Lynch & Co.’s former chief executive, Stan O’Neal, left in October after the firm’s $8.4 billion write-down.  He didn’t get a bonus or severance, but he retained $161.5 million in previously earned benefits and compensation because he met the age and service requirement for collecting those benefits.

 

I left my bonus over there, but I kept my $161.5 million over here

 

Charles Prince, Citigroup Inc.’s former CEO, lost his job, too. He left Citigroup in November with stock and other compensation valued at the time at $29.5 million, as well as a bonus. He didn’t get severance.

 

Tuesday [January 15, 2008 — Ed.] Citi reported a fourth-quarter loss of $9.83 billion.

 

That’s your problem now

 

Mr. O’Neal and Mr. Prince — along with Angelo Mozilo, chief executive officer of Countrywide Financial Corp., the nation’s largest home-mortgage lender by loan volume — have been asked to testify about their pay packages on Feb. 7 before the House Committee on Oversight and Government Reform.

 

I’ve written about Mr. Mozilo’s personal finances (Get Out Your Hatchets, Parts 1, 2, and 3), and how they have intersected with Countrywide’s fortunes. 

 

“You should plan to address how it aligns with the interests of … shareholders and whether this level of compensation is justified in light of your company’s recent performance and its role in the national mortgage crisis,” Committee Chairman Henry Waxman wrote in similar letters to the three men.

 

Much though there is street-theater entertainment value in watching formerly insulated executives squirm, I have difficulty seeing how Congress’s infinite wisdom is of any use here. 

 

Who are you to tell me I can’t exercise oversight?

 

Management oversight is the province of shareholders and their elected representatives, the board of directors, not Congress.

 

Mr. O’Neal declined to comment. Countrywide declined to comment. Mr. Prince couldn’t be reached for comment.

 

 

If all these executives were overpaid, and have exited stage left, who’s taken the losses?

 

[Continued tomorrow in Part 2.]

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