Mortgage exec incentives face increased federal, industry scrutiny

As the Federal Reserve promotes reforms, investors also call for change.

By Mark Trumbull | Staff writer of The Christian Science Monitor

from the April 17, 2008 edition

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The financial industry faces growing pressure to change the pay incentives that helped stoke a great mortgage boom and bust.

The surge in subprime lending was rooted, experts say, in fees and bonuses that made it profitable for Wall Street firms to focus on the quantity, not quality, of loans.

Now the pay issue is coming into focus on several fronts:

• The Federal Reserve has proposed new lending rules that include some limits on how mortgage brokers are paid.

• Investors, at corporate annual meetings this month, are urging reforms that could affect executive pay.

• The credit downturn itself creates a powerful motive for companies to better align their incentives for long-term success.

How much will actually change? The answer depends partly on how the economy fares in what could be a year of recession.

"If it gets really bad, the nature of the inquiry could be unbounded," says Raghuram Rajan, a finance expert at the University of Chicago.

New regulatory guidelines for mortgage lenders appear all but certain.

Congressional legislation is also possible. In a sign of their concern, lawmakers recently called several mortgage-related chief executives to face a grilling about their pay.

Changes by marketplace participants may be the most important, since a central problem defies one-size-fits-all regulation. The challenge is how to define "performance" in an era of performance-based pay: Over what time frame is achievement measured, and with what weight on managing risk as well as pursuing rewards?

Treasury Secretary Henry Paulson put it bluntly last month when he announced a package of financial market reforms.

"The ultimate success of any CEO is largely determined by the answer to one question: Do we have the right people in the right jobs with the right incentive structure?" he said. The proposals included a role for regulators. But Mr. Paulson said that "the markets … will ultimately sort this out."

The housing boom and bust had a number of causes, some of them unrelated to formal pay practices. On the part of consumers, for example, many home buyers simply saw housing as a better investment than the stock market.

But financial firms also saw subprime lending as a chance to earn big fees. During good times, few of the loans went into default. And the trend toward securitization (packaging new loans for resale as bond-like investments) allowed companies to generate still more fees while selling the loans – and a portion of their default risk – to other investors.

"They saw this as an opportunity for increasing return for shareholders, and for executives [to get] bigger bonuses," says Bruce Ellig, a New York consultant to corporate boards of directors. "I don't think the boards ... really understood the degree of risk they were taking."

But now the industry – and the whole economy – is paying a price as loans go bad.

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