Instead of obsessing over how much financial institution executives are paid, Congress and the administration should focus on what they get paid for.
The financial regulatory reform bill that just passed the House does not address compensation structures within financial institutions that reward employees for taking risks that destabilized the global financial system. Congress and regulators should require financial institutions to adopt compensation incentives that avoid systemic risk.
Perverse compensation policies were largely responsible for the origination of the mortgages that experienced shockingly high default rates, inaccurate ratings for mortgage-backed securities and overleveraging of MBS. The results were steep market-value declines of MBS, margin calls on leveraged MBS and markdowns by financial institutions that depleted capital, froze credit and caused rating downgrades that triggered payment and collateral posting obligations under private contracts such as credit-default swaps. Clearly, perverse compensation incentives contributed heavily to the financial crisis.
The first link in the chain leading to the financial crisis was the mortgage lender who paid employees for every mortgage originated even if it promptly defaulted. The lender also paid these employees more for originating high-interest loans even where the borrower qualified for a lower interest rate. This provided incentive for those employees to: help borrowers falsify their credit information, choose appraisers who provided higher values than the homes were worth, ignore red flags indicating that homes were not the borrower's primary residence and lure borrowers into loans they couldn't afford.
Congress and regulators should require mortgage originators to tie employees' compensation to the performance of the mortgages they originate. Bonuses could be paid over three years (most mortgage defaults occur within three years during normal times) and the unpaid portion forfeited in the event the mortgage defaulted due to poor credit underwriting.
The rating agencies were the second link. Fannie Mae, Freddie Mac and bond insurers have collected billions of dollars from mortgage originators because they failed to underwrite mortgages in accordance with stated diligence guidelines. Loan file reviews have revealed that more than 75% of loans violated these guidelines. Why didn't the rating agencies, which had full access to these loan files, discover or reflect these poor underwriting practices in their ratings? Perhaps because compensation was weighted heavily toward revenue production at the expense of accuracy and transparency and because analysts were not adequately compensated nor encouraged to challenge rating methodology, especially where it threatened a major revenue stream.
Had compensation been tied to rating accuracy, would the rating agencies have better adjusted their models for the lack of historical performance data regarding loans that never existed until recently, such as loans with teaser rates that later spike to unaffordable monthly payments, or option loans and negative-amortization mortgages that allow borrowers to skip low monthly payments that are then added the principal amount of the mortgage? Would the increase in appraised values to historic levels have raised concerns about loan-to-value ratios? Would the change in the mortgage business to an originate-and-sell model that involved the retention of little risk have prompted a more rigorous investigation into the originators' internal controls over the conduct of their employees in the origination process?
The SEC should require rating agencies to tie compensation to rating accuracy and transparency as a precondition to Nationally Recognized Statistical Rating Organization status. Moreover, NRSROs should be required to disclose their compensation policies so that failure to follow them would be a basis for liability.
That leads to the last link. Commercial and investment banks leveraged highly rated MBS as high as 35:1 without discovering the mortgage underwriting and rating failures referred to above. It is true that the rating agencies had better access to more data than the banks. But the banks were more sophisticated and had more resources than the rating agencies. So why didn't the banks respond to the red flags raised before 2007, when the crisis began? Again, much of the answer lies in compensation policies, particularly the policy of paying large bonuses based on the prior year's contribution to earnings. Banking regulators should require that bonuses for a given year be paid after the performance of the assets acquired in that year can be measured.
It is arguable that Lehman Brothers and Bear Stearns would not have failed if the mortgages backing the MBS they leveraged had been underwritten by people whose compensation was tied to their performance rather than the dollar volume of mortgages originated. It is likely that those failures would not have occurred if MBS been rated by analysts that were rewarded for rating accuracy and transparency as much as for revenue production, or had the rating agencies paid those responsible for challenging rating methodology as much as they paid the analysts for issuing triple-A ratings that were subsequently downgraded to junk. And perhaps Lehman and Bear would not have failed if their employees' compensation were tied to the performance of the assets they put on the banks' books.
