Executive Compensation and Sub-Prime Mortgage Crisis

The Lehman Brothers collapse was a catastrophe for most people. Shareholders lost their money and so did other investors.

The worst hit group was that of employees who lost their source of livelihood as well as their lifetime savings!

However, this was not the case with Richard Fuld, the CEO aka the top guy at Lehman Brothers. Mr Fuld walked out with half a billion dollars in severance pay. This was after the 900 million dollars that he had received in executive compensation in the seven years preceding the crisis. Apart from that, he also had three massive homes and a ranch!

The disparity between the effects of the crisis being faced by the lower level employees as against the effects faced by top ranking executives like Dick Fuld was apparent to the public. This created an outrage and a debate about executive compensation.

In this article, we will have a closer look at the nature of this executive compensation and how it drove people like Mr Fuld to behave the way that they did. Here are some of the salient features of executive compensation in those days:

High Risk Taking

The executive compensation models at leading investment banks and other financial institutions were very aggressive during the subprime mortgage crisis. Aggressive executive compensations have been linked to financial frauds in the past with cases like Enron and WorldCom.

However, here it was not fraudulent activity that was the concern. Most trades were perfectly legal. However, many Wall Street banks had leverage ratios of 25 to 1 and 33 to 1 on some of their investments. This means that an adverse rating of 4% could have wiped out their capital! It was only the aggressive executive compensation policies in place that lead to such high risk taking.

Banks and other institutions had been highly leveraged and had been making high leverage bets during the subprime mortgage crisis. This can be attributed to the fact that roughly 50% of the profits generated as a result of the trading operations was paid out to the traders. Thus, it was not uncommon for traders to be paid bonuses which were multiples of their original salary! Any survey of the executive compensation prior to the subprime collapse in the US mortgage industry would clearly depict a red flag on the high risk taking culture that was prevalent. The executive compensation trends clearly depicted an institutionalized risk taking

Incentivized Gimmicks

In many cases, the executives at these companies simply changed the accounting policies in order to ensure that the numbers look better. The executive compensation was simply based on the idea of achieving numbers. There was absolutely no attention paid to the authenticity of those numbers or the steps that were taken to reach those numbers. Earnings, valuations and other accounting facts was the only thing that mattered!

Now, these facts can be manipulated based on accounting policies used by the management. In case of subprime crisis, these accounting gimmicks certainly did take place. Many investment banks and other financial corporations have changed their accounting policies in order to bolster up their numbers. A lot of these companies did get sued later and had to pay damages.

However, the interesting thing is that the top executives who authorized the use of such policies did not suffer any repercussions. In fact, most of them were awarded bonuses based on the manipulated numbers!

Immediate Payoffs

Wall Street banks and all other financial institutions had the culture of immediate payoffs in their executive compensation DNA. These companies were not thinking long term. They wanted to retain their executives’ short term by giving them higher bonuses. Consider the case of the profits booked from securitization. These profits are based on cash flows which will occur several years in to the future. At the moment, there is no profit, only a negative cash flow!

The profit numbers are purely fictional and have an off chance of turning into reality. However, the executive compensation is based on these fictional numbers. Future profits are estimated today and payoffs made immediately.

This is a massive problem! This creates a situation where in the management of a company can introduce policies that will make losses in the future. However, they immediately reward themselves and thus the shareholder pays the bill for the losses as well as the massive paychecks!

Golden Parachutes

What is really sickening about the subprime mortgage crisis is the idea of golden parachutes for top executives. Golden parachutes simply mean a very hefty severance pay. In many cases, after receiving a golden parachute, the executives do not have to work and they can simply maintain their lifestyles!

In case of the 2008 bust, golden parachutes were given out to many CEO’s and top ranking officials. The reason why this trend is sickening is because the top executives had the visibility regarding the outcomes of the decisions that they were making. They are the ones that are supposed to be held responsible. They are the ones that should lose the most since they had the most to gain.

However, golden parachutes ensured that the losses of these top bosses were minimized. The suffering was laid upon the lower level workers as they lost their jobs and pension funds even as the culprits walked away with huge benefits in the form of golden parachutes.

Moral Hazard

The word moral hazard became a big buzzword in the media during the subprime financial crisis. Moral hazard simply means that one party will continue doing bad behavior because they know that they are protected from its consequences. Thus, the executive compensation methodology used at these institutions was under fire because it was allegedly creating a moral hazard. The executives had become brazen risk takers. They had everything to gain if the risk turned out well and nothing to lose if it didn’t! Post the subprime crisis, efforts have been taken to solve this agency problem created by the moral hazard built into the executive compensation packages.

Hence, the executive compensation packages were also a big contributor to the subprime mortgage crisis since they induced the top executives in financial institutions to take on huge risks.

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