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.
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 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.