Mortgage exec incentives face increased federal, industry scrutiny

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

from the April 17, 2008 edition

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The debacle is a recipe for shareholder discontent at corporate annual meetings. Details on executive pay are typically released at the same time as corporate financial results.

"There's an outrageous disconnect between pay and performance," Nell Minow, an investor advocate at the Corporate Library, said at the recent congressional hearing at which financial CEOs appeared .

"It takes a village to create this kind of disaster," she said. "But certainly these people are a part of it, and certainly the pay created perverse incentives that poured gasoline on the fire."

The pay schemes at several companies – notably Merrill Lynch and Citigroup – allowed chief executives to reap huge pay packages even while overseeing a share-price plunge that cost them their jobs.

The AFL-CIO this week began unveiling details on financial-industry pay packages on its website, www.paywatch.org. By the labor federation's analysis, executives reaped big gains from short-term results, while being insulated from negative consequences of the mortgage crisis.

One large lender, Washington Mutual, has seen its stock price plunge by about 70 percent, yet its board recently moved to shield top-executive bonuses from being affected by the loan losses, according to Proxy Governance, a shareholder advocacy group.

Against this backdrop, Proxy Governance predicts growing investor support this spring for tighter reins on executive pay.

Mr. Ellig, the boardroom adviser, suggests that directors should tie managerial pay to company performance over long periods, such as five-year spans. He adds that just as directors have oversight of managers, shareholders should have greater oversight of directors – their election and their pay.

Regulators, meanwhile, may overhaul some of the mechanics of the mortgage business. The Federal Reserve is gathering comments on new rules it proposed in December. Mortgage brokers would have to disclose more clearly how they are paid and reduce reliance on bonuses called "yield spread premiums." Critics say those premiums result in some consumers getting high-rate loans when they could qualify for lower interest rates.

For now, the hard times at corporations provide an impetus for rethinking incentives.

One example is the credit-ratings business. Critics complain that, although these companies have codes of ethics, they get their fees from the companies whose securities they rate. Firms such as Moody's and Standard & Poor's gave many mortgage securities high grades – which in hindsight proved to be overly optimistic.

Many at the ratings firms reject the idea that their failings were the result of flawed incentives. But whatever the causes, the ratings firms face a big loss of confidence among clients.

"The rating agencies themselves have an incentive to figure out what went wrong," Mr. Rajan says.

Huxley Somerville, a spokesman for Fitch Ratings, says his firm has been discussing the problem with investors, "getting their viewpoints."

Part of the answer may involve investors' own behavior. In the wake of the mortgage losses, they no longer want to buy convoluted securities where the risks are hard to analyze. Vanilla may become the most popular flavor for future mortgage securities.

"It's not going to be as complex as it was this time last year," Mr. Somerville says.

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