Today, the House Committee on Financial Services held a hearing on compensation in the financial services industry. Testifying before the Committee were:
- Lucian Bebchuk, Professor of Law, Economics and Finance and Director of the Program on Corporate Governance at the Harvard Law School
- Nell Minow, Editor and Co-Founder, The Corporate Library
- Joseph Stiglitz, University Professor of Economics, Columbia Business School
In a heated exchange between Chairman Barney Frank (D-MA) and Ranking Member Spencer Bacchus (R-AL), Rep. Bacchus said that he was disappointed by the Committee’s refusal to allow Edward DeMarco, Acting Director of the Federal Housing Finance Agency (FHFA, formerly the Office of Federal Housing Enterprise Oversight), to testify, as a minority party witness, before the Committee, to respond to questions regarding the December 24 announcement regarding bonus decisions at the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Chairman Frank replied that this hearing concerned private sector entities, and Fannie Mae and Freddie Mac were effectively public sector entities, which would be dealt with in a later hearing in February. He also indicated that “the committee will be recommending abolishing Fannie Mae and Freddie Mac in their current form and coming up with a whole new system of housing finance.”
Mr. Bebchuk began his testimony by reviewing the incentives for risk-taking in standard compensation arrangements. Executives, he stated, are rewarded for short-term results even when those results were subsequently reversed. As a result, executives are incented to pursue goals which may provide short-term successes even if those successes later result in a crisis to the firm. He reviewed the compensation structures of firms that later failed, specifically Bear Stearns and Lehman Brothers, and found that the top-five executive teams at these firms cashed out large amounts of performance-based compensation during the 2000-2008 time period, and that this bonus compensation was not “clawed back” when the firms collapsed. He estimated that the top executive teams of Bear Stearns and Lehman Brothers derived cash flows of about $1.4 billion and $1.0 billion, respectively, from cash bonuses and equity sales during the 2000-2008 time period.
Equity compensation, Mr. Bebchuck argued, should be linked to performance; however, it is desirable to separate the time that equity-based compensation can be cashed out from the time that it vests, and suggested five years was a reasonable period of time to “block” cashing out of equity incentives. Executives should also be limited to cashing out in any given year only a specified fraction of the portfolio of equity incentives held, for example, no more than 20%.
Mr. Bebchuk then suggested the following design features for a model compensation program:
- Equity awards should be made on pre-specified dates and not discretionary
- Terms and amount of post-hiring equity awards should not be based on the grant-date stock price
- Cash outs from restricted stock or options should be tied to the average price of stock over a reasonably long period of time
- Executives should not be permitted to use financial instruments to “hedge” against the equity-based awards the receive
Ms. Minow began with a comparison of the $1.5 billion loan guarantee given to Chrysler in 1979 and federal intervention in the current financial crisis. Lee Iacocca, then-CEO of Chrysler, received a $1 per year salary and escalated stock options that would be valueless absent a substantial increase in the stock price. She contrasted that arrangement with compensation in the current crisis, in which management teams have limited downside exposure and are receiving compensation that is effectively funded with federal funds. She reviewed a series of financial institutions in which equity awards were granted to executives at historically low prices in the late summer and fall of 2008. She termed such grants “mega-grants” and noted that each stock had risen in value, resulting in considerable profits to executives.
Ms. Minow suggested the following features for a model compensation program:
- Indexing options and stock grants to specific performance goals
- “Clawbacks” of bonuses to ensure any adjustments in financial reports would result in an adjustment of the bonuses
- Incentive compensation based on more than one performance metric
- Incentive compensation measuring performance over at least a year or more
- Long-term performance-based compensation comprising the majority of total compensation
Mr. Stiglitz began by noting the enormous presence of the financial industry as a percentage of corporate profits, stating that it garnered over 40% of all corporate profits in the years before the crisis. He accused the financial industry of badly managing risk and misallocating capital to the point of a collapse of the economy’s payments mechanism. He acknowledged that some parts of the financial system, for example, venture-capital firms, performed admirably and even served as a check on the poor performance of other firms. He noted that the capital allocated to asset backed securities could have been used to finance new investment that would have increased the longer-term productivity of the economy; however, in his view this misallocation resulted in venture-capital firms scaling back their investments, resulting in the dynamic parts of the U.S. economy being without necessary capital.
Mr. Stiglitz noted that the losses created by the recent financial crisis were greater than the cumulative profits in the four years preceding the crisis, and therefore from a long-term perspective, the profits (and consequently the performance of the top executive teams) were negative. He also noted the “negative externalities,” or the broader impacts, of the financial crisis on other sectors of the economy and on homeowners, retirees, workers and taxpayers.
Mr. Stiglitz emphasized the link between incentives and executive compensation. The prevailing compensation structure in the financial industry created incentives to engage in excessive risk taking and leverage, and distorted executives’ behavior by encouraging deceptive accounting and financial models with poor assumptions that were not rigorously questioned. He argued that these flawed incentives not only encouraged short-sighted behavior and poor quality of the financial products created, but also distorted accounting standards and misallocated capital. Finally, he noted that the compensation system did not even achieve its goal of “pay for performance,” since pay was high not only when performance was good but also when it was poor.