When did I earn it? Part 2: who took losses?
[Continued from yesterday’s Part 1.]
Yesterday’s post started deconstructing a Wall Street Journal article on executive pay and misaligned incentives by using Senator Howard Baker’s recurring compound question: “what did the President know, and when did he know it?”
Which piece of paper has the objective truth?
We found it was in the interest of these highly compensated executives to report large accrual earnings, even if the cash were to come in later — and this might well be perfectly appropriate, since mortgages are repaid over years and decades. That, in turn, led to an accelerated trading and swapping of stacks of paper that represented slices of the economic returns from other stacks of paper:
The financial world’s pay structures are also at the center of the market for new investment products, which grew rapidly in recent years.
I documented this, at length, in commenting on OFHEO’s report blasting Fannie Mae:
Over and over, the language is extraordinary — unprecedented in my thirty-year career. According to OFHEO (Fannie Mae itself neither confirmed nor denied the findings), the organization was configured to deliver maximum bonuses, with earnings being Botoxed to look better:
“Fannie Mae’s executives were precisely managing earnings to the one-hundredth of a penny to maximize their bonuses while neglecting investments in systems internal controls and risk management,” Lockhart said. “The combination of earnings manipulation, mismanagement and unconstrained growth resulted in an estimated $10.6 billion of losses, well over a billion dollars in expenses to fix the problems, and ill-gotten bonuses in the hundreds of millions of dollars.”
Earnings just kept rising!
What’s interesting, as the Fannie Mae scandals were overtaken by events and the general subprime mess, is how the Fannie Mae “arrogant and unethical corporate culture” (to quote OFHEO) presages what we have seen on Wall Street:
Maximizing executive bonuses. Fannie Mae’s senior management sought to maximize their personal bonuses through a deliberate strategy that permeated all aspects of the company’s operations.
This chapter reviews the emergence of Fannie Mae’s corporate culture, improper earnings management under Franklin Raines, the business strategy senior management developed to meet earnings targets, how senior executives defended Fannie Mae’s image, and the inappropriate “tone at the top” set by the Board of Directors and the highest level of senior management. Page 34.
Gaming the bonus formula. Management selected a bonus metric, Earnings Per Share, that could be gamed (manipulated for favorable effect) and was gamed.
How do I maximize my results?
Under the Fannie Mae executive compensation program, senior management reaped financial rewards when the
While companies typically link the compensation of their executives to firm performance, relying heavily on one accounting-based measure such as earnings per share is problematic. Academic literature and practical experience suggests that when such a linkage exists executives can and do act aggressively to maximize their compensation by making accounting adjustments. Page 5.
The same thing happened up and down Wall Street:
Wall Street came up with ways to repackage mortgages and other debts into securities that could be traded much like regular bonds. These, in turn, could be sold to new clients — such as mutual funds — that would have had little appetite for the original debts.
It enabled financial houses to sell off mortgages and other debts that previously might have remained on their own books. This meant the people who originated the loans often didn’t have much of a direct financial stake in whether the loans are eventually paid off.
I sold you the ticket, I saw you on the plane — do I also have to care whether you got to your destination?
What are you worried about?
It says right on the book, To Serve Man
“As soon as you’re out of the deal, you’ve made your profit,” says Rep. Paul Kanjorski (D., Pa.), who heads a House subcommittee overseeing markets.
It’s a cookbook!
The new securities are tradable, so they can routinely be sold to others. That has led to the revival of an old one-liner on Wall Street: “A rolling loan gathers no loss.”
Earnings, baby
Financial innovations like these helped spur the lending boom of recent years, by spreading risk more broadly. Along the way, they also boosted profits for Wall Street firms, which typically pocketed fees of around 1% on certain securities they underwrote, to the tune of hundreds of millions of dollars.
Some say the compensation of deal makers should be tied to the long-term performance of their deals. In November, a high-profile panel issued a report — known as the Geneva Report — calling on governments to consider requiring financial firms to hold on to some of the bonds they issue that are backed by loans they made.
Banks — including investment banks — are regulated and required to maintain some capital on their balance sheets. Extending this to require them to hold a piece of their own securities — to take their fee in their own product, rather than in cash — is perfectly logical, and helps align interests by assuring that they get paid when the security holders get paid.
The panel that authored the report, published by two European think tanks, included Roger Ferguson, former vice chairman of the Federal Reserve and now head of financial services with Swiss Reinsurance Co.
On Nov. 19, Swiss Re said it faced an $876 million after-tax loss due to subprime-mortgage-related holdings.
They should clearly know what to look for!
Agency risk and incentive alignment make sense not just at the level of companies vis-a-vis other companies, but with executives within companies.
Some Wall Street firms are taking steps to tie compensation to longer-term performance. Senior traders at Credit Suisse, for example, set aside part of their compensation — the firm declines to say how much — for a number of years. That can be taken back to cover losses in future years.
Keep that on deposit with us, okay?
“We have put in place compensation programs that ensure that our peoples’ interests are directly aligned with our shareholders over a multiyear horizon,” says Brady Dougan, Credit Suisse’s chief executive.
Still, there are significant obstacles to change. While banks may want to curb risky pay incentives, they don’t want to discourage risk taking altogether. Nor do they want to lose top producers to firms offering richer packages.
Erosion of standards is a continuing challenge in competitive markets. The only pure defense, a cartel, has its own problems. In short, conflicts of interest must be managed, because they can never be eliminated.
In good times, the pressure to abandon such restrictions could intensify, the Moody’s report noted. “A recent policy announced by several banks to cap wages at a ‘moderate’ level and pay the rest of the compensation in the form of stock is an acknowledgment of this problem. However, such ‘good intentions’ do not generally survive a boom period, and in any event typically have unintended consequences of their own,” the report said.
What happens when you impose unilateral price and consumption controls
The Federal Reserve, which oversees the
I’m for this. Just as a doctor has a duty to prescribe in the patient’s interest, and a trustee has a fiduciary duty to represent his clients, a lender — an expert — has, in my view, a duty to convey his expertise and fully inform the client. Wise ones do this as part of building and maintaining their reputations. Making it mandatory is perfectly legitimate.
Mr. Schmidt, the
360-degree review isn’t a bad idea at all — but the scorecard has to be updated over time, because things that start well can end badly, and vice versa. Then there’s another problem:
Mr. Schmidt, who with his wife runs a four-person mortgage-brokerage shop, says it’s impossible for him to know what percentage of the loans he brokered have soured, because of rules that protect borrowers’ privacy.
All right, then how are we gonna fix this?
We’re gonna cross the cash flow streams, that’s how
[Concluded tomorrow in Part 3.]
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